Output and the Exchange Rate in the Short Run

1. Output and the Exchange Rate in the Short Run

2. Introduction • How can we analyze the short run of an open economy? • What are the impacts on a country’s imports and exports from changes in the real exchange rate? • How much effect do changes in foreign trade have on growth rate of GDP? • What is the importance of the real exchange rate in an open economy?

3. Aggregate Demand • Relationship between total quantity demanded of goods and services in all sectors of the economy and the price level, holding all else constant • Total output of goods and services measured by real GDP – horizontal axis • Price level measured by GDP price deflator – vertical axis • AD curve slopes downward – as price level declines, quantity of goods demanded increases

4. Aggregate Demand • Does not behave in the same manner as an ordinary demand curve • Price of product falls • Consumer’s real income rises – increases amount consumed for normal good (income effect) • Lower price induces consumers to purchase more of product b/c cheaper (substitution effect)

5. Aggregate Demand • Neither the income or substitution effect are relevant to overall price level • If aggregate price level falls • Prices consumers pay are falling • Prices people receive as wages, rents, etc. are also falling • No change in demand

6. Aggregate Demand • Price level is measure of prices in general, not a particular price • As price level falls there is no substitution effect b/c prices in general are falling, not the price of a particular good.

7. Aggregate Demand • Why is AD negatively sloped? • As price level changes, value of individual’s real wealth changes – wealth effect • Increase in price level: • Reduces value of accumulated financial assets • Consumers reduce consumption of goods • Aggregate quantity demanded changes

8. Aggregate Demand • Why is AD negatively sloped? (cont.) • Rise in price level increases interest rates – interest rate effect • Lower business investment • Lower consumer spending on housing and cars • Aggregate quantity demanded falls • Price level changes impact country’s total exports and imports – international substitution effect

9. Aggregate Demand • Why is AD negatively sloped? (cont.) • Price level increase • Price of domestic goods rises relative to foreign goods • Foreign demand (exports) for domestic goods decreases • Domestic demand (imports) for foreign goods increases • Aggregate quantity demanded declines

10. Aggregate Demand • All three effects lead to decreases in aggregate quantity demanded (output of goods and services) as price level increases (all else equal) • The opposite is also true • Inverse relationship is shown as movement along aggregate demand curve

11. Aggregate Demand Curve

12. Changes in Aggregate Demand • Changing one of the variables held constant along the AD curve will cause a shift in the curve • Increases (decreases) in AD will shift the curve to the right (left) • New AD curve shows at any given price level, society wants to buy more (less) goods and services

13. Changes in Aggregate Demand • Expenditure approach to calculating GDP • Look at the four sectors of an open economy that buy real goods/services • Changes in any above factors, shifts AD

14. Changes in Aggregate Demand

15. Changes in Aggregate Demand • Consumption (C) • Consumer wealth • As consumer wealth increases (decreases), level of consumption increases (decreases) • Increase (decreases) in consumption shifts AD curve to right (left)

16. Changes in Aggregate Demand • Consumer expectations • More confident consumers are about the future, more likely to consume today • Increased confidence increases AD (curve shifts right) • Reverse is also true

17. Changes in Aggregate Demand • Degree of consumer indebtedness • High level of indebtedness from past consumption financed by borrowing • Must pay off existing dept • May need to reduce current consumption • Consumer spending falls • AD curve shifts left • Reverse is also true

18. Changes in Aggregate Demand • Taxes • Higher taxes (or lower transfer payments) reduce society’s after tax income • Lower income leads to lower consumption spending • AD curve shifts left • Reverse is also true

19. Changes in Aggregate Demand • Investment spending • Higher interest rates • Decreases business investment and public investment in housing • Aggregate demand decreases (shifts left) • Opposite is also true • Expectations of future economic conditions • Current economic conditions affect expectations of future in same direction thereby affecting investment spending

20. Changes in Aggregate Demand • Investment spending (cont.) • Government changes in business taxation • Increasing (decreasing) business taxes raise (lower) investment spending and aggregate demand

21. Changes in Aggregate Demand • Government Spending • Increasing in government spending on goods/services, increases aggregate demand • Opposite is also true • Government spending at federal, sate or local level

22. Changes in Aggregate Demand • Exports and Imports • Exports sensitive to changes in income of foreign countries • Increases in foreign incomes increase exports which increases aggregate demand (and vice versa) • Faster foreign economic growth leads to greater changes in US aggregate demand • Slower foreign growth (recessions) negatively impacts US aggregate demand

23. Changes in Aggregate Demand • Exports and Imports (cont.) • Movements in real exchange rate • As dollar depreciates • Foreign currency buys more US goods – increases exports • US currency buys fewer foreign goods – decreases imports • Aggregate demand increases • Opposite is also true

24. Changes in Aggregate Demand

25. Aggregate Supply • Relationship between the total quantity of goods/services an economy produces at various price levels, holding all other determinant of production unchanged. • Slopes upward to the right • As price level rises, quantity of goods and services economy produces increases

26. Aggregate Supply • Why is AS positively sloped? • Represents entire economy’s total production • Higher price level is necessary to bring a higher level of total production • Assume short run labor force, capital stock, stock of natural resources, and level of technology are constant

27. Aggregate Supply • Why is AS positively sloped? (cont.) • Related to both rising demand for output and rising unit costs as economy moves closer to full employment • As output expands, prices of some inputs rise before economy reaches full employment leading to rising unit costs • As some prices rise while others are constant, price level on average increases before reaching full employment

28. Aggregate Supply • Why is AS positively sloped? (cont.) • Most important price in economy is price of labor • Hiring more labor decreases K/L ratio • MPL decreases and wage rate increases • Leads to rising production costs • Rising price level means higher prices are necessary to increase total output – upward sloping AS curve

29. Aggregate Supply

30. Aggregate Supply • Change in aggregate supply means per unit production costs are rising (falling) for some reason unrelated to an increase in production (output) • Increases in AS will shift the curve to right • At any given price level, firms are willing and able to produce more goods/services • Firms can produce same level of output at lower unit costs – unit costs have declined

31. Changes in Aggregate Supply • Decreases in AS will shift the curve to the left • Unit costs of production have increased • Two types of changes or shifts in AS • Changes due to changes in potential real GDP • Changes in major determinants of AS curve held constant along the curve

32. Changes in Aggregate Supply

33. Changes in Aggregate Supply • Changes in potential real GDP • Factors of production • As factors of production (land, labor, capital, entrepreneurial ability) increase over time, AS curve will shift right • Productivity of factors of production • Increases in productivity reduce unit costs and shift AS curve to right • Synonymous with country’s long run economic growth

34. Changes in Aggregate Supply • Determinants of aggregate supply • Input prices • Increases in input prices increase costs of production decreasing AS • EX: increases in wages, oil shock • Exchange rate shock • Large change in real value of a country’s currency in short period of time • Change change firm’s costs of production changing aggregate supply

35. Changes in Aggregate Supply • Determinants of aggregate supply • Changes in business taxes • Increases in overall business taxes increases costs of production decreasing AS and vice versa • EX: sales taxes, excise taxes, payroll taxes • Public’s inflationary expectations • Perceived increases in future inflation cause adjustments in economic action today.

36. Changes in Aggregate Supply • Public’s inflationary expectations (cont.) • Producers may attempt to increase prices today to stay ahead of anticipated inflation • Workers attempt to receive larger salary increases today to protect real wages and standards of living • Aggregate supply curve will decrease (left shift)

37. Changes in Aggregate Supply

38. Aggregate Equilibrium • Intersection of AS and AD determines the open economy’s equilibrium • Equilibrium level of real output (production and spending) for economy at Ye • Equilibrium price level for the economy at Pe • Shifts in AS or AD will change equilibrium level of output and price level

39. Aggregate Equilibrium

40. Aggregate Equilibrium • Note that changes in exchange rate shift both AD and AS curves • Changes in exchange rate can affect an open economy’s equilibrium level of output and price level • Not only are trade flows (exports and imports) affected, but there are noticeable impacts on entire economy

41. Determinants of Current Account • Changes in AD and AS influence output • We will focus on one component of aggregate demand and supply – the current account • How does a change in the current account (exports minus imports) impacts the equilibrium level of output • Changes in other determinants of AD and AS will be ignored

42. Changes in Current Account • Exports • Level of income in foreign countries, Yf • Exports change with changes in foreign incomes • Size of change determined by two factors • Size of change in foreign income • Larger income changes have larger effects on exports • Changes in foreign income that affect a country’s exports are weighted averages of changes in income among the countries trading partners

43. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • Percentage change in a country’s exports relative to the percentage change in foreign income

44. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • Elasticity is a positive number • As foreign incomes increase (decrease), a country’s exports increase (decrease) • Size of country’s foreign income elasticity depends on product mix of a country’s exports

45. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • If a country exports a high percentage of goods with high income elasticities of demand, they will tend to have a higher foreign income elasticity and vice versa • US close to 1, Germany and Japan greater than 1, Chile, South Africa less than 1

46. Changes in Current Account • Exports (cont.) • Real exchange rate (RXR) • As the real value of country’s currency appreciates (depreciates, level of a country’s exports declines (increases) • Size of effect depends on • Size of change in real exchange rate • The larger the change in RXR, the larger the effect on exports

47. Changes in Current Account • Exports (cont.) • Real exchange rate (RXR) • Price elasticity of demand for exports • Sensitivity of a country’s exports to changes in the real exchange rate • Sensitivity of a country’s exports is inversely related to changes in real exchange rate

48. Changes in Current Account • Imports • Level of domestic income (Yd) • As domestic income rises, level of imports rises • Size of effect depends on two factors • Size of change in domestic income • Income elasticity of demand for imports

49. Changes in Current Account • Imports • Level of domestic income (Yd) • Income elasticity of demand for imports (cont.) • Income elasticity is positive – increases in domestic income cause an increase in imports • May be equal to, greater than or less than 1 • Real Exchange rate • As currency appreciates, imports increase

50. Changes in Current Account • Imports • Real Exchange rate (cont.) • Magnitude of effect depends on two factors • Size of change in real exchange rate – smaller changes have smaller effects • Price elasticity of demand for imports – percent change in imports relative to percent change in real exchange rate – direct relationship