OUTPUT

1
OUTPUT THE EXCHANGE RATE IN THE SHORT RUN
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Open-Economy Macroeconomics
The basic short run macroeconomic model is often
presented with no foreign trade (a closed
economy) as a simplifying assumption. The
purpose of this lecture is to relax the closed
economy simplifying assumption do develop the
basic macroeconomic model in the light of (a)
world trade and (b) what weve learned in
previous lectures.
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Aggregate Demand

• Perhaps the simplest approach is best add to
  basic Keynesian aggregate demand the current
  account (CA), or exports minus imports, and
  youve moved from a closed to an open economy
  model.

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Aggregate Demand

• In equilibrium
• YCIGX-M
• I,G, can be taken to be exogenous.
• Cab(Y-T) where Texogenous taxes
• MMomY-eE (induced imports vary positively with
  Y and negatively with the exchange rate, E)

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A Digression Real or Nominal Exchange Rate?

• The real exchange rate, qE(Pf/P) is measured in
  units of output, not units of currency.
• A convenient simplifying assumption is to frame
  ones work using the nominal exchange rate, E,
  where it is understood as follows

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A Digression Real or Nominal Exchange Rate?

• Solve the real exchange rate for E to get
• Eq(P/Pf)
• This expression can be imagined as a strictly
  empirical relationship between observable
  international price levels and the observed
  nominal exchange rate

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A Digression Real or Nominal Exchange Rate?

• Eq(P/Pf)
• The parameter q in this case consists of all
  the real factors that influence E productivity,
  technology, factor availability, all the supply
  side elements that can influence aggregate
  supply generally.

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A Digression Real or Nominal Exchange Rate?

• Eq(P/Pf)
• The ratio (P/Pf), on the other hand, represents
  all influences on price levels generally
  especially those having to do with money,
  financial markets, and monetary policy.

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A Digression Real or Nominal Exchange Rate?

• Eq(P/Pf)
• This is over-simplified, but it represents an
  extremely useful simplification. So long as we
  remember this equation, we are able to work with
  the currency-denominated nominal exchange rate as
  if it were the unit-denominated real exchange
  rate.

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Short Run Determination of Equilibrium
Output/Income

• Your textbook writes the equilibrium condition in
  general function formYD(EP/P,Y-T,I,G)
• Lets specify the model as follows

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Specification

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SOLUTION OF SPECIFIED MODEL

What does this show? Equilibrium income (Y) is a
function of the exchange rate (E). It is
actually a simple upwardly-sloping linear
function.
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SOLUTION OF SPECIFIED MODEL

INTERCEPT
SLOPE
This version of the equation is less interesting
than the same equation solved for E. Lets look
at the solution
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SOLUTION OF SPECIFIED MODEL, SOLVED FOR E

This is the equation for the DD curve
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SOLUTION OF SPECIFIED MODEL, SOLVED FOR E

This is the equation for the DD curve note it
has a slope that is definitely positive given all
the parameters specifications.
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Figure 16-3 Output Effect of a Currency
Depreciation with Fixed
Output Prices
An increase in E means an increase in Y
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The DD Schedule expresses the relationship
between E and Y
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Relaxing the assumptions about whats fixed

• Letting G, T, and the other exogenous variables
  change values allows us to imagine a DD schedule
  subject to comparative static shifts
• Any disturbance that raises aggregate demand for
  domestic output shifts the DD schedule to the
  right, any disturbance that lowers aggregate
  demand for domestic output shifts it to the left.

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These variables can shift the DD Schedule

• Government purchases
• Taxes
• Investment
• Domestic price levels (via EqP/Pf)
• Foreign price levels (via EqP/Pf)
• Domestic consumption
• Demand shift between foreign and domestic goods

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Summary what does the DD Schedule represent?

• It shows E and Y are directly (positively)
  related
• It shows alternate combinations of Y and E that
  satisfy the condition that aggregate
  supplyaggregate demand in all product markets
• It divides E-Y space into two areas one where
  aggregate demand exceeds aggregate supply,
  another where aggregate demand is less than
  aggregate supply

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The AA Schedule

• This combines the interest parity condition with
  the LM curve.
• It shows combinations of exchange rate, interest
  rate, and income consistent with equilibrium in
  asset markets.

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Interest Parity Condition
LM Curve
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Combine the two by substituting the interest
parity condition into the LM curves equation
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Multiply out by lambda
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And once again
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Multiply all terms by E, gather terms, and
simplify
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Now divide thru and you have Ef(Y) the AA
curve itself
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The slope of the AA curve is negative
So long as the expected value of the exchange
rate is positive (a logical certainty) everything
else has been specified such that this derivative
has to be less than zero in value.
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Asset Market Equilibrium in the Short Run The AA
Schedule

• For asset markets to remain in equilibrium
• A rise in domestic output must be accompanied by
  an appreciation of the domestic currency.
• A fall in domestic output must be accompanied by
  a depreciation of the domestic currency.

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Asset Market Equilibrium in the Short Run The AA
Schedule
Figure 16-6 Output and the Exchange Rate in
Asset Market Equilibrium
E1
1'
Domestic-currency return on foreign- currency
deposits
R1
L(R, Y1)
L(R, Y2)
2
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Short-Run Equilibrium for an Open Economy
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Reaching short run equilibrium
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Properties of Short-Run Equilibrium
Theres no reason why short run equilibrium will
coincide with the full employment level of real
income
Yf
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Properties of Short-Run Equilibrium
Thus macroeconomic monetary and fiscal policy
(and their exchange rate implications) are
important
Yf
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Properties of Short-Run Equilibrium
Theres also no reason why short run equilibrium
will coincide with a balanced (or any other
particular) current account
Yf
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Properties of Short-Run Equilibrium
The curve showing Y and E for any specific CA is
called the XX curve
X
X
Yf
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Deriving an XX curve for a balanced current
account
If exports equal imports
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Slope of the XX curve
The XX curves slope, m over alpha plus beta, is
definitely less than the slope of the DD curve
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Slope of XX curve versus slope of DD curve
Slope of XX curve
Slope of DD curve
Since beta is specified as between zero and one,
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Slope of XX curve versus slope of DD curve
Slope of XX curve
Slope of DD curve
Slope of DD curve includes slope of XX curve,
along with an additional term that has to be
positive
Since beta is specified as between zero and one,
the slope of the XX curve has to be less than the
slope of the DD curve
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Deriving the XX curve for a non-balanced CA
If exports exceed imports by phi dollars
The XX curve merely shifts up by a constant
amount.
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