Fiscal Expansion in the AADD model

1
Fiscal Expansion in the AA-DD model

• We start with an increase in government
  spending on the foreign good in the flexible
  exchange rate case.
• Lets suppose that the extra government
  spending is financed by the government selling
  bonds and that everyone ignores the future
  interest cost of servicing these bonds.

2
Fiscal expansion on the foreign good

• All that happens is the current account goes into
  deficit by the amount of the extra government
  spending!
• The government borrows from foreigners to buy
  goods from them and everybody else in Thailand
  need never know about it.
• Supply and demand for the home good are unchanged
  and the money market is unaffected.

3
The growth of long-term foreign debt

• As long as foreigners are willing to
  accumulate our bonds, at an unchanged interest
  rate, it is as if the governments spending was
  financed by foreign aid!
• If the foreigners suddenly refuse to buy any
  more of our bonds and wont roll over the
  existing stock, there will be a debt crisis and
  taxes will have to rise.
• If we have accumulated a lot of debt, taxes
  may have to rise a lot. The post debt crisis
  situation will then involve a fiscal contraction
  and RER depreciation!

4
Increased government spending on the home good

• We now look at a permanent increase in
  government spending on the home good in the
  flexible exchange rate case.
• Lets again suppose that the extra government
  spending is financed by the government selling
  bonds and that everyone ignores the future
  interest cost of servicing them.

5
Illustrative numerical assumptions

• For illustrative purposes, we assume that the
  increase government spending on the home good is
  from G10 tons to G11 tons
• Interest rate on dollar deposits, i 4
• Initial domestic price, P 1.00 baht per ton of
  home good
• Foreign price throughout, P 1 per ton of
  foreign good

6
More illustrative numbers

• Real balances M1000, P1.
• Even though P can adjust flexibly to maintain
  output at full employment output, well show that
  it does not need to change, but remains equal to
  1 throughout.
• The budget is initially balanced with tax, T G
  10. T never changes and is ignored in the
  diagram below. The exchange rate, S, is initially
  equal to 100 baht/ and, before the fiscal
  expansion, was expected to remain at 100 baht/

7
Net exports and the RER

• With PP1 and S100, the real exchange rate is
  initially equal to 100.
• We assume that an appreciation of the real of e
  from 100 to (100-e) is enough to contract net
  exports by one unit.
• A unit increase in government spending on the
  home good, together with a real appreciation of
  e would therefore leave aggregate demand for the
  home good unchanged foreigners buy a unit less,
  the government buys a unit more and output can
  remain unchanged.

8
(No Transcript)
9
Flexible rate case, permanent rise in G

• In both the short run and long run the
  equilibrium moves from point A to point B.
• There are two ways of getting this result
• Conjecture that it is true and then confirm that
  the conjectured answer is compatible with
  equilibrium in every market.
• Suppose, instead, that in the short-run, the
  economy is not at B and see which markets would
  be out of equilibrium and how this would affect
  the interest rate and exchange rate.

10
Lets conjecture that we get to B in the
short-run and then stay there

• At B, the supply of the home good is the same as
  at A, and the demand for it is also unchanged
  the government is buying a unit more, the
  foreigners are buying a unit less because S has
  fallen by e.
• At B, the exchange rate is expected to remain
  constant at its new level and the interest is
  still equal to the dollar interest rate, so we
  still have UIP.
• Nothing has happened to disturb the original
  money market equilibrium M and P are both
  unchanged.
• All markets were in equilibrium at A so they will
  all be in equilibrium at B.

11
What if output increased in the short-run?

• If the exchange rate appreciated by less than e,
  aggregate demand would increase and some further
  exchange rate appreciation would be expected to
  get to B in the long run.
• Unless the baht interest rate rose, there would
  be excess demand for money due to the rise in
  output
• But unless the baht interest rate fell, everyone
  would want to hold baht, not dollars because the
  baht would be expected to appreciate against the
  dollar between the short-run and long-run
  equilibriums.

12
The upward pressure on the baht, if S appreciates
by less than e in the short-run

• At an unchanged baht interest rate, UIP does not
  hold and foreigners would want to sell dollar
  securities to buy BOT bills.
• Thais would want to do this too, but might want
  to use some of the proceeds of the sales of
  dollar securities to add to their baht money
  holdings.
• With both Thais and foreigners wanting to sell
  and buy baht, the baht would appreciate against
  the and equilibrium would only be reached at B,
  where the short-run RER appreciation is equal to
  the total long-run RER appreciation, e.

13
A caveat for ambitious students (but it wont be
on the exam, so June can relax)

• The above analysis ignores the J-curve. If a RER
  appreciation of e is needed to reduce exports
  by one unit in the short-run and a RER
  appreciation of only e lt e will reduce exports
  by one unit in the long-run, then a permanent
  fiscal expansion will cause exchange rate
  overshooting in the short-run and an increase in
  Y. S falls by less than e and is then expected to
  appreciate. This allows the baht interest rate to
  rise by enough to offset the increased demand for
  money due to the rise in Y.

14
Temporary fiscal expansion flexible rate case

• The long-run equilibrium following any temporary
  change, whether in G or in anything else, will be
  back at A.
• That is what temporary means in the long run,
  every single variable will be back at its
  original level.
• The temporary (short-run) equilibrium in the
  flexible rate case is at C
• Here, once again, the diagram

15
(No Transcript)
16
The open economy multiplier, once again

• Notice that the movement from A to D corresponds
  to the open economy multiplier expansion analyzed
  in an earlier class
• The increase in output is 1/(ms).?G
• This is because with S held constant by the BOT
  and P constant because it can only be adjusted
  with a lag, exports are unchanged.

17
Why does a temporary increase in G expand output
in the short run?

• Answer because the change is temporary, the
  short-run appreciation of the baht between A and
  C is expected to be reversed between the
  short-run and long-run equilibriums, the exchange
  rate is expected to depreciate.
• This expected depreciation allows the baht
  interest rate to rise in the short-run to offset
  the effect on the demand for money of the rise in
  output.

18
Why does a fiscal expansion lead to RER
appreciation?

• Answer only because it is assumed that the
  increased government spending is on the home good
  and is financed by increased supply of the
  foreign good.
• It is no surprise that raising the demand for
  Thai goods and the supply of foreign goods raises
  the equilibrium price of Thai goods relative to
  foreign goods.

19
Back to increased government spending on the
foreign good

• When the increased spending is on the foreign
  good and is met by increased foreign supply,
  there is no change in the RER (slide 2)
• What if the increased spending is on the foreign
  good and is not met by increased supply of the
  foreign good?
• If taxes rise, consumer spending on the home good
  will fall and if the increased government
  spending is on the foreign good, the RER will
  have to depreciate to keep demand for the home
  good equal to full employment output (slide 3)

20
Permanent fiscal expansionFixed exchange rate
case

• The short-run equilibrium will be at D
• The long-run equilibrium will be back at A
• The next slide is the same old diagram once again
• Under the fixed exchange rate, fiscal expansion
  has a big impact in the short-run because the
  money supply is endogenous and can increase to
  accommodate the money demand without driving up
  the interest rate or appreciating the exchange
  rate, as happens in the flexible rate case.

21
(No Transcript)
22
Fixed rate case, long run

• In the long-run the domestic price level will
  rise by enough to restore output to its original
  equilibrium (full employment) level.
• If an RER appreciation of e is what is needed in
  the flexible rate case to reduce net exports by 1
  unit and leave demand equal to full employment
  output, then the same RER appreciation will
  restore full equilibrium in the fixed rate case.

23
Long-run RER appreciation in the fixed rate case

• RER Q SP/P
• With S and P fixed, the RER appreciation of e
  must be achieved by an increase in the domestic
  price level of e from 1 baht/ton to 100/(100-e)
  baht/ton
• Long-run RER, flexible rate case S100-e, P P
  1 Q 100-e
• Long-run RER, fixed rate case S100, P1,
  P100/(100-e) Q100-e

24
Money supply and demand in the fixed rate case

• In the movement from the initial equilibrium to
  the final equilibrium in the case of a permanent
  fiscal expansion under a fixed rate, M/P stays
  unchanged because both Y and i are unchanged.
• The money supply, M, must therefore also rise by
  e, or by a factor of 100/(100-e).
• This will be achieved by Thai residents selling
  some -denominated securities, or borrowing in
  -denominated securities and then selling the
  dollars in the spot market. The BOT must supply
  baht in exchange if it is to keep S fixed.