Ch. 16: Output and the Exchange Rate in the Short Run

1. Ch. 16: Output and the Exchange Rate in the Short Run

2. The Plan • Total expenditures (aggregate demand) will respond to Y, q, I, G, T. • Monetary sector will determine R and nominal exchange rate. • In the short run Y changes and impacts the money demand. • The effects of policy changes on the equilibrium values will be investigated.

3. Aggregate Demand • In the long run, the output Y of an economy is determined with the combination of labor, capital and technology fully employed. • In the short run, however, output is determined by the level of aggregate demand. • Aggregate demand is C+I+G+CA.

4. Determinants of Consumption • Consumption is a function of disposable income. • Yd = Y - T • C = Yd - S • MPC = DC/DYd < 1. • C = C (Yd)

5. Determinants of CA • CA = EX - IM • CA = CA(q,Yd) • q$/¥ = ($/¥)(P¥/P$) • q$/¥ = E(P*/P) • If P* is the cost of a typical basket in Japan and P is the cost of a typical basket in USA. • Real exchange rate is the US basket per Japanese basket.

6. Real Exchange Rate to EX • When real exchange rate q$/¥ = ($/¥)(P¥/P$) rises, foreign products become more expensive relative to domestic products. • Each unit of domestic basket purchases fewer units of foreign basket. • US basket per Japanese basket has increased. • Japanese will be more willing to buy US products because the opportunity cost is lower now: EX goes up.

7. Real Exchange Rate to IM • When real exchange rate q$/¥ = ($/¥)(P¥/P$) rises, domestic consumers will purchase fewer units of the more expensive foreign products. • But imports in the aggregate demand stipulation (C+I+G+EX-IM) is in terms of domestic real income, or domestic output units. • Since more domestic output units may have to be sacrificed for fewer foreign products, IM may increase or decrease as a result of q increase.

8. Real Exchange Rate and CA • As q increases, EX goes up. • As q increases, IM may go down or up. • Assuming that the volume effect on IM dominates the value effect, we can conclude that q increase will result in CA increase. • A real appreciation of the yen will increase US current account.

9. Disposable Income and CA • An increase in disposable income will increase consumption expenditures. • Some of the consumption expenditures are on imports. • An increase in disposable income, therefore, will worsen the current account.

10. Variables of Aggregate Demand • Aggregate demand is AD = C + I + G + CA • C is dependent on disposable income C = C(Y-T) • CA is dependent on real exchange rate and disposable income CA = CA(q$/¥ , Y-T) • Assuming I and G are given (exogenous), aggregate demand will be determined by q,Y-T, I, and G.

11. A Caveat • The full model should include determinants of I (real interest rate) and S (real interest rate and disposable income). • Of course, the impact of monetary sector on interest rates and exchange rates will need to be developed, too. That will come later. • Now we analyze the impact of the stipulated variables on aggregate demand.

12. Real Exchange Rate • A rise in real exchange rate, q$/¥ = ($/¥)(P¥/P$), makes domestic goods cheaper relative to Japanese goods. • US exports increase and US imports (may) decrease. • CA rises, raising the aggregate demand.

13. Real Income • If taxes are constant, an increase in real income (Y) will raise consumption and worsen CA. • Taxes usually respond to Y, so they need not be constant, but let’s assume they are. • Typically, because of nontraded goods, a higher portion of the consumption increase will go to domestic output rather than imports. • The domestic consumption effect of income increase will exceed the import effect and Y increase will raise AD.

14. Real Income and Aggregate Demand • A unit increase in real income will not increase consumption of domestic output by the same unit because • some of the increase will go to imports. • Some of the increase will go to savings. • If taxes respond to income, some of the increase will go to taxes. • Aggregate demand as a function of real income Y will have a slope less than one.

15. Equilibrium in the Output Market • Aggregate supply is the output produced (Y). • Equilibrium requires AD = AS. • If we draw AD as a function of Y, then equilibrium will only take place when Y = AD, or along the 45 degree line. • This analysis holds in the short run, that is output adjusts to bring equilibrium because we kept prices constant in the short run.

16. Equilibrium in the Short Run At Y1, AD>Y. Firms respond to excess demand by increasing output, bringing the system toward Y*. AD AD=Y AD At Y2, Y>AD. Firms respond to excess supply by reducing production, bringing the system toward Y*. Y1 Y* Y2 Y

17. Real Exchange Rate • A rise in the real exchange rate, q$/¥ = ($/¥)(P¥/P$), can occur either by nominal appreciation of yen or rise in Japanese price level or drop in US price level. • All of these will make US products cheaper and will give a boost to CA. • Higher CA will translate into higher AD.

18. Equilibrium with q Change AD A rise in q$/¥, real depreciation of USD, will improve CA and increase AD. AD=Y AD’ AD Equilibrium will take place at the higher Y2. Y1 Y2 Y

19. Nominal Exchange Rates and Output Equilibrium • In the short run both Japanese and US price levels will remain constant. • A nominal appreciation of the yen will translate as a real appreciation of the yen. • The relationship between the nominal exchange rate and the short run equilibrium of the output will comprise the DD curve.

20. Nominal Exchange Rates and Output Equilibrium AD Short run equilibrium, given exchange rates takes place at the intersection of white lines. When E rises, ¥ appreciates and $ depreciates, CA improves and AD increases. The new equilibrium takes place at the blue Y level, corresponding to blue nominal exchange rate. Y $/¥ DD Y

21. Shifts of DD Schedule • Any change in variables that will force the AD curve to shift will also shift the DD curve in the same direction. • Exception is a change in the nominal exchange rate; that change will be a movement along the DD curve. • All other forces that will change C, I, G, CA will shift the DD curve.

22. Shifts in DD Schedule An increase in C or G or I or foreign price level, ceteris paribus, will all shift the AD upwards and DD to the right. Likewise, a decrease in T or domestic price level, ceteris paribus, will all shift the AD upwards and DD to the right. Of course, AD would shift down and DD to the left if the variables changed in the opposite direction. In all cases, $/¥ is kept constant. AD Y $/¥ DD Y

23. Asset Market Equilibrium in the Short Run • We will trace the required nominal exchange rate and real income to keep that will satisfy interest parity and monetary sector equilibrium. • Interest parity R = R* + (Ee - E)/E • Monetary equilibrium Ms/P = L(R,Y)

24. Asset Market Equilibrium R R R M/P $/¥ Y up => real money demand up => R up => E down (USD appreciates) AA E1 AA shows the asset market equilibrium. E2 R Y1 Y2

25. Ms Decrease or P Increase R R R M/P $/¥ Money supply decrease or P increase raises R. At the same output level, $ appreciates and AA shifts left. AA E1 E2 R Y1

26. A Rise in Ee or R* R R R M/P An increase in the expected dollar returns from yen deposits raises the exchange rate (yen appreciates). AA shifts right. $/¥ E2 AA E1 R Y1

27. Equilibrium in Output and Asset Markets Point 1 implies $ returns on yen deposits have to be higher. If they are not, there will be flight from yen into $: E will fall. $/¥ Unless the exchange rate and output combination falls on AA, the asset market will be out of equilibrium. Likewise, if the combination is away from DD, the output market will be out of equilibrium. 1 DD 2 At 2 asset market is in equilibrium but output market isn’t. AD>AS. Firms increase production to meet excess demand. AA Y

28. Temporary Ms Increase R R Temporary means the public expects the reversal of the policy in the future. R M/P $/¥ Ms up => R down => $ depreciates => CA improves => Y increases => real money demand rises => R increases => E falls ($ appreciates). AA E2 E1 R Y1

29. Temporary G Increase or T Decrease A one time increase in G raises Y. AD and DD both shift to the blue lines. Even though the output market is in equilibrium, the higher income has raised the R and made $ more attractive. AD As funds flow into $, E falls (yen depreciates).The fall of E makes Japanese products cheaper. US CA falls and AD adjusts. Both markets reach equilibrium along the brick lines. Y $/¥ DD AA Y

30. Full Employment Policies for a Fall in Demand for Domestic Products E DD Fiscal expansion Monetary expansion E1 AA Y1

31. Full Employment Policies for a Rise in Money Demand E DD E1 Fiscal expansion Monetary expansion AA Y1

32. Permanent Shifts • A permanent change in fiscal and monetary policy affects the long run exchange rate. • Because permanent changes affect expectations, they affect the current exchange rates, as well. • In the following examples, we will assume that the economy starts at full employment with expected exchange rate equal to current exchange rate, or R=R*.

33. Permanent Ms Increase R R The expected E rise ($ depreciation) makes the return curve shift and depreciate the $ even more. R M/P $/¥ Ms up => R down => $ depreciates => CA improves => Y increases => real money demand rises => R increases => E falls ($ appreciates). DD AA E2 E1 R Y1

34. Permanent Ms Increase • The economy started at full employment at Y1. • Higher money supply moved the economy to above Y1. • As the price level adjusts to the higher money supply two things happen: • The real money supply falls shifting AA to the left. • Real appreciation of $ lowers CA and DD.

35. Permanent Ms Increase R R R M/P $/¥ Price level increase shifts both DD and AA to the left. Higher price level shifts real money supply to the left. Lower Y shifts real money demand to the left. DD AA E3 E2 E1 R Y1

36. Permanent Fiscal Expansion P and M are constant; R doesn’t change. Gov. purchases increase the demand for US output and appreciate $ in the long run. DG = -DCA. AD $/¥ DD AA R Y1 Y

37. XX Curve XX shows a constant value of CA. To the right of the intersection, as Y increases, to have AS=AD, $ has to depreciate a lot to compensate for the increased imports and increased savings to eliminate any excess supply. This means CA turns positive along DD. To the left of the intersection, CA turns negative along DD. Monetary expansion, therefore, moves CA toward surplus. Fiscal expansion moves CA toward deficit. E DD XX AA Y