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Slide 16-2Copyright 2003 Pearson Education, Inc.
Chapter Organization
Determinants of Aggregate Demand in an Open
Economy The Equation of Aggregate Demand
How Output Is Determined in the Short Run
Output Market Equilibrium in the Sort Run: The DD
Schedule
Asset Market Equilibrium in the Short Run: The AASchedule
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
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Slide 16-3Copyright 2003 Pearson Education, Inc.
Temporary Changes in Monetary and Fiscal Policy
Inflation Bias and Other Problems of PolicyFormulation
Permanent Shifts in Monetary and Fiscal Policy
Macroeconomic Policies and the Current Account
Gradual Trade Flow Adjustment and Current Account
Dynamics Summary
Chapter Organization
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Slide 16-4Copyright 2003 Pearson Education, Inc.
Appendix: The IS-LMModel and the DD-AA Model
Appendix: Intertemporal Trade and the CurrentAccount
Chapter Organization
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Slide 16-5Copyright 2003 Pearson Education, Inc.
Introduction
Macroeconomic changes that affect exchange rates,
interest rates, and price levels may also affect output. This chapter introduces a new theory of how the
output market adjusts to demand changes when
product prices are themselves slow to adjust. A short-run model of the output market in an open
economy will be utilized to analyze:
The effects of macroeconomic policy tools on outputand the current account
The use of macroeconomic policy tools to maintainfull employment
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6/67Slide 16-6Copyright 2003 Pearson Education, Inc.
Determinants of Aggregate
Demand in an Open Economy
Aggregate demand
The amount of a countrys goods and servicesdemanded by households and firms throughout the
world.
The aggregate demand for an open economys outputconsists of four components:
Consumption demand (C)
Investment demand (I)
Government demand (G)
Current account (CA)
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Determinants of Consumption Demand
Consumption demand increases as disposable income(i.e., national income less taxes) increases at the
aggregate level.
The increase in consumption demand is less than theincrease in the disposable income because part of the
income increase is saved.
Determinants of Aggregate
Demand in an Open Economy
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Slide 16-8Copyright 2003 Pearson Education, Inc.
Determinants of the Current Account
The CA balance is viewed as the demand for acountrys exports (EX) less that country's own demand
for imports (IM).
The CA balance is determined by two main factors:The domestic currencys real exchange rate against
foreign currency (q = EP*/P)
Domestic disposable income (Yd)
Determinants of Aggregate
Demand in an Open Economy
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Slide 16-9Copyright 2003 Pearson Education, Inc.
How Real Exchange Rate Changes Affect the Current
Account An increase in q raises EXand improves the domestic
countrys CA.
Each unit of domestic output now purchases fewer unitsof foreign output, therefore, foreign will demand more
exports.
An increase q can raise or lowerIMand has anambiguous effect on CA.
IMdenotes the value of imports measured in terms of
domestic output.
Determinants of Aggregate
Demand in an Open Economy
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Slide 16-10Copyright 2003 Pearson Education, Inc.
There are two effects of a real exchange rate:
Volume effectThe effect of consumer spending shifts on export andimport quantities
Value effectIt changes the domestic output worth of a given volumeof foreign imports.
Whether the CA improves or worsens depends onwhich effect of a real exchange rate change isdominant.
We assume that the volume effect of a real exchangerate change always outweighs the value effect.
Determinants of Aggregate
Demand in an Open Economy
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Slide 16-11Copyright 2003 Pearson Education, Inc.
Trade Elasticities
Let EX(q) = exports
Let IM(q,Y) = imports (in volume terms, e.g., numberof widgets
Then imports valued in terms of domestic goods
(exports) = q IM(q,Y)
Exports EXrise when q rises (real depreciations)
Import volume IM falls when q rises
So import value q IMmay rise or fall when q rises.
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Slide 16-12Copyright 2003 Pearson Education, Inc.
Trade Elasticities (cont.)
CA(q,Y) = EX(q) qIM(q).
So a rise in q (real depreciation of the home currency)may cause home current account to rise or worsen.
Depends on elasticities of export and import demand
w.r.t the real exchange rate q. Define:
, *q dEX q dIM EX dq IM dq
= =
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Slide 16-13Copyright 2003 Pearson Education, Inc.
Trade Elasticites (cont.)
You can show (see Chapter 16, appendix 2) that thecondition for a real depreciation to improve thecurrent account balance (other things equal) is thatthe elasticities be sufficiently big.
This gives the following Marshall-Lernercondition:
* 1. + >
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Slide 16-14Copyright 2003 Pearson Education, Inc.
Some Empirical Estimates of Trade
Elasticities for Manufactured Goods
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Slide 16-15Copyright 2003 Pearson Education, Inc.
Trade Elasticities (cont.)USD Real Effective Exchange Rate: IMF Measures
70
80
90
100
110
120
130
140
150
1980
1983
1986
1989
1992
1995
1998
2001
2004
Relative CPIs
Relative ULCs
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004*
PercentofG
DP
Current account of U.S.
i f A
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Slide 16-16Copyright 2003 Pearson Education, Inc.
How Disposable Income Changes Affect the Current
Account An increase in disposable income (Yd) worsens the CA.
A rise in Ydcauses domestic consumers to increase
their spending on all goods.
Determinants of Aggregate
Demand in an Open Economy
D i f A
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Slide 16-17Copyright 2003 Pearson Education, Inc.
Determinants of Aggregate
Demand in an Open Economy
Table 16-1: Factors Determining the Current Account
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Slide 16-18Copyright 2003 Pearson Education, Inc.
The four components of aggregate demand are
combined to get the total aggregate demand:D = C(YT) + I+ G + CA(EP*/P, YT)
This equation shows that aggregate demand for home
output can be written as:
D = D(EP*/P, YT, I, G)
The Equation of Aggregate Demand
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Slide 16-19Copyright 2003 Pearson Education, Inc.
The Real Exchange Rate and Aggregate Demand
An increase in q raises CA and D.It makes domestic goods and services cheaper relative
to foreign goods and services.
It shifts both domestic and foreign spending fromforeign goods to domestic goods.
A real depreciation of the home currency raises
aggregate demand for home output. A real appreciation lowers aggregate demand for home output.
The Equation of Aggregate Demand
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Slide 16-20Copyright 2003 Pearson Education, Inc.
Real Income and Aggregate Demand
A rise in domestic real income raises aggregatedemand for home output.
A fall in domestic real income lowers aggregate
demand for home output.
The Equation of Aggregate Demand
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Slide 16-21Copyright 2003 Pearson Education, Inc.
Figure 16-1: Aggregate Demand as a Function of Output
Output (real income), Y
Aggregate
demand, D
Aggregate demand function,
D(EP*/P, Y T, I, G)
45
The Equation of Aggregate Demand
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Slide 16-22Copyright 2003 Pearson Education, Inc.
How Output Is
Determined in the Short Run Output market is in equilibrium in the short-run when
real output, Y, equals the aggregate demand fordomestic output:
Y= D(EP*/P, YT, I, G) (16-1)
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Slide 16-23Copyright 2003 Pearson Education, Inc.
Figure 16-2: The Determination of Output in the Short Run
Output, Y
Aggregate
demand, D
45
Aggregate demand =
aggregate output, D = Y
Aggregate demand
2
Y2
D11
Y1
3
Y3
How Output Is
Determined in the Short Run
k ilib i i h
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Slide 16-24Copyright 2003 Pearson Education, Inc.
Output, the Exchange Rate, and Output Market
Equilibrium With fixed price levels at home and abroad, a rise in
the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goodsand services.
Any rise in q will cause an upward shift in the aggregate
demand function and an expansion of output.Any fall in q will cause output to contract.
Output Market Equilibrium in the
Short Run: The DD Schedule
O k ilib i i h
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Slide 16-25Copyright 2003 Pearson Education, Inc.
Output Market Equilibrium in the
Short Run: The DD ScheduleFigure 16-3: Output Effect of a Currency Depreciation with FixedOutput Prices
Output, Y
Aggregate
demand, D
45
D = Y
1
Y1
Aggregate demand (E2)
Aggregate demand (E1
)
Y2
2Currency
depreciates
O M k E ilib i i h
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Slide 16-26Copyright 2003 Pearson Education, Inc.
Deriving the DD Schedule
DD scheduleIt shows all combinations of output and the exchange
rate for which the output market is in short-run
equilibrium (aggregate demand = aggregate output).It slopes upward because a rise in the exchange rate
causes output to rise.
Output Market Equilibrium in the
Short Run: The DD Schedule
O M k E ilib i i h
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Slide 16-27Copyright 2003 Pearson Education, Inc. Y2
DD
Output Market Equilibrium in the
Short Run: The DD ScheduleFigure 16-4: Deriving the DD Schedule
Output, Y
Aggregate demand, D D = Y
Y1
Aggregate demand (E2)
Aggregate demand (E1)
Y2
Output, Y
Exchange rate, E
Y1
1E1E
2
2
O M k E ilib i i h
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Slide 16-28Copyright 2003 Pearson Education, Inc.
Factors that Shift the DD Schedule
Government purchases Taxes
Investment
Domestic price levels
Foreign price levels
Domestic consumption Demand shift between foreign and domestic goods
A disturbance that raises (lowers) aggregate demand for
domestic output shifts the DD schedule to the right (left).
Output Market Equilibrium in the
Short Run: The DD Schedule
O M k E ilib i i h
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Slide 16-29Copyright 2003 Pearson Education, Inc. Y2
Output Market Equilibrium in the
Short Run: The DD ScheduleFigure 16-5: Government Demand and the Position of the DD ScheduleD = Y
Y1
D(E0P*/P, Y T, I, G2)
D(E0P*/P, Y T, I, G1)
Y2
Output, Y
Exchange rate, E
Y1
Aggregate demand curves
2
Government
spending rises
Output, Y
Aggregate demand, D
DD1
E01
DD
2
A t M k t E ilib i i th
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Slide 16-30Copyright 2003 Pearson Education, Inc.
AA Schedule
It shows all combinations of exchange rate and outputthat are consistent with equilibrium in the domesticmoney market and the foreign exchange market.
Asset Market Equilibrium in the
Short Run: The AA Schedule
A t M k t E ilib i i th
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Slide 16-31Copyright 2003 Pearson Education, Inc.
Output, the Exchange Rate, and Asset Market
Equilibrium We will combine the interest parity condition with the
money market to derive the asset market equilibrium
in the short-run. The interest parity condition describing foreign
exchange market equilibrium is:
R = R* + (Ee E)/E
where: Ee is the expected future exchange rate
R is the interest rate on domestic currency deposits
R* is the interest rate on foreign currency deposits
Asset Market Equilibrium in the
Short Run: The AA Schedule
A t M k t E ilib i i th
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Slide 16-32Copyright 2003 Pearson Education, Inc.
The R satisfying the interest parity condition must alsoequate the real domestic money supply to aggregate
real money demand:
Ms/P= L(R, Y)
Aggregate real money demand L(R, Y) rises when theinterest rate falls because a fall in R makes interest-
bearing nonmoney assets less attractive to hold.
Asset Market Equilibrium in the
Short Run: TheAA
Schedule
A t M k t E ilib i i th
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Slide 16-33Copyright 2003 Pearson Education, Inc.
Asset Market Equilibrium in the
Short Run: The AA ScheduleFigure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Domestic-currency
return on foreign-currency deposits
Foreign
exchange
market
Moneymarket
E22'
R2
E1 1'
R1
Real money
supply
MS
P1
L(R, Y2)
L(R, Y1)
Real domestic money holdings
Domestic
interest
rate, R
Exchange Rate, E
0
2
Output rises
A t M k t E ilib i i th
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Slide 16-34Copyright 2003 Pearson Education, Inc.
For asset markets to remain in equilibrium:
A rise in domestic output must be accompanied by anappreciation of the domestic currency.
A fall in domestic output must be accompanied by a
depreciation of the domestic currency.
Asset Market Equilibrium in the
Short Run: The AA Schedule
A t M k t E ilib i i th
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Slide 16-35Copyright 2003 Pearson Education, Inc.
Deriving the AA Schedule
It relates exchange rates and output levels that keep themoney and foreign exchange markets in equilibrium.
It slopes downward because a rise in output causes a
rise in the home interest rate and a domestic currencyappreciation.
Asset Market Equilibrium in the
Short Run: The AA Schedule
A t M k t E ilib i i th
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Slide 16-36Copyright 2003 Pearson Education, Inc.
Figure 16-7: The AA Schedule
Output, Y
Exchange
Rate, E
Asset Market Equilibrium in the
Short Run: The AA Schedule
AA
Y1
E1
1
Y2
E22
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Slide 16-37Copyright 2003 Pearson Education, Inc.
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
A short-run equilibrium for the economy as a whole
must bring equilibrium simultaneously in the outputand asset markets.
That is, it must lie on both DD and AA schedules.
Asset Market Equilibrium in the
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Slide 16-38Copyright 2003 Pearson Education, Inc.
Factors that Shift the AA Schedule
Domestic money supply Domestic price level
Expected future exchange rate
Foreign interest rate
Shifts in the aggregate real money demand schedule
Asset Market Equilibrium in the
Short Run: The AA Schedule
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Slide 16-39Copyright 2003 Pearson Education, Inc.
Figure 16-8: Short-Run Equilibrium: The Intersection ofDD and AA
Output, Y
Exchange
Rate, E
AA
Y1
E11
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
DD
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Slide 16-40Copyright 2003 Pearson Education, Inc.
Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
AA
Y1
E11
Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
DD
3E3
2E2
Output, Y
Exchange
Rate, E
Temporary Changes
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Slide 16-41Copyright 2003 Pearson Education, Inc.
Temporary Changes
in Monetary and Fiscal Policy
Two types of government policy:
Monetary policyIt works through changes in the money supply. Fiscal policy
It works through changes in government spending ortaxes.
Temporary policy shifts are those that the publicexpects to be reversed in the near future and do notaffect the long-run expected exchange rate.
Assume that policy shifts do not influence the foreigninterest rate and the foreign price level.
Temporary Changes
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Slide 16-42Copyright 2003 Pearson Education, Inc.
Monetary Policy
An increase in money supply (i.e., expansionarymonetary policy) raises the economys output.The increase in money supply creates an excess supply
of money, which lowers the home interest rate. As a result, the domestic currency must depreciate (i.e., home
products become cheaper relative to foreign products) and
aggregate demand increases.
Temporary Changes
in Monetary and Fiscal Policy
Temporary Changes
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Slide 16-43Copyright 2003 Pearson Education, Inc.
DD
Figure 16-10: Effects of a Temporary Increase in the Money Supply
Output, Y
Exchange
Rate,E
AA2
Y2
E22
AA1
1E1
Y1
Temporary Changes
in Monetary and Fiscal Policy
Temporary Changes
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Slide 16-44Copyright 2003 Pearson Education, Inc.
Fiscal Policy
An increase in government spending, a cut in taxes, orsome combination of the two (i.e, expansionary fiscalpolicy) raises output.
The increase in output raises the transactions demandfor real money holdings, which in turn increases the
home interest rate.
As a result, the domestic currency must appreciate.
Temporary Changes
in Monetary and Fiscal Policy
Temporary Changes
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Slide 16-45Copyright 2003 Pearson Education, Inc.
DD1
Figure 16-11: Effects of a Temporary Fiscal Expansion
Output, Y
Exchange
Rate,E
AA
DD2
Y1
E11
2
Y2
E2
Temporary Changes
in Monetary and Fiscal Policy
Temporary Changes
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Slide 16-46Copyright 2003 Pearson Education, Inc.
Policies to Maintain Full Employment
Temporary disturbances that lead to recession can beoffset through expansionary monetary or fiscalpolicies.
Temporary disturbances that lead to overemploymentcan be offset through contractionary monetary or fiscal
policies.
Temporary Changes
in Monetary and Fiscal Policy
Temporary Changes
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Slide 16-47Copyright 2003 Pearson Education, Inc.
Figure 16-12: Maintaining Full Employment After a Temporary Fall in
World Demand for Domestic Products
Output, Y
Exchange
Rate, E
DD1
AA2
AA1
YfY2
E22
DD2
1E1
3E3
Temporary Changes
in Monetary and Fiscal Policy
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Inflation Bias and Other
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Slide 16-49Copyright 2003 Pearson Education, Inc.
Inflation Bias and Other
Problems of Policy Formulation
Problems of policy formulation:
Inflation biasHigh inflation with no average gain in output that
results from governments policies to prevent recession
Identifying the sources of economic changes Identifying the durations of economic changes
The impact of fiscal policy on the government budget
Time lags in implementing policies
Permanent Shifts in
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Slide 16-50Copyright 2003 Pearson Education, Inc.
Permanent Shifts in
Monetary and Fiscal Policy
A permanent policy shift affects not only the current
value of the governments policy instrument but alsothe long-run exchange rate.
This affects expectations about future exchange rates.
A Permanent Increase in the Money Supply A permanent increase in the money supply causes the
expected future exchange rate to rise proportionally.
As a result, the upward shift in the AA schedule is
greater than that caused by an equal, but transitory,
increase (compare point 2 with point 3 in Figure 16-14).
Permanent Shifts in
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Slide 16-51Copyright 2003 Pearson Education, Inc.
DD1
Figure 16-14: Short-Run Effects of a Permanent Increase in the Money
Supply
Output, Y
Exchange
Rate, E
AA2
Y2
E22
AA1
1E1
Yf
3
Permanent Shifts in
Monetary and Fiscal Policy
Permanent Shifts in
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Slide 16-52Copyright 2003 Pearson Education, Inc.
Adjustment to a Permanent Increase in the Money
Supply The permanent increase in the money supply raisesoutput above its full-employment level.
As a result, the price level increases to bring theeconomy back to full employment.
Figure 16-15 shows the adjustment back to full
employment.
Permanent Shifts in
Monetary and Fiscal Policy
Permanent Shifts in
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Slide 16-53Copyright 2003 Pearson Education, Inc.
DD2
Figure 16-15: Long-Run Adjustment to a Permanent Increase in the
Money Supply
Output, Y
Exchange
Rate, EDD1
AA2
AA3
Yf
3E3
AA1
Y2
E2
2
E1 1
Permanent Shifts in
Monetary and Fiscal Policy
Permanent Shifts in
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Slide 16-54Copyright 2003 Pearson Education, Inc.
A Permanent Fiscal Expansion
A permanent fiscal expansion changes the long-runexpected exchange rate.If the economy starts at long-run equilibrium, a
permanent change in fiscal policy has no effect onoutput.
It causes an immediate and permanent exchange rate jump that
offsets exactly the fiscal policys direct effect on aggregate
demand.
Permanent Shifts in
Monetary and Fiscal Policy
Permanent Shifts in
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Slide 16-55Copyright 2003 Pearson Education, Inc.
DD1
Figure 16-16: Effects of a Permanent Fiscal Expansion Changing
the Capital Stock
Output, Y
Exchange
Rate, EDD2
AA1
AA2
Yf
2E2
1E1
Permanent Shifts in
Monetary and Fiscal Policy
3
Macroeconomic Policies
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Slide 16-56Copyright 2003 Pearson Education, Inc.
Macroeconomic Policies
and the Current Account
XXschedule
It shows combinations of the exchange rate and outputat which the CA balance would be equal to somedesired level.
It slopes upward because a rise in output encouragesspending on imports and thus worsens the current
account (if it is not accompanied by a currency
depreciation). It is flatter than DD.
Macroeconomic Policies
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Slide 16-57Copyright 2003 Pearson Education, Inc.
Monetary expansion causes the CA balance to increasein the short run (point 2 in Figure 16-17).
Expansionary fiscal policy reduces the CA balance.If it is temporary, the DD schedule shifts to the right
(point 3 in Figure 16-17).If it is permanent, both AA and DD schedules shift
(point 4 in Figure 16-17).
Macroeconomic Policies
and the Current Account
Macroeconomic Policies
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Slide 16-58Copyright 2003 Pearson Education, Inc.
Figure 16-17: How Macroeconomic Policies Affect the Current Account
Output, Y
Exchange
Rate,E
AA
Yf
E11
DD
XX
4
3
2
Macroeconomic Policies
and the Current Account
Gradual Trade Flow Adjustment
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Slide 16-59Copyright 2003 Pearson Education, Inc.
The J-Curve
If imports and exports adjust gradually to realexchange rate changes, the CA may follow a J-curvepattern after a real currency depreciation, first
worsening and then improving.Currency depreciation may have a contractionary initial
effect on output, and exchange rate overshooting will be
amplified. It describes the time lag with which a real currency
depreciation improves the CA.
j
and Current Account Dynamics
Gradual Trade Flow Adjustment
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Slide 16-60Copyright 2003 Pearson Education, Inc.
2
Figure 16-18: The J-Curve
Time
Current account (in
domestic output units)
1 3
Long-run
effect of real
depreciation
on the current
account
Real depreciation takesplace and J-curve begins
End of J-curve
j
and Current Account Dynamics
Gradual Trade Flow Adjustment
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Slide 16-61Copyright 2003 Pearson Education, Inc.
Exchange Rate Pass-Through and Inflation
The CA in the DD-AA model has assumed thatnominal exchange rate changes cause proportionalchanges in the real exchange rates in the short run.
Degree ofPass-throughIt is the percentage by which import prices rise when the
home currency depreciates by 1%.
In the DD-AA model, the degree of pass-through is 1.Exchange rate pass-through can be incomplete because
of international market segmentation.
Currency movements have less-than-proportional effects onthe relative prices determining trade volumes.
j
and Current Account Dynamics
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Slide 16-62Copyright 2003 Pearson Education, Inc.
Summary
The aggregate demand for an open economys output
consists of four components: consumption demand,
investment demand, government demand, and the
current account.
Output is determined in the short run by the equalityof aggregate demand and aggregate supply.
The economys short-run equilibrium occurs at the
exchange rate and output level.
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Slide 16-63Copyright 2003 Pearson Education, Inc.
Summary
A temporary increase in the money supply causes a
depreciation of the currency and a rise in output.
Permanent shifts in the money supply cause sharper
exchange rate movements and therefore have stronger
short-run effects on output than transitory shifts. If exports and imports adjust gradually to real
exchange rate changes, the current account may
follow a J-curve pattern after a real currency
depreciation, first worsening and then improving.
Appendix I: The IS-LMModel
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Slide 16-64Copyright 2003 Pearson Education, Inc.
Figure 16AI-1: Short-Run Equilibrium in the IS-LMModel
Output, Y
Interest
rate, R
Y1
R11
Appendix I: The S Model
and the DD-AA Model
LM
IS
Appendix I: The IS-LMModel
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Slide 16-65Copyright 2003 Pearson Education, Inc.
R2
Figure 16AI-2: Effects of Permanent and Temporary Increases in the
Money Supply in the IS-LMModel
pp
and the DD-AA Model
R3
LM2
Output, Y
Interest rate, RLM1
Y3
3
Y2
2
Y1
1
R1
3
E3
1
E1E2
2
Exchange rate, E ( increasing)
Expected
domestic-currencyreturn on
foreign-currency
deposits
IS1
IS2
Appendix I: The IS-LMModel and
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Slide 16-66Copyright 2003 Pearson Education, Inc.
R2
Figure 16AI-3: Effects of Permanent and Temporary Fiscal
Expansions in the IS-LMModel
pp
the DD-AA Model
R1
Output, Y
Interest rate, R LM
Yf
1
Y2
22
E2
Exchange rate, E ( increasing)
Expecteddomestic-currency
return on
foreign-currency
deposits
E1
1
E3
3
IS1
IS2
Appendix II: Intertemporal Trade
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pp p
and Consumption Demand
Present
Future
consumption
D1P = Q1P
1
Figure 16AII-1: Change in Output and Saving
Indifference
curves
Intertemporalbudget constraintsIntertemporalbudget constraints
2
D2
2
Q2P
D1F = Q1F
D2F