Chapter 16

Output and the Exchange Rate

in the Short Run
2
Preview
Determinants of aggregate demand in the short
run
A short run model of output market equilibrium
A short run model of asset market equilibrium
A short run model for both output market
equilibrium and asset market equilibrium
Effects of temporary and permanent changes in
monetary and fiscal policies.
Adjustment of the current account over time.
3
Introduction
LR models are useful when all prices of inputs and
outputs have time to adjust.
In the SR, 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 builds on the previous models of exchange
rates to explain how output is related to exchange rates
in the short run.
macroeconomic policies affect output, employment and the
current account.
4
Determinants of Aggregate Demand (AD)
AD= aggregate amount of goods and services
that people 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.

AD = C+I+G+CA
5
Determinants of AD
Determinants of C :
-Disposable income (Yd): income from production (Y) minus taxes
(T). Yd means C but C < Yd.
Real interest rates may influence the amount of saving and C, and wealth may influence C but we
assume that they are unimportant
Determinants of CA EX IM
-Disposable income: Yd means more expenditure on foreign
products (imports), IM thus CA.
-Foreign income: Y* means more expenditure by foreigners on
our products, EX thus CA .
-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.



6
How Real Exchange Rate Changes Affect CA
The CA measures the value of exports relative to the value
of imports: CA EX IM.
When the real exchange rate EP*/P (q) rises, foreign products
become expensive relative to domestic products.
1. The volume of exports bought by foreigners : CA
2. The volume of imports bought by domestic residents: CA
3. The value of imports in terms of domestic products : the
value/price of imports rises, since foreign products are more
valuable/expensive: CA
Evidence indicates that for most countries the volume
effect dominates the value effect in 1 year or less.
Therefore, we assume that the volume effect dominates
the value effect:
A real depreciation ( q) leads to a CA surplus.
7
Determinants of AD (cont.)
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
exogenously.
A more complicated model shows that investment
depends on the cost of borrowing for investment, the
interest rate.
8
Determinants of AD (cont.)
AD is therefore expressed as:
D = C(Y T) + I + G + CA(EP*/P, Y T,Y*)
Or more simply:
D = D(EP*/P, Y T, I, G,Y*)
Investment and
government
purchases, both
exogenous
Current account as
a function of the real
exchange rate and
disposable income.
Consumption
as a function
of disposable
income
9
Determinants of AD (cont.)
Determinants of aggregate demand include:
Real exchange rate (EP*/P=q): a in q CA,
and therefore AD for domestic products.
Disposable income: a in Yd C, but CA.
Since total C expenditure is > expenditure on foreign
products, the 1st effect dominates the 2nd effect.
As Y for a given level of taxes, C and AD < Y
10
SR Equilibrium for AD and Output Y
Equilibrium is achieved when the value of output Y
(and income from production) = AD.
Y = D( EP*/P, YT, I, G, Y* )
+ + + + +
Value of output,
income from
production
Equilibrium condition
Aggregate demand as a function of the
real exchange rate, disposable income,
investment, government purchases
Note: despite its similarity with the national income identity, this is not an
accounting identity: it is an equilibrium condition.

The equilibrium is where the LHS and RHS, plotted as functions of Y, intersect.
11
Figure 16-2: The Determination of Output in the Short Run
Output, Y
Aggregate
demand, D
45

Output, Y

AD
2
Y
2
D
1
1
Y
1
3
Y
3
AD>Y,
firms
Increase
output
AD<Y,
Firms decrease output
12
The previous analysis determines Y given EP*/P. We now
determine Y and EP*/P jointly in the SR, in the output and
the asset markets.

Note: With fixed prices, changes in EP*/P changes in E.

The DD schedule shows combinations of Y and E for which
the output market is in SR equilibrium (AD = Y).

A rise in EP*/P (due to a rise in E, P* or fall in P) makes
foreign output more expensive than domestic output. This
increases AD (shifts the AD schedule up). In equilibrium,
Y matches AD, hence Y increases (vice versa for a fall in
EP*/P).

****Hence, the DD schedule slopes upward***
Output Market Equilibrium
13
Y
2
DD
Figure 16-4: The DD Schedule
Output, Y
Aggregate demand, D
D = Y
Y
1
AD (E
2,
P, P*, G, I Y*)
AD (E
1
, P, P*, G, I, Y* )
Y
2
Output, Y
Exchange rate, E
Y
1
1

E
1
E
2
2

Currency
depreciates

14
Factors that shift the DD curve
Changes in the exchange rate cause movements along a DD
curve. Factors other than E causing an increase in AD, shift
the AD schedule up and the DD schedule to the right:
for ex: G AD and Y in equilibrium. Y for every E: DD
curve shifts right.

Higher government expenditure G

Lower taxes T

Higher investment I

A fall in domestic prices P

A rise in foreign prices P*

Higher domestic consumption due to change in tastes

Structural demand shifts from foreign to domestic goods


15
Y
2
Figure 16-5: Government Demand and the DD Schedule
D = Y
Y
1
D(E
0
P*/P, Y T, I, G
2
)
D(E
0
P*/P, Y T, I, G
1
)
Y
2
Output, Y
Exchange rate, E
Y
1
2

Government
spending rises
Output, Y
Aggregate demand, D
DD
1

E
0
1

DD
2

A rise in G to G2
raises Y at every
Level of E. Thus
DD shifts to right
16
SR Equilibrium for Assets
Asset market equilibrium=equilibrium in both FX market
and M market.
1. FX market : interest parity determines equilibrium.
R = R* + (E
e
E)/E
2. Money market: real money supply and demand
determine equilibrium. M
s
/P = L(R, Y)
When Y L (real money demand)
leading to a in R, leading to E, appreciation of the domestic
currency.
When Y, E , the domestic currency depreciates.
***A market equilibrium (AA): an inverse relation
between Y and E, AA slopes downward***
17
Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Domestic-currency
return on foreign-
currency deposits
Foreign
exchange
market
Money
market
E
2

2'
R
2

E
1
1'
R
1

Real money
supply
M
S

P
1
L(R, Y
2
)
L(R, Y
1
)
Real domestic money holdings
Domestic
interest
rate, R

Exchange Rate, E
0
2
Output rises
18
Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Domestic-currency
return on foreign-
currency deposits
E
2

2'
R
2

E
1
1'
R
1

M/P

M
S

P
1
L(R, Y)
Real domestic money holdings
Domestic
interest
rate, R

E
0
2
M/P
M
S

P
19
Figure 16-7: The AA Schedule
Output, Y
Exchange
Rate, E
AA
Y
1

E
1

1
Y
2

E
2

2
{E1,Y1}=equilibrium Y in M market and
Equilibrium E in FX market
AA negatively sloped
because equilibrium in
A markets lead to a negative
relation between Y and E:
Y XD for MR and E
20
Y

AA
AA
Y
1
Y
2
MS R then:
E for every Y or
Y for every E
AA shifts up (right).
E
Shifting the AA Curve
XS of M reduces R. US
assets become less
attractive, investors
switch to foreign assets,
sell $, the US$
depreciates for given Y
21
Factors other than the exchange rate causing a fall
in real money demand, rise in MS, or a rise in
foreign currency returns, shift the AA schedule to
the right:

in domestic prices P: An decrease in P increases M/P, decreases R,
causing the $ to depreciate (a rise in E): the AA curve shifts up (right).

E
e
: if markets expect the $ to depreciate in the future, foreign assets
become more attractive, causing the US$ to depreciate (a rise in E): the
AA curve shifts up (right).
in R*: foreign assets become more attractive, leading to a depreciation of
the US$ (a rise in E): the AA curve shifts up (right).

A structural in real money demand or a rise in real MS: if domestic
residents are willing to hold lower real money balances, R falls, leading to a
depreciation of the US$ (a rise in E): the AA curve shifts up (right).

Shifting the AA Curve
22
Putting the DD and AA Curves Together:
A short run equilibrium means the nominal exchange
rate E and level of output Y such that:
1. equilibrium in the output markets holds: AD=AS.
2. equilibrium in the FX markets holds (UIRP): R=R*+x.
3. equilibrium in the M market holds: M/P=L(.) Real
money supply=Real money demand.

A short run equilibrium occurs at the intersection of the
DD and AA curves
output market equilibrium holds on the DD curve
asset market equilibrium holds on the AA curve

23
Figure 16-8: Short-Run Equilibrium of Output and Asset Market:
the intersection of the DD and AA curves
Output, Y
Exchange
Rate, E
Y
1

E
1

1
DD
24
Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
AA
Y
1

E
1

1
DD
3
E
3
2 E
2
Output, Y
Exchange
Rate, E
E adjusts immediately
so that asset markets
are in equilibrium.
The US$ appreciates
and Y increases until
output markets are in
equilibrium
25
Temporary Changes in
Monetary Policy (MP) and
Fiscal Policy (FP)
MP: policy in which the central bank (CB) influences the
MS: MP primarily influences asset markets (Money
market and FX market).
FP: policy in which governments (fiscal authorities)
influence the amount of government purchases G and
taxes T. FP primarily influences AD and Y.
Temporary policy changes are expected to be reversed
in the near future and thus do not affect E
e
, expectations
about exchange rates in the long run. We also assume
policy changes not to affect R* and P*(a reasonable
assumption for a small economy; less realistic for a
large economy.)

26
Temporary Changes in Monetary Policy:

A change in monetary policy shifts the AA curve
but leaves the DD curve unchanged.

An increase in MS (i.e., expansionary MP) creates
an XS of M which lowers R.
As a result, E depreciates (i.e., home products
become cheaper relative to foreign products) and
AD increases.

A temporary expansionary MP increases Y and
depreciates E .

27
DD
Figure 16-10: Effects of a Temporary Increase in the Money Supply
Output, Y
Exchange
Rate, E
AA
2

Y
2

E
2

2
AA
1

1
E
1

Y
1

28
Temporary Changes in Fiscal Policy:

A change in FP shifts the DD curve but leaves the
AA curve unchanged.

An increase in G, a cut in T, or a combination of
the two (i.e., expansionary FP) shifts DD to right,
increases Y, raises the transactions demand for
real money balances (MD), which in turn increases
R.
As a result, E appreciates.

A temporary expansionary FP increases Y and
appreciates the currency.
29
DD
1

Figure 16-11: Effects of a Temporary Fiscal Expansion
Output, Y
E
AA
DD
2

Y
1

E
1

1
2
Y
2

E
2

30
Government policies may help maintain
full employment:

Resources used in the production process
can either be over-employed or under-
employed. When resources are employed at
their normal (or long run) level, the economy
operates at full employment Y
F.
If Y<Y
F
, few hours worked, lower than normal
output produced resulting in high unemployment.
If Y>Y
F
employment is above full employment,
many overtime hours, higher than normal output
produced resulting in inflationary pressures.
31
Government policies may help maintain full employment:

Temporary disturbances leading to recessions can be
offset through expansionary MP or FP.
Temporary disturbances leading to overemployment
can be offset through contractionary MP or FP.

However, we must use policies that correct for the right
shock:

In response to lower demand for domestic Y (e.g., a
fall in world demand), FP must expand: expansionary
MP would further weaken E.

In response to higher demand for domestic currency
(e.g., from foreign investors), MP must expand:
expansionary FP would further strengthen E.
32
Figure 16-12: Maintaining full Employment After a Temporary
Fall in Demand for Domestic Products
Output, Y
Exchange
Rate, E
DD
1

AA
2

AA
1

Y
f
Y
2

E
2

2
DD
2

1 E
1

3 E
3

A fall in world demand for
our output shifts DD to DD
2
,
Y falls to Y
2
below Y
f
,
E depreciates to E
2
.
Temporary fiscal expansion
restores eqm back to 1, no
Change in E
Temporary monetary expansion
restores Y back to Y
f
but
causes further E
depreciation.
33
DD
1

Figure 16-13: Maintaining Full Employment After a Temporary
Increase in Money Demand
Output, Y
Exchange
Rate, E
DD
2

AA
1

AA
2

Y
f

Y
2

E
2

2
3 E
3

1 E
1

A rise in money demand
shifts AA to AA
2
,
Y falls to Y
2
below Yf,
E appreciates to E
2
.

Temporary monetary
expansion restores eqm
back to 1, no change in E.

Temporary fiscal
expansion restores
eqm back to 1, but E
appreciates further.
34
Problems in policy implementation:

Inflation bias: Government may try to take advantage of sticky
prices by pursuing expansionary monetary policy. But if the
public anticipates this strategy, it will bargain for higher wages,
causing higher prices and no output gain.

It may be difficult to trace the source of shocks to either output
or asset markets.

Fiscal policy has an impact on the government budget: it may
have to be reverted in the future, or it may be offset by changes
in private savings (Ricardian equivalence).

Time lags in implementing policies: fiscal policy changes are
often slow to be agreed upon; monetary policy changes have
often effect with long lags.
35
Permanent policy shifts affect the long-run E and,
therefore, the future expected exchange rate, E
e
.

Permanent Monetary Expansion (increase in money
supply) has the following SR effects:

lowers R and makes people expect a future depreciation of
the domestic currency, increasing the expected return of
foreign currency deposits.
E and Y rise more than the case when expectations are
constant (Chapter 14 results).
The AA curve right (point 3) more than the case when
expectations are held constant (point 2).
Short Run Effects of Permanent Shifts in
Monetary and Fiscal Policy
36
DD
1

Figure 16-14: Short-Run Effects of a Permanent Increase
in Money Supply
Output, Y
Exchange
Rate, E
AA
2

Y
2

E
2

3
AA
1

1 E
1

Y
f

2
37
Long-Run Effects of Permanent Changes
in Monetary Policy
With employment and hours above their normal
levels, there is a tendency for wages to rise over
time.
With strong demand for Y and with increasing
wages, producers have an incentive to raise
output prices over time.
Both higher wages and higher output prices are
reflected in a higher price level.
What are the effects of rising prices?
38
DD
2

Figure 16-15: Long-Run Adjustment to a Permanent Increase
in Money Supply
Output, Y
Exchange
Rate, E
DD
1

AA
2

AA
3

Y
f

4
E
4

AA
1

Y
2

E
2

2
E
1

1
As P rises,
1. EP*/P falls (real
appreciation), loss of
Competitiveness, CA
deteriorates, AD
falls and DD shifts to left.
2. M/P falls, AA shifts to
left. As R rises, E
appreciates also.
If the horizontal shift of AA
is larger than that of DD,
we observe overshooting
of E by E
2
-E
4
. Otherwise,
Undershooting occurs.
Y goes back to Y
f

39
Effects of Permanent Changes in
Fiscal Policy
A permanent increase in G or reduction in T

Effect on goods market: AD rises, DD shifts to right.
Effect on asset market: people expect a domestic currency
appreciation in the short run due to increased AD, E
e
falls,
thereby reducing the expected return on foreign currency
deposits, AA shifts to left
The second shift offsets the first shift: the shift in exchange rate
expectation limits the expansionary effect of FP: it crowds out
AD for domestic products, by making them more expensive
internationally.
When the economy starts at full employment, the offset is
complete: permanent fiscal expansions have no effect on output.

40
DD
1

Figure 16-16: Effects of a Permanent Fiscal Expansion
Output, Y
Exchange
Rate, E
DD
2

AA
1

AA
2

Y
f

3 E
2

1 E
1

2
2: Temporary fiscal
expansion
3: new equilibrium
with permanent
fiscal expansion.
If we start at Y
f
, the
effect of permanent
fiscal expansion is
zero.
41
We study the current account effect of policies by
including in the DD-AA model a schedule XX showing
combinations of E and Y at which CA equals its
desired level X:
CA( EP
*
/P, Y-T ) = X

X may be zero; or less than zero, for a developing
economy that needs foreign capital to finance growth;
or greater than zero, for a mature economy repaying
foreign debt.

The schedule XX slopes upward (E/Y>0) because
a rise in Y raises imports and thereby worsens the CA
thus E must rise to restore equilibrium.
Macroeconomic Policies and the Current
Account
42

The XX schedule is flatter than the DD schedule:
XX schedule: as Y rises CA goes into deficit and hence E must
rise to bring it back to its desired level (X).
DD schedule: as Y rises CA goes into deficit and AD falls. But
a rise in Y also creates excess supply in goods market
(saving). Thus, in order to equate AD to Y, E must rise not
only to clear the CA component of AD but also to remove the
excess supply by increasing foreigners demand for our
product and thus AD further.
Hence when Y rises, the rise in E is higher for DD than for XX.
E/Y
slope XX
< E/Y
slope DD
.

Note: CA need not be = 0 at the short run equilibrium.
For simplicity, however, we suppose that it is.
43
Equilibrium and the Current Account
Output, Y
Exchange
Rate, E
Y
f

E
1

1
DD
XX
On any point above XX,
CA is in surplus: For given
Y, a rise in E leads to CA+
On any point below XX,
CA is in deficit: for given
E, a rise in Y leads to a CA-
44
Macroeconomic Policies and the CA
Policies affect the CA through their influence on
the value of the domestic currency.
A monetary expansion depreciates the domestic
currency and often increases the CA+ in the short run
(point 2 in Figure 16-17).
A fiscal expansion (increase in government
purchases or decrease in taxes) appreciates the
currency and worsens the CA
A temporary expansion shifts the DD schedule to the right
(point 3 in Figure 16-17).

A permanent expansion shifts both the AA and the DD
schedules (point 4 in Figure 16-17).


45
Figure 16-17: Macroeconomic Policies and the Current Account
Output, Y
Exchange
Rate, E
Y
f

E
1

1
DD
XX
4
3
2
2: CA+ Temporary
expansion in monetary
policy.
3: CA- Temporary
expansion in fiscal policy
4: CA- Permanent
expansion in fiscal policy
46
The DD-AA model assumes real depreciations (rise in EP*/P) to
improve the CA immediately (vice versa for appreciations).

However, the volume of imports and exports responds slowly to a
change in the real exchange rate. But the value of imports become
immediately more expensive. A depreciation may then have an
initial negative effect on the CA.

Thus the CA may follow a J-curve pattern after a real currency
depreciation:
First the CA worsens, as the price of import rises and export and
import volumes have not yet responded.
Next, the CA begins to improve, as the volume of export rises
and the volume of import falls.

Empirical evidence is for most industrial countries CA to start
improving beginning about a year after a devaluation.



Gradual Trade Adjustment, the CA and
the J-Curve
47
2
Figure 16-18: The J-Curve
Time
Current account (in
domestic output units)
1 3
Long-run
effect of real
depreciation
on the current
account
Real depreciation takes
place and J-curve begins
End of J-curve
Volume effect
dominates the
value effect
Value effect
dominates the
volume effect.
48
Pass Through Effect

Pass through from the exchange rate to import prices
measures the percentage by which dollar import prices
rise when the dollar depreciates by 1%.
If P
m
$
=E.P
m
* (where P
m
$
=dollar price of imports, P
m
*=foreign
price of imports) then pass through shows by how much P
m
$

rises when E rises 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: P
m
$
/E=1
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.
49
Pass Through 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.
volume of imports and exports will not adjust much over time
since domestic currency prices do not change much.
Pass through less than 100% dampens the effect of
depreciation or appreciation on the current account.