Output and the Exchange

Rate
in the Short Run
(Chapter 17 of the Book)
 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
 IS-LM model

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 Long-run models are useful when all prices of
inputs and outputs have time to adjust.
 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.

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 Aggregate demand is the aggregate amount of
goods and services that individuals and institutions
are willing to buy:
1. consumption expenditure
2. investment expenditure
3. government purchases
4. net expenditure by foreigners: the current account

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 Determinants of consumption expenditure include:
◦ Disposable income: income from production (Y) minus
taxes (T).
◦ More disposable income means more consumption
expenditure, but consumption typically increases less than
the amount that disposable income increases.
◦ Real interest rates may influence the amount of saving and
spending on consumption goods, but we assume that they
are relatively unimportant here.
◦ Wealth may also influence consumption expenditure, but
we assume that it is relatively unimportant here.

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 For simplicity, we assume that exogenous political
factors determine government purchases G and the
level of taxes T.
 For simplicity, we currently assume that 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.

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 Determinants of the current account include:
◦ Real exchange rate: prices of foreign products relative to
the prices of domestic products, both measured in
domestic currency: EP*/P
 As the prices of foreign products rise relative to those of
domestic products, expenditure on domestic products rises, and
expenditure on foreign products falls.

◦ Disposable income: more disposable income means more

expenditure on foreign products (imports).

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 The current account measures the value of
exports relative to the value of imports:
CA ≈ EX – IM.
◦ When the real exchange rate EP*/P rises, the prices
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 of imports in terms of domestic products rises:
the value/price of imports rises, since foreign products
are more valuable/expensive.

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 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.

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 Determinants of the current account include:
◦ Real exchange rate: an increase in the real exchange rate
increases the current account.
◦ Disposable income: an increase in the disposable income
decreases the current account.

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 Aggregate demand is therefore expressed as:
D = C(Y – T) + I + G + CA(EP*/P, Y – T)

Consumption Investment
Current account as
expenditure expenditure and
a function of the real
as a function government
exchange rate and
of disposable purchases, both
disposable income.
income exogenous
 Or more simply: D = D(EP*/P, Y – T, I, G)

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 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 the disposable income
increases consumption expenditure, but decreases the
current account.
 Since consumption expenditure is usually greater than
expenditure on foreign products, 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.

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 Equilibrium is achieved when the value of
income from production (output) Y equals the
value of aggregate demand D.
Y = D(EP*/P, Y – T, I, G)

Aggregate demand as a function of the

Value of output real exchange rate, disposable income,
and income from investment expenditure and government
production purchases

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 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 makes
foreign goods and services more expensive relative
to domestic goods and services.
 A rise in the nominal exchange rate (a domestic
currency depreciation) increases aggregate demand
of domestic products.
 In equilibrium, production will increase to match
the higher aggregate demand.

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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.

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 Changes in the exchange rate cause movements
along a DD curve. Other changes cause it to shift:

1. Changes in G: more government purchases cause

higher aggregate demand and output in
equilibrium. Output increases for every exchange
rate: the DD curve shifts right.

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2. Changes in T: lower taxes generally increase
consumption expenditure, increasing aggregate
demand and output in equilibrium for every
exchange rate: the DD curve shifts right.
3. Changes in I: higher investment expenditure is
represented by shifting the DD curve right.
4. Changes in P relative to P*: lower domestic prices
relative to foreign prices are represented by
shifting the DD curve right.

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5. Changes in C: willingness to consume more and
save less is represented by shifting the DD curve
right.
6. Changes in demand of domestic goods relative to
foreign goods: willingness to consume more
domestic goods relative to foreign goods is
represented by shifting the DD curve right.

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 We consider two sets of asset markets:
1. Foreign exchange markets
◦ interest parity represents equilibrium:
R = R* + (Ee – E)/E

2. Money market
◦ Equilibrium occurs when the quantity of real monetary
assets supplied matches the quantity of real monetary
assets demanded: Ms/P = L(R, Y)
◦ A rise in income from production causes the demand of
real monetary assets to increase.

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 When income and production increase,
◦ demand of real monetary assets increases,
◦ leading to an increase in domestic interest rates,
◦ leading to an appreciation of the domestic
currency.
 Recall that an appreciation of the domestic
currency is represented by a fall in E.
 When income and production decrease, the
domestic currency depreciates and E rises.

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 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.

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1. Changes in Ms: an increase in the money supply
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).

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2. Changes in P: An increase in the level of average
domestic prices decreases the supply of real
monetary assets, increasing interest rates, causing
the domestic currency to appreciate (a fall in E): the
AA curve shifts down (left).
3. Changes in the demand of real monetary assets: if
domestic residents are willing to hold a lower
amount of real money assets and more non-
monetary assets, interest rates on nonmonetary
assets would fall, leading to a depreciation of the
domestic currency (a rise in E): the AA curve shifts
up (right).

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4. Changes in R*: An increase in the foreign interest
rates makes foreign currency deposits more
attractive, leading to a depreciation of the domestic
currency (a rise in E): the AA curve shifts up (right).
5. Changes in Ee: if market participants expect the
domestic currency to depreciate in the future,
foreign currency deposits become more attractive,
causing the domestic currency to depreciate (a rise
in E): the AA curve shifts up (right).

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 A short-run equilibrium means a nominal
exchange rate and level of output such that
1. equilibrium in the output markets holds:
aggregate demand equals aggregate output.
2. equilibrium in the foreign exchange markets
holds: interest parity holds.
3. equilibrium in the money market holds: the
quantity of real monetary assets supplied equals
the quantity of real monetary assets demanded.

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 A short-run equilibrium occurs at the intersection
of the DD and AA curves:
◦ output markets are in equilibrium on the DD curve
◦ asset markets are in equilibrium on the AA curve

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 Monetary policy: policy in which the central bank
influences the supply of monetary assets.
◦ Monetary policy is assumed to affect asset markets first.
 Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of
government purchases and taxes.
◦ Fiscal policy is assumed to affect aggregate demand and
output first.
 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.

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 An increase in the quantity of monetary
assets supplied lowers interest rates in the
short run, causing the domestic currency to
depreciate (E rises).
◦ The AA shifts up (right).
◦ Domestic products relative to foreign products are
cheaper, so that aggregate demand and output
increase until a new short-run equilibrium is
achieved.

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 An increase in government purchases or a
decrease in taxes increases aggregate
demand and output in the short run.
◦ The DD curve shifts right.
◦ Higher output increases the demand for real
monetary assets,
 thereby increasing interest rates,
 causing the domestic currency to appreciate
(E falls).

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 Resources used in the production process can either be over-
employed or underemployed.
 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.
◦ 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.

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 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.

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2. Economic data are difficult to measure and to
understand.
◦ Policy makers 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.

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 “Permanent” policy changes are those that are
assumed to modify people’s expectations about
exchange rates in the long run.

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 A permanent increase in the quantity of monetary
assets supplied has several effects:
◦ It 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 (Econ Chapter
14/Finance Chapter 3 results).
◦ The AA curve shifts up (right) more than is the case when
expectations are held constant.

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 With employment and hours above their normal
levels, there is a tendency for wages to rise over
time.
 With strong demand for goods and services and
with increasing wages, producers have an incentive
to raise prices over time.
 Both higher wages and higher output prices are
reflected in a higher level of average prices.
 What are the effects of rising prices?

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 A permanent increase in government purchases or
reduction in taxes
◦ increases aggregate demand
◦ makes people expect the domestic currency to appreciate
in the short run due to increased aggregate demand,
thereby reducing the expected rate of return on foreign
currency deposits and making the domestic currency
appreciate.

 The first effect increases aggregate demand of

domestic products, the second effect decreases
aggregate demand of domestic products (by
making them more expensive).

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 If the change in fiscal policy is expected to be
permanent, the first and second effects
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.

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 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.
 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.

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 The XX curve slopes upward but is flatter than the
DD curve.
◦ DD represents equilibrium values of aggregate demand and
domestic output.
◦ As domestic income and production increase, domestic
saving increases, which means that aggregate demand
(willingness to spend) by domestic residents does not rise
as rapidly as income and production.

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◦ As domestic income and production increase, the domestic
currency must depreciate to entice foreigners to increase
their demand of domestic products in order to keep the
current account (only one component of aggregate
demand) at its desired level—on the XX curve.
◦ As domestic income and production increase, the domestic
currency must depreciate more rapidly to entice foreigners
to increase their demand of domestic products in order to
keep aggregate demand (by domestic residents and
foreigners) equal to production—on the DD curve.

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 Policies affect the current account through their
influence on the value of the domestic currency.
◦ An increase in the quantity of monetary assets supplied
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.

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 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.

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 Pass-through from the exchange rate to import
prices measures the percentage by which import
prices change when the value of the domestic
currency 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.
 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.

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 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.

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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.

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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.

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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.

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 Appendix 1:
Intertemporal Trade
and Consumption
Demand
70
 Chapter 17 (6)

Appendix 2: The
Marshall-Lerner
Condition and
Empirical Estimates
of Trade Elasticities
72