Chapter 6 Output and the Exchange

Rate in the Short Run

P$
Learning Objectives
1 Explain the role of the real exchange rate in determining the aggregate
demand for a country’s output.
2 See how an open economy’s short-run equilibrium can be analyzed as
the intersection of an asset market equilibrium schedule (AA) and an
output market equilibrium schedule (DD).
3 Understand how monetary and fiscal policies affect the exchange rate
and national output in the short run.
4 Describe and interpret the long-run effects of permanent macroeconomic
policy changes.
5 Explain the relationship among macroeconomic policies, the current
account balance, and the exchange rate.
Introduction
• Long-run models are useful when all prices of inputs and
outputs have time to adjust to supply/demand changes.
• In the short run, some prices of inputs and outputs may not
have time to adjust, due to labor contracts, costs of
adjustment, or imperfect information about willingness of
customers to pay at different prices.
• This chapter builds on the short-run and long-run models
of exchange rates to explain how output is related to
exchange rates in the short run.
– It shows how macroeconomic policies can affect
production, employment, and the current account.
Long Run and Short Run
Variable Long Run Short Run
P, the overall price level Flexible Fixed
Y, inflation-adjusted GNP Fixed Flexible
Preview
• Determinants of aggregate demand in the short run
• A short-run model of output markets
• A short-run model of asset markets
• A short-run model for both output markets and asset
markets
• Effects of temporary and permanent changes in monetary
and fiscal policies
• Adjustment of the current account over time
Output Market
Determinants of Aggregate Demand
• Aggregate demand (D) is the aggregate amount of goods
and services that individuals and institutions are willing to
buy:
1. consumption expenditure (C)
2. investment expenditure (I)
3. government purchases (G)
4. net expenditure by foreigners: the current account (CA)

𝐷𝐷 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝐶𝐶𝐶𝐶

We will assume I & G are given (exogenous), but that C & CA

are functions of other variables
Determinants of Aggregate
Consumption
• Assume consumption depends on disposable
income
– Disposable income = income from production (Y)
minus taxes (T), or Yd = Y-T
– Assume consumption increases with disposable
income…
 but by less than the increase in disposable income
– e.g. C = (1-s) Yd
• We will ignore other factors that may influence
consumption for now
– Real interest rates, wealth, consumer confidence, etc.
Determinants of CA = EX - IM
• Assume current account depends on:

– Disposable income: more disposable income means

more expenditure on foreign products (imports) and a
fall in CA

– Real exchange rate: prices of foreign products relative

to the prices of domestic products:
𝐸𝐸𝑃𝑃∗
q=
𝑃𝑃
How Do Real Exchange Rate Changes
Affect the Current Account?
• The current account measures the value of exports
relative to the value of imports: CA ≈ EX − IM.
EP ∗
– When the real exchange rate rises, the prices
P
of foreign products rise relative to the prices of domestic
products.
1. The volume of exports that are bought by foreigners
rises.
2. The volume of imports that are bought by domestic
residents falls.
3. The value/price of imports in terms of domestic
products rises, since foreign products are more
valuable/expensive.
IM = 𝑞𝑞 × 𝑄𝑄𝐼𝐼𝐼𝐼
How Do Real Exchange Rate Changes
Affect the Current Account?
• If the volumes of imports and exports do not change much,
the value effect may dominate the volume effect when
the real exchange rate changes.
– For example, contract obligations to buy fixed amounts
of products may cause the volume effect to be small.
• However, evidence indicates that for most countries the
volume effect dominates the value effect after one year or
less.
• Let’s assume for now that a real depreciation leads to an
increase in the current account: the volume effect
dominates the value effect.
Factors Determining the Current Account
Government and Investment
• For simplicity, we assume:
– exogenous political factors determine government
purchases G and the level of taxes T
– investment expenditure I is determined by
exogenous business decisions
 a more complicated model shows that investment
depends on the cost of spending or borrowing to
finance investment: the interest rate.
 our predictions in this chapter wouldn’t
qualitatively change if we included endogenous
investment
Determinants of Aggregate Demand
• Aggregate demand is therefore expressed as:
 EP ∗ 
=
D C (Y − T ) + I + G + CA  ,Y − T 
 P 

Consumption
expenditure Investment
as a function expenditure and Current account as
of disposable government a function of the real
income purchases, both exchange rate and
exogenous disposable income.

 EP ∗ 
• Or more simply:
= D D ,Y − T , I,G 
 P 
  EP ∗ 
=D D ,Y − T , I,G 
 P 

Determinants of Aggregate Demand

• Determinants of aggregate demand include:
– Real exchange rate: an increase in the real exchange
rate increases the current account, and therefore
increases aggregate demand of domestic products.
– Disposable income: an increase in disposable income
increases consumption expenditure but decreases the
current account.
 Since consumption expenditure is usually greater
than expenditure on foreign products, assume the
first effect dominates the second effect.
 As income increases for a given level of taxes,
aggregate consumption expenditure and aggregate
demand increase by less than income.
Aggregate Demand as a Function of
Output
Short-Run Equilibrium for Aggregate
Demand and Output
• Equilibrium is achieved when the value of income from
production (output) Y equals the value of aggregate
demand D
 EP ∗ 
=Y D ,Y −T , I,G 
 P 
– where aggregate demand is a function of the real
exchange rate, disposable income, investment
expenditure and government purchases.

• Note: output Y and exchange rate E are the only endogenous

variables; all other variables are exogenous (recall P is fixed in short
run)… see where we’re going here?
 Output Market Equilibrium

Production is
greater
than aggregate
demand: firms
Aggregate decrease output
demand is
greater than
production:
firms increase
output
Short-Run Equilibrium and the Exchange
Rate
• How does the exchange rate affect the short-run
equilibrium of aggregate demand and output?
• With fixed domestic and foreign levels of average prices,
a rise in the nominal exchange rate (a domestic currency
depreciation):
– makes foreign goods and services more expensive relative to
domestic goods and services (increases the real exchange rate)
– increases aggregate demand of domestic products
– in equilibrium, production will increase to match the higher
aggregate demand

𝐸𝐸 ↑ → 𝑞𝑞 ↑ → 𝐸𝐸𝐸𝐸 ↑ & 𝐼𝐼𝐼𝐼 ↓ → 𝐶𝐶𝐶𝐶 ↑ → 𝐷𝐷 ↑ → 𝑌𝑌 ↑

Output Effect of a Currency Depreciation
with Fixed Output Prices
Deriving the DD Schedule
Short-Run Equilibrium and the Exchange
Rate: DD Schedule
DD schedule
• shows combinations of output and the exchange rate at
which the output market is in short-run equilibrium (such
that aggregate demand = aggregate output).
• slopes upward because a rise in the exchange rate
causes aggregate demand and aggregate output to rise.
Shifting the DD Curve
• Changes in the exchange rate cause movements along
the DD curve. Other changes cause it to shift.
• For example:
– more government purchases (higher G) cause higher
aggregate demand and output in equilibrium. Output increases
for every exchange rate: the DD curve shifts right.
Government Demand Increase
Shifting the DD Curve
• The DD curve shifts right if:
– G increases
– T decreases
– I increases
– P decreases
– P* increases
– C increases (unrelated to Y or T)
– CA increases (unrelated to q, Y, or T)

• In short, anything that shifts AD up (down) shifts the

DD curve right (left)
Discussion
• Given our current assumptions, what would happen to
the DD curve if government increases spending but also
increased taxes the same amount to maintain a
balanced budget?

• G goes up by x
• C goes down less than x
• CA goes also goes up (though less than C goes down)
• AD goes up (DD curve shifts right)

𝐸𝐸𝑃𝑃∗
𝐷𝐷 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 − 𝑥𝑥 + 𝐼𝐼 + (𝐺𝐺 + 𝑥𝑥) + 𝐶𝐶𝐶𝐶 , 𝑌𝑌 − 𝑇𝑇 − 𝑥𝑥
𝑃𝑃
Asset Markets
Short-Run Equilibrium in Asset
Markets
• We have already seen the equilibrium conditions for the
two asset markets:

1. Foreign exchange markets (chapter 3)

– interest parity represents equilibrium:

= R
R ∗
+
( E e
−E )
E
2. Money market (chapter 4)
– real money supply = real money demand:
MS
= L ( R,Y )
P
Simultaneous Equilibrium in the U.S. Money
Market and the Foreign Exchange Market
Short-Run Equilibrium in Asset
Markets
• The DD curve connects output to the exchange rate in the
output market
• Q: How does output connect to the exchange rate in asset
markets?
• A: By influencing real money demand 𝐿𝐿 𝑅𝑅, 𝑌𝑌
– a rise in income from production causes real money
demand to increase
Output and the Exchange Rate in Asset
Market Equilibrium
Short-Run Equilibrium in Asset
Markets
• When income and production increase:
– real money demand increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic currency.
𝑌𝑌 ↑ → 𝐿𝐿 𝑌𝑌, 𝑅𝑅 ↑ → 𝑅𝑅 ↑ → 𝐸𝐸 ↓
• When income and production decrease, the domestic
currency depreciates and E rises.
• The inverse relationship between output and exchange
rates needed to keep the foreign exchange markets and
the money market in equilibrium is summarized as the AA
curve.
The AA Schedule
Shifting the AA Curve
• Changes in output (Y) cause movements along the AA
curve. Other changes cause it to shift.
• For example:
– an increase in the money supply (MS) reduces interest rates in
the short run, causing the domestic currency to depreciate (a
rise in E) for every Y: the AA curve shifts up (right).
Shifting the AA Curve
Shifting the AA Curve

Exchange
rate, E

E2

E1

AA’

AA

Y1 Output, Y
Shifting the AA Curve
• The AA curve shifts right if:
– MS increases
– P decreases (reduces real money supply)
– Ee or R* increases (increases expected return on
foreign currency deposits)
– 𝐿𝐿 𝑅𝑅, 𝑌𝑌 decreases (unrelated to R or Y)
Output & Asset Markets
Putting the Pieces Together: the DD and
AA Curves
• A short-run equilibrium means a nominal exchange rate
and level of output such that there is equilibrium in all
markets:
1. the output market: aggregate demand (D) equals
aggregate output (Y)
2. the foreign exchange market: interest parity holds
3. the money market: money supply equals money demand
 Short-Run Equilibrium: The Intersection
of DD and AA

The output The short run

market is in equilibrium occurs
equilibrium on at the intersection
the DD curve of the DD and AA
curves.

The asset At that point all

markets are markets are in
in equilibrium equilibrium.
on the AA
curve
How the Economy Reaches Its Equilibrium

Because asset markets adjust very quickly, the exchange rate jumps immediately
from point 2 to point 3 on AA. The economy then moves to point 1 along AA as
output rises to meet aggregate demand.
How the Economy Reaches Its Equilibrium

• E2 is above AA curve so interest parity doesn’t hold

(excess demand for dollars)
• E falls to AA curve very quickly (E3) – asset markets are in
equilibrium
• Once on AA curve, E3 is still above DD curve (excess
demand for domestic output)
• Y starts to increase
• As it does, asset markets continue to be in equilibrium
causing E to fall as Y increases (move along AA curve)
• Continues until E1 is reached
Policy Changes
Temporary Changes in Monetary and
Fiscal Policy
• Monetary policy: when central bank influences the economy
through changes in the money supply
– assumed to affect asset markets first (the AA curve)
• Fiscal policy: when governments influence the economy
through changes in government purchases (G) and taxes (T)
– assumed to affect output market first (the DD curve)
• Temporary policy changes are expected to be reversed in the
near future and thus do not affect expectations about
exchange rates in the long run.
– i.e. temporary changes in MS,G, or T do not effect Ee
Effects of a Temporary Increase in the
Money Supply

By shifting AA1 upward, a temporary increase in the money supply

causes a currency depreciation and a rise in output.
Effects of a Temporary Fiscal Expansion
(higher G or lower T)

By shifting DD1 to the right, a temporary fiscal expansion causes a

currency appreciation and a rise in output.
Policies to Maintain Full Employment
• Resources used in the production process can either be over-
employed (boom) or underemployed (recession).
• When resources are used effectively and sustainably,
economists say that production is at its potential or natural
level.
– When resources are not used effectively, resources are
underemployed: high unemployment, few hours worked,
idle equipment, lower than normal production of goods and
services (Recession)
– When resources are not used sustainably, labor is over-
employed: low unemployment, many overtime hours, over-
utilized equipment, higher than normal production of goods
and services (Boom)
Maintaining Full Employment after a Temporary
Fall in World Demand for Domestic Products
Temporary DD2
fiscal policy
Temporary
could reverse
the fall in
E3 monetary
expansion could
aggregate
depreciate the
demand and
output
E2 domestic currency
further

AA2
Temporary fall in
world demand for
domestic products
reduces output below
its normal level
Y2 Yf
Maintaining Full Employment after a Temporary
Fall in World Demand for Domestic Products
Policies to Maintain Full Employment after a
Money Demand Increase
Temporary
fiscal policy
Increase in money
could increase
demand raises
aggregate
demand and DD2 interest rates and
appreciates the
output
domestic currency

Temporary monetary
policy could
E2 increase money
supply to match
money demand
E3

AA2
Y2 Yf
Policies to Maintain Full Employment after a
Money Demand Increase
Policies to Maintain Full Employment
• Policies to maintain full employment may seem easy in
theory, but are hard in practice.
1. We have assumed that prices and expectations do not
change, but people may anticipate the effects of policy
changes and modify their behavior.
– Workers may require higher wages if they expect
overtime and easy employment, and producers may
raise prices if they expect high wages and strong
demand due to monetary and fiscal policies.
– Fiscal and monetary policies may therefore create
price changes and inflation, thereby preventing high
output and employment: inflationary bias.
Policies to Maintain Full Employment
2. Economic data are difficult to measure and to understand.
– Policymakers cannot interpret data about asset markets
and aggregate demand with certainty, and sometimes
they make mistakes.
3. Changes in policies take time to be implemented and to
affect the economy.
– Because they are slow, policies may affect the economy
after the effects of an economic change have
dissipated.
4. Policies are sometimes influenced by political or
bureaucratic interests.
Permanent Changes in Monetary and
Fiscal Policy
• “Permanent” policy changes are those that are assumed
to modify people’s expectations about exchange rates in
the long run.
– i.e. permanent changes in MS,G, or T do effect Ee
Remember this?
𝐸𝐸 𝑒𝑒 $/€
𝑅𝑅$ = 𝑅𝑅€ + −1
𝐸𝐸$/€
Permanent Changes in Monetary Policy
in the Short Run
• A permanent increase in the money supply:
– Lowers interest rates in the short run and makes
people expect future depreciation of the domestic
currency, increasing the expected rate of return on
foreign currency deposits.
– The domestic currency depreciates (E rises) more
than is the case when expectations are constant
– The AA curve shifts up (right) more than when
expectations are held constant.
 i.e. keeping Y fixed, higher E needed to maintain
equilibrium in the asset markets
Short-Run Effects of a Permanent Increase in
the Money Supply
Short-run graph is same
as temporary increase in
MS, but AA curve shifts
further – think of point 3
as the result of a
temporary change

What about the long-run?

Permanent Changes in Monetary Policy
in the Long Run
• With high employment and strong demand for output, wages
and prices tend to rise over time
• What are the effects of rising prices?
– Reduce real money supply: increasing interest rates:
domestic currency appreciation: left shift of AA curve
– Domestic products more expensive relative to foreign
goods: reduction in AD: left shift of DD curve

 EP ∗ 
=Y D ,Y −T , I,G 
 P 
Long-Run Adjustment to a Permanent Increase
in the Money Supply
Higher prices
make domestic DD2 Short-run effect of
products more permanent monetary
expensive expansion
relative to E2
foreign goods: Higher prices
reduction in AD E3 reduce
real money
supply leading
to lower E

AA2

In the long run, AA3

output returns to its
normal level, and
we also can see
overshooting:
E1 < E3 < E2
Yf Y2
Long-Run Adjustment to a Permanent
Increase in the Money Supply
Permanent Changes in Fiscal Policy
• A permanent increase in government purchases or
reduction in taxes
– increases AD, shifts DD curve right (similar to a
temporary increase)
– decreases Ee (decreases expected return on foreign
currency deposits), shifts AA curve left immediately
 Ch. 5: E decreases with increased real demand
• The first effect increases AD (shifts DD curve)
• The second effect decreases AD (move along DD curve)
– domestic goods relatively more expensive

• Both serve to appreciate the domestic currency

immediately
Effects of a Permanent Fiscal Expansion

An increase in
government
purchases raises
aggregate demand

When the increase of

government purchases
is permanent, the
domestic currency is
expected to
appreciate, and does
appreciate.
Effects of Permanent Changes in Fiscal
Policy
• If the change in fiscal policy is expected to be permanent,
the first and second effects on AD exactly offset each
other, so that output remains at its potential or natural (or
long run) level.
• We say that an increase in government purchases
completely crowds out net exports, due to the effect of
the appreciated domestic currency.
• Important prediction: if at long-run output level, permanent
fiscal expansion has no net effect on output (even in the
short run!!)
– Consequently, temporary fiscal policy is more effective than
permanent fiscal policy
Summary on Policy Changes
• Temporary monetary or fiscal policy
– Do not change expected exchange rates
– Can deal with temporary real or monetary shocks

• Permanent monetary policy

– Best used to deal with permanent monetary shocks
 e.g. permanent money demand increase puts downward
pressure on prices, permanent money supply increase can
offset the shock, resulting in immediate full employment and
stable prices

• Permanent fiscal policy

– Less effective than temporary fiscal policy
 e.g. stimulate less output with same increase in G
– Also, often not very realistic
Macroeconomic Policy
and the Current Account
Remember…

Note: to keep the CA fixed (say at some level X) as Y

increases would require higher E
Macroeconomic Policies and the Current
Account
• To determine the effect of monetary and fiscal policies on
the current account,
– derive the XX curve to represent the combinations of
output and exchange rates at which the current
account is at its desired level X.
• As income from production increases, imports increase
and the current account decreases when other factors
remain constant.
• To keep the current account at its desired level, the
domestic currency must depreciate as income from
production increases: the XX curve should slope upward.
The XX Curve shows where CA = X

Above XX, CA>X

Below XX, CA<X
Macroeconomic Policies and the Current
Account
• The XX curve slopes upward but is flatter than the DD
curve. Why?
– DD represents Y = D.
– Remember our previous assumptions…
 C increases with Y but by less than 1-to-1
 I and G are exogenous

Y = 𝐷𝐷 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝐶𝐶𝐶𝐶
– So we need CA to increase with Y to keep Y = D
Macroeconomic Policies and the Current
Account
– On the XX curve—as Y goes up, we import more, so
currency must depreciate to stimulate exports and
keep CA fixed at desired level.

– On the DD curve—as Y goes up, currency must

depreciate more rapidly to stimulate enough exports
for CA to increase and aggregate demand to equal Y.

𝑌𝑌 = 𝐷𝐷 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝐶𝐶𝐶𝐶
How Macroeconomic Policies Affect the
Current Account An increase in the money supply shifts up the AA
curve and depreciates the domestic currency,
increasing the current account above XX.

A temporary
fiscal
expansion
shifts the
DD and
appreciates
the domestic
currency,
decreasing
the CA
below XX.

Because the AA curve also shifts,

a permanent fiscal expansion
decreases the CA more.
Macroeconomic Policies and the Current
Account
• Policies affect the CA through their influence on E.
– An increase in money supply depreciates the domestic
currency and often increases the current account in
the short run.
– An increase in government purchases or decrease in
taxes appreciates the domestic currency and often
decreases the current account in the short run.

• Sounds good in theory, but in practice it takes time for

imports and exports to adjust…
Real World Issues
Value Effect, Volume Effect, and the
J-Curve IM = 𝑞𝑞 × 𝑄𝑄𝐼𝐼𝐼𝐼

• If the volume of imports and exports is fixed in the short

run, a depreciation of the domestic currency
– will not affect the volume of imports or exports,
– but will increase the value/price of imports in domestic
currency and decrease the current account:
CA ≈ EX − IM.
– The value of exports in domestic currency does not
change.
• The current account could immediately decrease after a
currency depreciation, then increase gradually as the
volume effect begins to dominate the value effect.
The J-Curve

The J-curve describes the time lag with which a real currency
depreciation improves the current account.
Value Effect, Volume Effect, and the
J-Curve
• Pass-through from the exchange rate to import prices
measures the percentage by which import prices (EP*)
change when the value E changes by 1%.
• In the DD-AA model, the pass-through rate is 100%: import
prices in domestic currency exactly match a depreciation
of the domestic currency (i.e. P* is fixed).
• In reality, pass-through may be less than 100% due to
price discrimination in different countries.
– Firms that set prices may decide not to match changes
in the exchange rate with changes in prices of foreign
products denominated in domestic currency.
Value Effect, Volume Effect, and the
J-Curve
• If prices of foreign products in domestic currency do not
change much because of a pass-through rate less than
100%, then
– the value of imports will not rise much after a domestic
currency depreciation, and the current account will not
fall much, making the J-curve effect smaller.
– the volume of imports and exports will not adjust much
over time, since domestic currency prices do not
change much.
• Pass-through of less than 100% dampens the effect of
depreciation or appreciation on the current account.
A Low-Output Liquidity Trap
𝑌𝑌 ↓ → 𝐿𝐿 𝑌𝑌, 𝑅𝑅 ↓ → 𝑅𝑅 ↓ → 𝐸𝐸 ↑

But when R hits zero (liquidity

trap), cannot fall any lower.
Lower Y no longer impacts E.
Expansionary Monetary policy
also not effective.
Likely better luck with
expansionary fiscal policy.
Summary
1. Aggregate demand is influenced by disposable income and the real
exchange rate.
2. The DD curve shows combinations of exchange rates and output
where aggregate demand = aggregate output.
3. The AA curve shows combinations of exchange rates and output
where the foreign exchange markets and money market are in
equilibrium.
4. In the DD-AA model, we assume that a depreciation of the domestic
currency leads to an increase in the current account and aggregate
demand.
5. But reality is more complicated, and the
J-curve shows that the value effect at first dominates the volume
effect.
Summary
6. A temporary increase in the money supply is predicted to increase
output and depreciate the domestic currency.
7. A permanent increase does both to a larger degree in the short run,
but in the long run output returns to its normal level.
8. A temporary increase in government purchases is predicted to
increase output and appreciate the domestic currency.
9. A permanent increase in government purchases is predicted to
completely crowd out net exports, and therefore to have no effect on
output.