Output and the Exchange Rate in the Short Run Chapter 17 Krugman, Obstfeld, and Melitz 10e ECO41 International Economics Udayan Roy Long Run and Short Run Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand. 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 market demand. This chapter discusses a theory of the short run behavior of a small economy with flexible exchange rates under perfect capital mobility 16-2 Long Run and Short Run Variable Long Run Short Run P, the overall price level Endogenous Exogenous Y, inflation-adjusted GNP Exogenous Endogenous Ee, expected future value of the exchange rate Endogenous Exogenous Every theory consist of exogenous variables and endogenous variables. Endogenous variables are those variables whose up and down movements the theory is trying to explain. Exogenous variables are those variables that the theory finds useful in explaining the up and down movements of the endogenous variables. However, the theory has nothing to say about the up and down movements of the exogenous variables. In other words, the exogenous variables are mystery variables. Changes in the exogenous variables explain changes in the endogenous variables, but the theory has no idea why the exogenous variables occasionally change in value. Equilibrium in the markets for goods and services requires that the output of goods and services be equal to the demand for goods and services. We discussed this earlier in this course, in my

PowerPoint lecture on Chapter 16. THE DD CURVE Determinants of Aggregate Demand Aggregate demand (D) is the aggregate amount of goods and services that people are willing to buy. It consists of the following types of expenditure: 1. 2. 3. 4. consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditure by foreigners: the current account (CA) So, Determinants of Aggregate Demand Assumption: Consumption expenditure (C) increases when disposable income (Y T)which is income (Y) minus taxes (T)increases but by less than the increase in disposable income Consumption (C) = ( , ) D B A National Income (Y) Determinants of Aggregate Demand is exogenous consumption. This is what consumption spending would be when after-tax income is zero. reflects the impact on consumption spending of all factors other than after-tax income. For example, may change when there are changes in interest rates, households wealth, or consumers confidence 16-7 The Consumption Function Consumption (C)

= ( , ) D B Down shift: C0 or T A National Income (Y) Determinants of Aggregate Demand Both investment spending (I) and government spending (G) are assumed to be exogenous Investment (I) Government Purchases (G) National Income (Y) National Income (Y) Determinants of Aggregate Demand Assumption: The balance on the current account (CA) increases when the real exchange rate (q) increases Recall that the real exchange rate is the price of foreign products relative to the price of domestic products: q = EP*/P when disposable income decreases more disposable income (Y-T) means more expenditure on foreign products (imports). Therefore, when YT rises, CA falls. Determinants of Aggregate Demand is exogenous net exports. It mainly represents import tariffs. Net Exports (CA) + Up shift: CA0, E, P*, P, T National Income (Y) 0 = , , ( )

Determinants of Aggregate Demand Recall that consumption spending (C) increases when disposable income (Y T) increases, but by a smaller amount. For example, if disposable income increases by $100, consumption spending may increase by, say, $80. Part of this $80say, $30may be spent on imports. So, net exports (CA) would decrease by $30. Assumption: When Y T increases, CA decreases, but by less than the increase in C. 16-12 Determinants of Aggregate Demand Therefore, Effect of Income on Aggregate Demand When Y T increases, C increases, but by less than the increase in Y T. When Y T increases, CA decreases, but by less than the increase in C. As a result, aggregate demand increases when disposable income (Y T) or income (Y) increases. But the increase in aggregate demand is smaller than the increase in disposable income or income. Aggregate Demand (D) Aggregate Demand (D) Up shift: C0, T, I, G, CA0, E, P*, P D B A = ( , ) + + + , , ( National Income (Y) ) An increase in national income (Y) leads to an increase in consumption (C) and a decrease in net exports (CA). But, by assumption, the increase in C outweighs the decrease in CA. Therefore, aggregate demand increases (D) when national income increases (Y). However, the increase in D is smaller than the increase in Y because of the assumption

that, when Y increases, C also increases but by less. So, the aggregate demand curve is rising but flatter than the 45-degree line. Equilibrium in the Goods Market For the goods market to be in equilibrium, GNP must equal aggregate demand: Therefore, This equation represents equilibrium in the domestic countrys goods markets Goods Market Equilibrium(Y = D) Aggregate Demand (D) ; the 45-degree line A = ( , ) + + + , , ( National Income (Y) ) Goods Market Equilibrium(Y = D) Aggregate Demand (D) ; the 45-degree line Up shift: C0, T, I, G, CA0, E, P*, P B A = ( , ) + + + , , ( National Income (Y) ) Any combination of the changes C0, T, I, G, CA0, E, P*, P will lift aggregate demand up. So, the goods market equilibrium outcome will move from A to B. Therefore, if the goods market remains in equilibrium, any combination of the changes C0, T, I, G, CA0, E, P*, P will lead to Y.

The DD Curve We just saw that any combination of C0, T, I, G, CA0, E, P*, P lifts aggregate demand up. Therefore, if the goods market remains in equilibrium, any combination of C0, T, I, G, CA0, E, P*, P will lead to Y. In particular, E will lead to Y. This gives us the DD curve. Shifts of the DD Curve We have seen that even if E remains fixed, any combination of C0, T, I, G, CA0, P*, P lifts aggregate demand up. Therefore, at any fixed E, any combination of C0, T, I, G, CA0, P*, P will lead to Y. Therefore, C0, T, I, G, CA0, P*, P will shift the DD curve to the right. Shifts of the DD Curve So, we see that the DD curve shifts to the right if: There is an increase in C0, I, G, CA0, or P*, or There is a decrease in T or P Note that every one of these shifts represents an increase in aggregate demand So, the DD curve shifts right whenever an exogenous change boosts aggregate demand Shifting the DD Curve The DD curve shifts right if: G increases Simply put, the DD curve shifts right whenever an exogenous change boosts aggregate demand T decreases I increases P decreases

P* increases C increases for some unknown reason (C0) CA increases for some unknown reason (CA0) Equilibrium in the foreign currency markets requires interest rate parity (Ch. 14). Equilibrium in the money market requires equality of money supply and money demand (Ch. 15). THE AA CURVE Two Markets: Foreign Exchange and Money So far, we have seen the equilibrium conditions for the two asset markets The foreign exchange market (Ch. 14), and The money market (Ch. 15) = + = Equilibrium in Asset Markets Equivalently, Interest parity equation then yields This equationthe AA equationmust be true if there is equilibrium in the foreign exchange and money markets Equilibrium in Asset Markets AA equation: L0 and R* are assumed exogenous throughout

Ee and P are assumed exogenous for short-run analysis Ms is assumed exogenous under flexible exchange rates So, we get an inverse link between Y and E. This gives us the AA Curve Equilibrium in Asset Markets AA equation: We get an inverse link between Y and E. Why? If E increases, the right-hand-side of the equation decreases. Therefore, Y must decrease. Fig. 17-7: The AA Curve = + 1 0 ( ) Shifting the AA Curve Suppose the economy is initially at Point 2 Suppose there is a decrease in Ms or R* or Ee, or an increase in L0 or P If E stays unchanged at E2, then Y must decrease The economy must go from Point 2 to, perhaps, Point 3 In other words, a decrease in Ms or R* or Ee, or an increase in L0 or P shifts the AA curve left 3 AA2 Shifting the AA Curve The AA curve shifts right if:

Ms increases P decreases Reduces money demand Ee increases Increases R -- recall interest parity which in turn reduces money demand R* increases L decreases for some unknown reason (L0) Reduces money demand E = + ( ) E0 E1 Y0 Y1 Y Shifting the AA Curve The AA curve shifts right if: Ms increases Simply put, the AA curve shifts right whenever an exogenous change increases P decreases money supply or decreases money e E increases demand R* increases L decreases for some unknown reason (L0) E

= + ( ) E0 E1 Y0 Y1 Y All markets must be simultaneously in equilibrium SHORT-RUN MACROECONOMIC EQUILIBRIUM Putting the Pieces Together: the DD and AA Curves A short-run equilibrium means 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 (MS) equals money demand (Md). 16-33 Fig. 17-8: Short-Run Equilibrium: The Intersection of DD and AA The output market is in equilibrium on the DD curve The short run equilibrium occurs at the intersection of the DD and AA curves. At that point all markets are in equilibrium. The asset markets are in equilibrium on the AA curve

17-34 SHORT-RUN PREDICTIONS OF TEMPORARY CHANGES IN OUR EXOGENOUS VARIABLES Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason (C0) CA increases for some unknown reason (CA0) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0)

Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change. Shifts in the AA curve We have seen earlier that any combination of Ms, Ee, R* , and L0 will shift the AA curve to the right and leave the DD curve unchanged Therefore, both E and Y must increase This yields the predictions summarized in the table DD E DD E0 AA Y Y0 AA Y E Ms + + L0 Ee + + R*

+ + Shifts in the DD curve We saw earlier that C0, T, I, G, CA0, P* will shift the DD curve to the right and not affect the AA curve. Therefore, E must decrease and Y must increase. This yields the predictions summarized in the table E DD E0 AA Y Y0 DD AA Y E Ms + + L0 Ee

+ + R* + + G, I, C0 + CA0 + T + P* + Change in Domestic Prices (P) Recall that P causes both AA and DD curves to shift rightward Therefore, it is clear that Y But E could decrease, stay unchanged, or increase, as in the three diagrams below E E

DD AA E DD AA Y DD AA Y Y Short Run Predictions, Flexible Exchange Rate System Combining our results, we get the predictions of how all our exogenous variables affect national income (Y) and the price of the foreign currency (E). We still need to derive predictions for q, R, and CA. DD AA Y E Ms + + L0 Ee

+ + R* + + G, I, C0 + CA0 + T + P* + P ?

The Real Exchange Rate: Part 1 Recall that the real exchange rate is the price of foreign goods (measured in units of domestic goods) Recall that one exogenous variable cannot affect another, by definition Therefore, the equation above implies that if any exogenous variable, other than P and P*, changes, its effect on q will be the same as its effect on E. The Real Exchange Rate: Part 1 We just saw that if any exogenous variable, other than P and P*, changes, its effect on q will be the same as its effect on E. This gives us the predictions in the table I will come back to the missing cells later DD AA Y E q Ms + + + L0 Ee

+ + + R* + + + G, I, C0 + CA0 + T + + P* +

Later P ? Later The Current Account We have seen that there are two ways to figure out the effect of a change in an exogenous variable on a countrys current account Method 1: Method 2: The Current Account Method 2: Recall thatfor fixed C0, T, I, and Gnet exports (CA) is directly related to national income (Y). Recall that one exogenous variable cannot affect another, by definition Therefore, the equation above implies that if any exogenous variable, other than C0, T, I, and G, changes, its effect on CA will be the same as its effect on Y. The Current Account Therefore, we get the predictions in this table I will return to the missing cells DD AA Y CA E q Ms +

+ + + L0 Ee + + + + R* + + + + G, I, C0 + Later

CA0 + + T Later + + P* + + Later P ? Later The Current Account Method 1: From the table in the previous

slide, check that if C0, T, I, G, then disposable income increases and the real exchange rate decreases. As is directly related to q and inversely related to Y T, it follows that CA must decrease. DD AA Y CA E q Ms + + + + L0 Ee + + +

+ R* + + + + G, I, C0 + Later CA0 + + T + Later + + P*

+ + Later P ? Later The Real Exchange Rate: Part 2 If P or P*, note that CA and Y T. But, as is inversely related to Y T, CA can increase only if q increases. Therefore, if P or P*, then q. DD AA Y CA E q Ms + +

+ + L0 Ee + + + + R* + + + + G, I, C0 + CA0

+ + T + + + P* + + Later + P ? Later The Interest Rate (R) To derive the predictions for the interest rate, I will use the equations we studied in Chapters 14 and 15: Ch. 14:

Ch. 15: or, equivalently, . The Interest Rate (R) Lets use . Recall that one exogenous variable cannot affect another, by definition Therefore, the equation above implies that if any exogenous variable, other than L0, P, and Ms, changes, its effect on R will be the same as its effect on Y. This yields the predictions in the table DD AA Y CA q E R Ms + + + + Later L0 Later

Ee + + + + + R* + + + + + G, I, C0 + + CA0 + +

+ T + + + P* + + + + P ? Later The Interest Rate (R) Lets use . Recall that one exogenous variable cannot affect another, by definition Therefore, the equation above implies that if any exogenous variable, other than R* and Ee, changes, its effect on R will be the inverse of its effect on E.

This yields the predictions in the table The effects of P on E and R remain ambiguous, unfortunately. DD AA Y CA q E R Ms + + + + Later L0 Later + Ee +

+ + + + R* + + + + + G, I, C0 + + CA0 + + + T

+ + + P* + + + + P ? Later ? Summary: Short Run Predictions, Flexible Exchange Rate System DD AA Y CA q E

R Ms + + + + L0 + Ee + + + + + R* + + +

+ + G, I, C0 + + CA0 + + + T + + + P* + +

+ + P ? ? The exogenous variablespolicy variables and shocksare listed on the first column and the endogenous unknowns are listed on the first row. The predictions above are for temporary changes in the exogenous variables. The 2nd and 3rd columns show how the DD and AA curves are shifted by an increase in the exogenous variables. Summary: Short Run Predictions, Flexible Exchange Rate System DD AA Y CA q E R Ms +

+ + + L0 + Ee + + + + + R* + + + + + G, I, C0

+ + CA0 + + + T + + + P* + + + + P

? ? Q: If the economy is in a recessionwith falling output and rising unemploymentwhat kind of monetary and fiscal policy would be appropriate? A: Expansionary fiscal policy (G and/or T) and expansionary monetary policy (Ms) Summary: Short Run Predictions, Flexible Exchange Rate System DD AA Y CA q E R Ms + + + + L0

+ Ee + + + + + R* + + + + + G, I, C0 + + CA0

+ + + T + + + P* + + + + P ? ?

Q: If the economy has a huge trade deficit and it has become necessary to increase net exports (CA), what kind of monetary and fiscal policy would be appropriate? A: Contractionary fiscal policy (G and/or T) and expansionary monetary policy (Ms) Summary: Short Run Predictions, Flexible Exchange Rate System DD AA Y CA q E R Ms + + + + L0 + Ee +

+ + + + R* + + + + + G, I, C0 + + CA0 + + + T

+ + + P* + + + + P ? ? Q: If foreign prices or foreign interest rates decrease, what kind of monetary and fiscal policy would keep output and unemployment stable in the domestic country? A: Expansionary fiscal policy (G and/or T) and expansionary monetary policy (Ms) Practice: Short Run Predictions, Flexible Exchange Rate System DD Ms L0 Ee R* G, I, C0 CA0 T

P* P AA Y CA q E R Short-run effects of temporary changes in MONETARY POLICY Temporary Changes in Monetary Policy Monetary policy: what central banks do to influence the economy through changes in the money supply (MS). AA Y CA q E R Ms + + + + L0

+ Monetary policy primarily affects asset markets (the AA curve). Ee + + + + + + + + + + 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. Specifically, temporary changes in MS do not affect Ee. Expansionary monetary policy: MS Contractionary monetary policy: MS DD R* G, I, C0 +

+ CA0 + + + T + + + P* + + + + P

? ? Short-Run Monetary Policy The standard story of expansionary monetary policy that you may remember from your previous macroeconomics courses is as follows: The nations central bank prints money (Ms) and lends it to banks. Banks get the public to borrow the newly printed money by reducing the interest rate (R). Seduced by the cheap interest rate, both households and businesses borrow and spend. This increase in aggregate demand leads to higher output (Y). DD AA Y CA q E R Ms + + + + L0

+ Ee + + + + + R* + + + + + G, I, C0 + + CA0

+ + + T + + + P* + + + + P ? ?

Short-Run Monetary Policy In international macroeconomics, however, a different monetary policy mechanism is emphasized: When the central bank expands money supply, the interest rate falls (R). This induces people to move their wealth abroad by selling the domestic currency and buying the foreign currency. This increases the price of the foreign currency (E). This increases the relative price of foreign goods (q). So, net exports surge (CA). This increase in aggregate demand leads to higher output (Y). DD AA Y CA q E R Ms + + + + L0

+ Ee + + + + + R* + + + + + G, I, C0 + + CA0 + +

+ T + + + P* + + + + P ? ? Changes in E and R e Any increase in Ee, the expected future

value of the foreign currency, or in R*, the foreign interest rate, cause the same shifts as expansionary monetary policy: the AA curve shifts rightward and the DD curve is unaffected Therefore, Y and E. As P and P*, being exogenous, are unaffected, E implies q * DD AA Y CA q E R Ms + + + + L0 + Ee

+ + + + + R* + + + + + G, I, C0 + + CA0 + + +

T + + + P* + + + + P ? ? Changes in E and R e * Heres an informal story about the effects of increases in R* and Ee: When the foreign interest rate rises and the expected future value of the foreign currency rises, keeping money in foreign banks becomes more attractive. So people sell the domestic currency and buy the foreign currency to move

money abroad. So the domestic currency loses value and the foreign currency gains value (E). This makes foreign goods more expensive (q). Consequently the domestic countrys net exports increase (CA). This boosts domestic aggregate demand and output (Y). Changes in E and R e Continuing the informal story about the effects of increases in R* and Ee: The rise in output causes money demand to rise, which means less lending. Less lending pushes up the domestic interest rate (R). In short, everything increases! * DD AA Y CA q E R Ms + + + + L0

+ Ee + + + + + R* + + + + + G, I, C0 + + CA0 +

+ + T + + + P* + + + + P ? ? DD

Short-run effects of temporary changes in FISCAL POLICY AA Y CA q E R Ms + + + + L0 + Ee + + +

+ + R* + + + + + G, I, C0 + + CA0 + + + T +

+ + P* + + + + P ? ? Short-Run Fiscal Policy Fiscal policy is what governments do to influence the economy through changes in government spending (G) and taxes (T). Fiscal policy primarily influences the goods market (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. Specifically, temporary changes in G and T do not affect Ee. Expansionary fiscal policy: G and/or T Contractionary fiscal policy: G and/or T 16-64 Short-Run Fiscal Policy An increase in government purchases or a decrease in taxes increases aggregate demand and output. The DD curve shifts right.

Higher output increases money demand, and thereby increases interest rates, causing an increase in the value of the domestic currency (a fall in E). This reduces net exports, but not too much, which is why output increases despite falling net exports. Short-Run Fiscal Policy Heres an informal story of the effects of expansionary fiscal policy: Fiscal stimulus raises domestic aggregate demand and output (Y). This raises money demand, meaning people become less willing to lend. This raises the domestic interest rate (R). DD AA Y CA q E R Ms + + + + L0

+ Ee + + + + + R* + + + + + G, I, C0 + + CA0 + +

+ T + + + P* + + + + P ? ? Short-Run Fiscal Policy Continuing the informal story of expansionary fiscal policy: So people sell foreign currencies and buy the domestic currency to move their wealth to

domestic banks. This raises the value of the domestic currency and reduces the value of the foreign currency (E). This makes foreign goods cheaper (q). Both the rising income at home and the cheaper foreign goods reduce net exports (CA). DD AA Y CA q E R Ms + + + + L0 + Ee +

+ + + + R* + + + + + G, I, C0 + + CA0 + + + T

+ + + P* + + + + P ? ? Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases

I increases P decreases P* increases C increases for some unknown reason (C0) CA increases for some unknown reason (CA0) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0) Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change. Fig. 17-11: Effects of a Temporary Fiscal Expansion G and/or T C0, CA0, P* and I also shift DD to the right and leave AA unaffected. So, they too have the same effect: Y, E, and R. 17-69 Change in Foreign Prices (P*) We saw earlier that P* causes the DD

curve to shift right and has no effect on the AA curve Therefore, E and Y. And, from , it follows that CA From , it then follows that q [Can you verify this?] DD AA Y CA q E R Ms + + + + L0 + Ee +

+ + + + R* + + + + + G, I, C0 + + CA0 + + + T

+ + + P* + + + + P ? ? Change in Foreign Prices (P ) * Recall that (interest parity) We just saw that a temporary increase in P* reduces E But it cannot affect R* and Ee, which are exogenous It follows that the domestic interest rate must increase: R

An Increase in Import Tariffs or Foreign National Income (CA0) We have seen before that CA0 causes Y, E, R, and q Then, from , it follows that CA DD AA Y CA q E R Ms + + + + L0 + Ee +

+ + + + R* + + + + + G, I, C0 + + CA0 + + + T

+ + + P* + + + + P ? ? Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases

I increases P decreases P* increases C increases for some unknown reason (C0) CA increases for some unknown reason (CA0) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0) Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change. Change in Domestic Prices (P) As Y, it follows from that CA From , it then follows that q [Can you verify this?] Finally, the interest parity equation () implies that, as Ee and R* are exogenous and, therefore, unaffected by P, the ambiguous behavior of E implies that R too could decrease, stay unchanged, or increase DD AA

Y CA q E R Ms + + + + L0 + Ee + + + + + R*

+ + + + + G, I, C0 + + CA0 + + + T + + +

P* + + + + P ? ? Requires a quick detour of Chapter 16 SHORT-RUN EFFECTS OF PERMANENT CHANGES IN GOVERNMENT POLICY The Exchange Rate in the Future Recall from Chapter 16, the long-run predictions for the price of the foreign currency (under flexible exchange rates, obviously). When there is a permanent change in an exogenous variable, it is reasonable to expect the future value of the exchange rate to change If there are permanent changes in any of the exogenous variables, we must assume that Ee would change as indicated. Right away! Long Run Yf C0 + I + G T CA0 Ms L0

R* M s g Y fg * P* E ? + + + + Fiscal Policy Note from the previous slide that a permanent increase in G and/or a permanent decrease in T will cause E to decrease in the long run Therefore, we should expect Ee to decrease in the short run, in fact immediately G and/or T shifts the DD curve right And Ee shifts the AA curve left Shifting the AA and DD Curves The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason (C0)

CA increases for some unknown reason (CA0) The AA curve shifts right if: Ms increases P decreases Ee increases R* increases L decreases for some unknown reason (L0) Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change. Fiscal Policy in the Short Run When expansionary fiscal policy is temporary, the DD curve shifts right and the AA curve is unaffected When expansionary fiscal policy is permanent, the DD curve shifts right and the AA curve shifts left Therefore, expansionary fiscal policy is less effective when it is permanent!! Permanent Increase in Money Supply The AA curve shifts right because of the increase in MS. The equilibrium moves from point 1 to point 3 in Fig 17-14. In the long run, E will rise (See 3 slides back) This will have the immediate effect of raising Ee. The increase in Ee shifts the AA curve to the right again. The equilibrium moves from point 3 to point 2. Both E and Y increase more for a permanent increase in MS than for a temporary increase in MS. Permanent in Ms: Overshooting? AA1 is the initial AA curve AA2 is AA1 plus effect of Ee caused by permanent in Ms. AA3 is AA2 plus effect of Ms/P caused by permanent in Ms. In the long run, Ms/P returns to original level. So, the economy goes from the lower of the two green dots to a black dot in the short run, and to the higher of the two green dots in the long run. E DD2 DD1

E DD2 DD1 AA3 Overshooting Y DD2 DD1 AA3 AA2 AA1 AA2 AA1 Yf E Yf Y Neither over nor under! AA3 AA2 AA1 Yf Undershooting Y