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1、Output and Exchange Rate in the Short Run,WONG Ka Fu28th February 2000,Aggregate demand for domestic goods,D=C+I+G+CA=C+I+G+EX-IM,Consumption of domestic goods,C=C(Yd),dC/dYd 0=C(Y-T)Yd=disposable income,Consumption by home citizens,Consumption,Consumptionof domestic goodsI.e.,C,Consumptionof foreig
2、n goodsI.e.,IM,Current account,CA=CA(qH/F,Yd)=EX(qH/F,Yd)-IM(qH/F,Yd)qH/F=(EH/F PF)/PH The units of home good basket per foreign good basket.For completeness,we can also writeCA=CA(qH/F,Yd,YFd),YFd=Foreign disposable income,CA/qH/F 0(CA measured in domestic output),qH/F,EX,IM,volume,price,IM?,CA,Ass
3、umed,CA/Yd 0,Y,EX,IM,CA,Aggregate Demand for domestic goods,D=C+I+G+CA=C(Y-T)+I+G+CA(qH/F,Y-T)=D(qH/F,Y-T,I,G),1 D/Y 0,Y,C,CA,D,Although an increase in Y is expected to raise the total consumption(IM and C)by an unknown amount,we assume the increase in C is larger than the increase in IM.,Because im
4、port increasesbut export remains unchanged,1 D/Y 0,Output(real income),Y,Aggregate demand,D,D(qH/F,Y-T,I,G),Determination of output in the short run,Output(real income),Y,Aggregate demand,D,D(qH/F,Y-T,I,G),D=Y,Effect of an increase in E on short-run output equilibrium,Output(real income),Y,Aggregate
5、 demand,D,D=Y,D(EH/F2 PF/PH,Y-T,I,G),Home currency depreciation,i.e.,E2E1,Y1,Y2,D(EH/F1 PF/PH,Y-T,I,G),Output,Y,Output,Y,D=Y,D(EH/F1 PF/PH,Y-T,I,G),D(EH/F2 PF/PH,Y-T,I,G),E1,E2,D,E,DD,Y1,Y2,The DD schedule,Output,Y,Output,Y,D=Y,D(EH/F1 PF/PH,Y-T,I,G),D(EH/F2 PF/PH,Y-T,I,G),E1,E2,D,E,DD,Y1,Y2,If we w
6、ere at 3.,3,3,Output,Y,Output,Y,D=Y,D(EH/F PF/PH,Y-T,I,G1),D(EH/F PF/PH,Y-T,I,G2),E,D,E,DD1,Y1,Y2,Effect of an G increase,DD2,The following changes have similar effect on DD schedule,An increase in GA decrease in TAn increase in IA decrease in PHAn increase in PFAn autonomous increase in consumption
7、A shift of demand from foreign to domestic goods,Rate of return(in home currency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH),1,1,EH/F1,Real money holdings,Relationship between Exchange rate and money supply,Rate of return(in home currency),Expec
8、ted return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH1),1,1,EH/F1,Real money holdings,Effect of an increase in output,L(RH,YH2),EH/F2,2,2,AA,Output,Y,ExchangeRate,E,E1,E2,Y1,Y2,AA,Output,Y,ExchangeRate,E,E1,E2,Y1,Y2,3,If we were at 3.,Rate of return(in home curr
9、ency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH1),1,1,EH/F1,Real money holdings,If we were at 3.,L(RH,YH2),EH/F2,2,2,3,Factors that shift the AA schedule,A change in real money supply A change in MsA change in PA change in EeA change in RFA chan
10、ge in L(RH,Y),Output,Y,ExchangeRate,E,DD,AA,Y1,E1,Short-run equilibrium:The intersection of DD and AA,1,Output,Y,ExchangeRate,E,DD,AA,Y1,E1,If we were at 2.,1,E3,E2,2,3,Note:Asset market adjust much faster than output,Temporary changes in monetary and fiscal policy,Temporary policy shifts are shifts
11、 that the public expects to be reversed in the near future.A temporary policy shift does not affect the long-run expected exchange rate,EH/Fe.,A permanent increase in money supply,Time,Money supply,t0,A temporary increase in money supply,Time,Money supply,t0,t1,Output,Y,ExchangeRate,E,DD,AA1,Y1,E1,A
12、 temporary increase in money supply,1,2,AA2,Y2,E2,A temporary Fiscal expansion(increase in government expenditure),Time,Government expediture,t0,t1,Output,Y,ExchangeRate,E,DD1,AA,Y1,E1,A Temporary Fiscal Expansion,1,DD2,2,E2,Y2,A temporary under full employment caused by a temporary fall in world de
13、mand,the restoration of full employment,and,A temporary fall in world demand,Time,World demand,t0,t1,Output,Y,ExchangeRate,E,DD2,AA,Y2,E2,A temporary fall in world demand,2,DD1,1,E1,Yf,Two ways to restore full employment,A temporary fiscal policyA temporary monetary policy,Output,Y,ExchangeRate,E,DD
14、2,AA,Y2,E2,Restoring full employment by a temporary fiscal expansion,2,DD1,1,E1,Yf,Output,Y,ExchangeRate,E,DD2,AA1,Y2,E2,Restoring full employment by a temporary monetary expansion,2,DD1,1,E1,Yf,E3,3,AA2,Different effects in the use of fiscal and monetary tools to restore full employment,Fiscaltempo
15、rary increase in G:purchase domestic goodsbudget deficitExchange rate returns to pre-shock level,Monetarytemporary increase in money supplyinterest rate decreasesExchange rate(E)higher than pre-shock levelExchange rate also higher than the case without any stabilizing policy.,A temporary under full
16、employment caused by a temporary increase in money demand,the restoration of full employment,and,A temporary increase in money demand,Time,Money demand,t0,t1,Output,Y,ExchangeRate,E,DD1,AA2,Y2,E2,A temporary increase in money demand,2,Yf,E1,1,AA1,Two ways to restore full employment,A temporary fisca
17、l policyA temporary monetary policy,Output,Y,ExchangeRate,E,DD1,AA2,Y2,E2,2,Yf,E1,1,AA1,Restoring full employment by a temporary monetary expansion,Output,Y,ExchangeRate,E,DD1,AA2,Y2,E2,Restoring full employment by a temporary fiscal expansion,2,DD2,3,E3,Yf,E1,1,AA1,Permanent shifts in monetary and
18、fiscal policy,A permanent policy shift affects not only the value of the governments policy instrument(the money supply,government spending,or taxes)but also the long-run exchange rate and hence expectations about future exchange rates,A permanent increase in money supply,A permanent increase in mon
19、ey supply,Time,Money supply,t0,Rate of return(in home currency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH1/PH),EH/F3,Real money holdings,Effect of a permanent increase in money supply,L(RH,YH),EH/F1,EH/F2,(MsH2/PH),Output,Y,ExchangeRate,E,DD,AA1,Yf,E1,A perm
20、anent increase in money supply,1,2,AA2,Y2,E2,3,Change in price level after a permanent increase in money supply,Price level rigid in the short runPrice level slowly adjusts in the intermediate runPrice level changes by the same proportion as the change in money supply in the long run.,Output,Y,Excha
21、ngeRate,E,DD1,AA1,Yf,E1,Long-run adjustment to a permanent increase in money supply,1,2,AA2,Y2,E2,3,AA3,DD2,E3,Overshooting revisited,After a permanent change in monetary policy,the initial response of exchange rate is greater than its long-run response.,A permanent fiscal expansion,Output,Y,Output,
22、Y,D=Y,D(EH/F1 PF/PH,Y-T,I,G),D(EH/F2 PF/PH,Y-T,I,G),E1,E2,D,E,DD,Y1,Y2,The DD schedule,Output,Y,Output,Y,D=Y,D(EH/F PF/PH,Y-T,I,G1),D(EH/F PF/PH,Y-T,I,G2),E,D,E,DD1,Y1,Y2,Effect of an G increase,DD2,Output,Y,ExchangeRate,E,DD1,E1,Effect of a Permanent Fiscal Expansion on DD,DD2,A permanent fiscal ex
23、pansion implies an increase in world relative demand for home products,Relative demand for home products,EH/F,because EH/F=qH/F(PH/PF),qH/F,Rate of return(in home currency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH),1,1,EH/F1,Real money holdings
24、,Relationship between Exchange rate and money supply,Rate of return(in home currency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH1),1,1,EH/F1,Real money holdings,Effect of an increase in output,L(RH,YH2),EH/F2,2,2,AA,Output,Y,ExchangeRate,E,E1,E2,
25、Y1,Y2,Rate of return(in home currency),Expected return on foreign deposit,Return on home deposit,HD/FDexchange rate,0,(MsH/PH)1,L(RH,YH1),EH/F1,Real money holdings,Effect of a decrease in expected EH/F,EH/F2,Output,Y,ExchangeRate,E,AA1,E1,Effect of a Permanent Fiscal Expansion on AA,E2,AA2,Claim:,sh
26、ort-run output unchanged after a permanent fiscal expansion,Output,Y,ExchangeRate,E,DD1,AA1,Yf,E1,A Permanent Fiscal ExpansionClaim:short-run output unchanged,1,DD2,2,E2,AA2,3,Why must the shift in AA offset the shift in DD in the short run?,A possibility:A permanent fiscal expansion implies an incr
27、ease in world relative demand for home products,Relative demand for home products,EH/F,because EH/F=qH/F(PH/PF),qH/F,Assumptions,The economy starts out in long-run equilibrium,I.e.,Y=YfRH=RF,The long-run effect of a permanent fiscal expansion,output unchanged YfMs unchangedL(R,Y)unchanged because ou
28、tput unchangedP unchanged,Proof by contraction,Know what would happen in the long runWant to show that the proposed short-run equilibrium is consistent with the“known”long run equilibrium.Suppose the proposed SR is wrong,I.e.SR equilibrium output is above full employmentWant to show that we will nev
29、er return to the“known”long run equilibrium.,Can Y Yf in the short run?,1.Note that Ms/P unchanged in the short run2.Suppose Y Yf in the short run.,Output,Y,ExchangeRate,E,DD1,AA1,Yf,E1,If Y Yf in the short run,1,DD2,2,E2,AA2,3,Can Y Yf in the short run?,3.L(R,Y)rises for a given interest rate RH.4.
30、Because Ms/P unchanged in the short run,RH must rise.I.e.,RH RF.5.By interest parity,E would decrease.This is the supposed short-run equilibrium as shown in the figure.,Can Y Yf in the short run?,6.However,because we expect output to fall back to full employment,interest parity implies Ee will have
31、to increase in the long run.7.Since P unchanged in the long run,q must increase.,Can Y Yf in the short run?,8.This makes home good cheaper and stimulates demand.9.Output would increase even more.Thus,the assumption that short run output is larger than Yf contradicts that long run output will be Yf.H
32、ence,Y cannot be larger than Yf,What is the Current Account balance at equilibrium?,Output,Y,ExchangeRate,E,XX curve:CA(EPF/PH,Y-T)=X,Yf,E1,XX(CA=a),Output,Y,ExchangeRate,E,XX curve:CA(EPF/PH,Y-T)=X,Yf,E1,XX(CA=a),XX(CA=b),ba becauseCA/qH/F 0 CA/Yd 0,Output,Y,ExchangeRate,E,DD1,Macroeconomic policy
33、and current account,Yf,E1,1,AA1,XX,Output,Y,ExchangeRate,E,DD,XX is flatter than DD,E1,XX,An increase in E leads to an improvement in CA and an increase in equilibrium output in goods market.,In order to keep CA constant,for this output level,E must decrease to depress export and raise import.,Outpu
34、t,Y,ExchangeRate,E,DD1,Current account after a temporary monetary expansion,Yf,E1,AA1,XX(CA=a),AA2,XX(CAa),Current account improves,How quickly does current account respond to foreign exchange rate changes?,J-curve,CA worsens immediately after a real currency depreciation and improves only some mont
35、hs later.Because most import and export orders are placed several months in advance and the primary effect of the depreciation is to raise the value of the pre-contracted level of imports in terms of domestic products.,Empirical Evidence:,6-12 months lagonly about 50%of the full quantity adjustment
36、takes place in the first three years90%in the first five years,Reasons for lag,Imperfect dissemination of information,during which importers recognize that relative prices have changedlag in deciding to place new import orderproduction lag even after new import order is placed,Reasons for lag:hyster
37、esis,producers sometimes relocate their factories to the country where costs are lower because of an exchange rate advantage.Even after the exchange rate has returned to old levels,a company that decided to move operations abroad when the dollar was high might never move back,after having incurred t
38、he costs of moving.I.e.,hysteresis.,End of J curve,Real depreciation takes place,Time,Long run effect of real depreciation on the CA,J-curve,J-curve,Implication:If expansionary monetary policy actually depresses output in the short run,the domestic interest rate will need to fall further than it nor
39、mally would to clear the home money market.,Exchange rate pass-through,The percentage by which import prices rise when the home currency depreciates by one percent is known as the degree of pass-through from the exchange rate to import prices.,Reason(s)for incomplete pass-through,International marke
40、t segmentation:imperfectly competitive firms will charge different prices for the same product in different countries.The firm may wait to find out if the currency movement reflects a definite trend before making price and production commitments that are costly to undo.,Want to know more.,Chapter 16 of Krugman and Obstfeldthe appendix,in particular,if you want to know more aboutThe relationship between IS-LM and DD-AA analysisThe conditions under which CA improves after a depreciation,
