International Finance

Output and the Exchange Rate in the Short Run

Fei Zhou

HKBU

Monday 8th January, 2024

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Preview
• Determinants of aggregate demand in the short run
• A short-run model of output markets
• A short-run model of asset markets
• A short-run model for both output markets and asset markets
• Effects of temporary changes in monetary and fiscal policies
Introduction
• Long-run models are useful when all prices of inputs and
outputs have time to adjust.
• 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 willingness of
customers to pay at different prices.
• This lecture builds on the short-run and long-run models
of exchange rates to explain how output is related to
exchange rates in the short run.
– It shows how macroeconomic policies can affect
production, employment, and the current account.
Determinants of Aggregate Demand (1 of 3)
• Aggregate demand is the aggregate amount of goods
and services that individuals and institutions are willing to
buy:

1. consumption expenditure
2. investment expenditure
3. government purchases
4. net expenditure by foreigners: the current account
Determinants of Aggregate Demand (2 of 3)
• Determinants of consumption expenditure include:
– Disposable income: income from production (Y)
minus taxes (T).
– More disposable income means more consumption
expenditure, but consumption typically increases less
than the amount that disposable income increases.
– Real interest rates may influence the amount of
saving and spending on consumption goods, but we
assume that they are relatively unimportant here.
– Wealth may also influence consumption expenditure,
but we assume that it is relatively unimportant here.
Determinants of Aggregate Demand (3 of 3)
• Determinants of the current account include:
– Real exchange rate: prices of foreign products relative to
the prices of domestic products, both measured in
𝐸𝑃∗
domestic currency: 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.
– Disposable income: more disposable income means
more expenditure on foreign products (imports).
How Real Exchange Rate Changes Affect
the Current Account (1 of 2)
• The current account measures the value of exports relative to the value
of imports: CA » EX - IM.
EP *
– When the real exchange rate rises, the prices
P
of foreign products rise relative to the prices of domestic products.

1. The volume of exports that are bought by foreigners rises.

2. The volume of imports that are bought by domestic
residents falls.
3. The value of imports in terms of domestic products rises: the
value/price of imports rises, since foreign products are more
valuable/expensive.
How Real Exchange Rate Changes Affect
the Current Account (2 of 2)
• If the volumes of imports and exports do not change much, the
value effect may dominate the volume effect when the real
exchange rate changes.
– For example, contract obligations to buy fixed amounts of
products may cause the volume effect to be small.
• However, evidence indicates that for most countries the
volume effect dominates the value effect after 1 year or less.
• Let’s assume for now that a real depreciation leads to an
increase in the current account: the volume effect dominates
the value effect.
Figure 17.1 Aggregate Demand as a
Function of Output

EP *
Aggregate demand is a function of the real exchange rate , disposable
P
income (Y - T ), investment demand (I), and government spending (G). If all
other factors remain unchanged, a rise in output (real income), Y, increases
aggregate demand. Because the increase in aggregate demand is less than the
increase in output, the slope of the aggregate demand function is less than 1 (as
indicated by its position within the 45-degree angle).
Table 17.1 Factors Determining the
Current Account

Change Effect on Current Account, CA

EP *
Real exchange rate, ­ CA ­
P
C A upward arrow

start fraction E P asterisk over P end fraction upward arrow

EP * CA ¯
Real exchange rate, ¯ C A downward arrow

P
start fraction E P asterisk over P end fraction downward arrow

Disposable income, Y d ­ Y super d upward arrow

CA ¯
C A downward arrow

Disposable income, Y ¯
d
CA ­
C A upward arrow

Y super d downward arrow

Determinants of Aggregate Demand (1 of 4)
• Determinants of the current account include:
– Real exchange rate: an increase in the real
exchange rate increases the current account.
– Disposable income: an increase in the disposable
income decreases the current account.
Determinants of Aggregate Demand (2 of 4)
• For simplicity, 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 by exogenous business
decisions.
– A more complicated model shows that investment
depends on the cost of borrowing to finance
investment: the interest rate.
Determinants of Aggregate Demand (3 of 4)
• Aggregate demand is therefore expressed as:
æ EP * ö
D = C (Y -T ) + I + G + CA ç ,Y -T ÷
è P ø
– where C (Y - T ) is consumption expenditure as a
function of disposable income,
– I + G is investment expenditure and government purchases
(both exogenous), and
æ EP*
ö
– CA ç ,Y -T ÷ is the current account as a function of the real
è P ø
exchange rate and disposable income.
æ EP * ö
• Or more simply: D = D ç ,Y - T , I,G ÷
è P ø
Determinants of Aggregate Demand (4 of 4)
• Determinants of aggregate demand include:
– Real exchange rate: an increase in the real exchange rate
increases the current account, and therefore increases
aggregate demand of domestic products.
– Disposable income: an increase in the disposable income
increases consumption expenditure, but decreases the current
account.
▪ Since consumption expenditure is usually greater than
expenditure on foreign products, the first effect dominates
the second effect.
▪ As income increases, aggregate consumption expenditure
and aggregate demand increase by less than income.
Short-Run Equilibrium for Aggregate
Demand and Output
• Equilibrium is achieved when the value of output and
income from production Y equals the value of aggregate
demand D

æ EP * ö
Y = Dç ,Y -T , I,G ÷
è P ø

– where aggregate demand is a function of the real

exchange rate, disposable income, investment
expenditure, and government purchases.
Figure 17.2 The Determination of Output
in the Short Run

In the short run, output settles at Y 1 (point 1), where aggregate

demand, D1, equals aggregate output, Y .
1
Short-Run Equilibrium and the Exchange
Rate: DD Schedule (1 of 2)
• How does the exchange rate affect the short-run equilibrium of
aggregate demand and output?
• With fixed domestic and foreign levels of average prices, a rise
in the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goods and
services.
• A rise in the nominal exchange rate (a domestic currency
depreciation) increases aggregate demand of domestic
products.
• In equilibrium, production will increase to match the higher
aggregate demand.
Figure 17.3 Output Effect of a Currency
Depreciation with Fixed Output Prices

A rise in the exchange rate from E 1 to E 2 (a currency depreciation)

will increase aggregate demand and output.
 Figure 17.4 Deriving the DD Schedule

The DD schedule (shown in the lower panel) slopes upward because a rise in the
exchange rate from E 1 to E 2 all else equal, causes output to rise from Y 1 to Y 2 .
Short-Run Equilibrium and the Exchange
Rate: DD Schedule (2 of 2)
DD schedule
• shows combinations of output and the exchange rate at
which the output market is in short-run equilibrium (such
that aggregate demand = aggregate output).
• slopes upward because a rise in the exchange rate
causes aggregate demand and aggregate output to rise.
Shifting the DD Curve (1 of 3)
• Changes in the exchange rate cause movements along a
DD curve. Other changes cause it to shift:

1. Changes in G: more government purchases cause

higher aggregate demand and output in equilibrium.
Output increases for every exchange rate: the DD curve
shifts right.
2. Changes in T: lower taxes generally increase
consumption expenditure, increasing aggregate
demand and output in equilibrium for every exchange
rate: the DD curve shifts right.
Figure 17.5 Government Demand and the
Position of the DD Schedule

A rise in government demand from G1 to G 2 raises output at every level of

the exchange rate. The change therefore shifts DD to the right.
Shifting the DD Curve (2 of 3)
3. Changes in I: higher investment expenditure shifts the
DD curve right.
4. Changes in P: higher domestic prices make domestic
output more expensive compared to foreign output and
reduce net export demand, shifting the DD curve left.
5. Changes in P*: higher foreign prices make domestic
output less expensive compared to foreign output and
increase net export demand, shifting the DD curve right.
Shifting the DD Curve (3 of 3)
6. Changes in C: willingness to consume more and save
less shifts the DD curve right.
7. Changes in demand of domestic goods relative to
foreign goods: willingness to consume more domestic
goods relative to foreign goods shifts the DD curve right.
Short-Run Equilibrium in Asset Markets (1 of 2)
• Consider two sets of asset markets:
1. Foreign exchange markets

– interest parity represents equilibrium: R = R * +

(E e
-E )
E
2. Money market

– Equilibrium occurs when the quantity of real monetary assets

supplied matches the quantity of real monetary
MS
assets demanded: = L ( R,Y )
P

– A rise in income from production causes the demand of real

monetary assets to increase.
Figure 17.6 Output and the Exchange
Rate in Asset Market Equilibrium

For the asset (foreign exchange and money) markets to remain in equilibrium,
a rise in output must be accompanied by an appreciation of the currency, all
else equal.
Short-Run Equilibrium in Asset Markets (2 of 2)

• When income and production increase,

– demand of real monetary assets increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic currency.
• Recall that an appreciation of the domestic currency is
represented by a fall in E.
• When income and production decrease, the domestic
currency depreciates and E rises.
Short-Run Equilibrium in Asset Markets:
AA Curve
• AA curve: asset market equilibrium schedule
• The inverse relationship between output and exchange
rates needed to keep the foreign exchange markets
and the money market in equilibrium is summarized as
the AA curve.
Figure 17.7 The AA Schedule

The asset market equilibrium schedule (AA) slopes downward because a

rise in output from Y 1 to Y 2 , all else equal, causes a rise in the home
interest rate and a domestic currency appreciation from E 1 to E 2 .
Shifting the AA Curve (1 of 3)
1. Changes in M s : an increase in the money supply
reduces interest rates in the short run, causing the
domestic currency to depreciate (a rise in E) for every
Y: the AA curve shifts up (right).

2. Changes in P: An increase in the level of average

domestic prices decreases the supply of real monetary
assets, increasing interest rates, causing the domestic
currency to appreciate (a fall in E): the AA curve shifts
down (left).
Shifting the AA Curve (2 of 3)
3. Changes in E e : if market participants expect the
domestic currency to depreciate in the future, foreign
currency deposits become more attractive, causing the
domestic currency to depreciate (a rise in E): the AA
curve shifts up (right).

4. Changes in R * : An increase in the foreign interest

rates makes foreign currency deposits more attractive,
leading to a depreciation of the domestic currency (a
rise in E): the AA curve shifts up (right).
Shifting the AA Curve (3 of 3)
5. Changes in the demand of real monetary assets: if
domestic residents are willing to hold a lower amount of
real money assets and more non-monetary assets,
interest rates on nonmonetary assets would fall, leading
to a depreciation of the domestic currency (a rise in E):
the AA curve shifts up (right).
Putting the Pieces Together: the DD and
AA Curves (1 of 2)
• A short-run equilibrium means a nominal exchange rate
and level of output such that

1. equilibrium in the output markets holds: aggregate

demand equals aggregate output.
2. equilibrium in the foreign exchange markets holds:
interest parity holds.
3. equilibrium in the money market holds: the quantity of
real monetary assets supplied equals the quantity of
real monetary assets demanded.
Putting the Pieces Together: the DD and
AA Curves (2 of 2)
• A short-run equilibrium occurs at the intersection of the
DD and AA curves:
– output markets are in equilibrium on the DD curve
– asset markets are in equilibrium on the AA curve
Figure 17.8 Short-Run Equilibrium: The
Intersection of DD and AA

The short-run equilibrium of the economy occurs at point 1, where the output
market (whose equilibrium points are summarized by the DD curve) and the
asset market (whose equilibrium points are summarized by the AA curve)
simultaneously clear.
Temporary Changes in Monetary and
Fiscal Policy
• Monetary policy: policy in which the central bank influences
the supply of monetary assets.
– Monetary policy is assumed to affect asset markets first.
• Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of government
purchases and taxes.
– Fiscal policy is assumed to affect aggregate demand and
output first.
• 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.
Temporary Changes in Monetary Policy
• An increase in the quantity of monetary assets supplied
lowers interest rates in the short run, causing the
domestic currency to depreciate (E rises).
– The AA shifts up (right).
– Domestic products relative to foreign products are
cheaper, so that aggregate demand and output
increase until a new short-run equilibrium is achieved.
Figure 17.10 Effects of a Temporary
Increase in the Money Supply

By shifting AA1 upward, a temporary increase in the money supply

causes a currency depreciation and a rise in output.
Temporary Changes in Fiscal Policy
• An increase in government purchases or a decrease
in taxes increases aggregate demand and output in
the short run.
– The DD curve shifts right.
– Higher output increases the demand for real
monetary assets,
▪ thereby increasing interest rates,
▪ causing the domestic currency to appreciate
(E falls).
Figure 17.11 Effects of a Temporary
Fiscal Expansion

By shifting DD1 to the right, a temporary fiscal expansion causes a

currency appreciation and a rise in output.
Policies to Maintain Full Employment (1 of 3)
• Resources used in the production process can either be over-
employed or underemployed.
• When resources are used effectively and sustainably, economists
say that production is at its potential or natural level.
– When resources are not used effectively, resources are
underemployed: high unemployment, few hours worked, idle
equipment, lower than normal production of goods and services.
– When resources are not used sustainably, labor is over-
employed: low unemployment, many overtime hours, over-
utilized equipment, higher than normal production of goods and
services.
Figure 17.12 Maintaining Full Employment after a
Temporary Fall in World Demand for Domestic Products

A temporary fall in world demand shifts DD1 to DD 2 , reducing output from Y 1 to Y 2

and causing the currency to depreciate from E to E
1 2
(point 2). Temporary fiscal
expansion can restore full employment (point 1) by shifting the DD schedule back to its
original position. Temporary monetary expansion can restore full employment (point 3)
by shifting AA1 to AA2 . The two policies differ in their exchange rate effects: The
fiscal policy restores the currency to its previous value (E 1 ), whereas the monetary
policy causes the currency to depreciate further, to E3.
 Figure 17.13 Policies to Maintain Full
Employment After a Money Demand Increase

After a temporary money demand increase (shown by the shift from AA1 to AA2 ),
either an increase in the money supply or temporary fiscal expansion can be used to
maintain full employment. The two policies have different exchange rate effects: The
monetary policy restores the exchange rate back to E 1, whereas the fiscal policy
leads to greater appreciation (E ).
3
Policies to Maintain Full Employment (2 of 3)
• Policies to maintain full employment may seem easy in theory, but are
hard in practice.

1. We have assumed that prices and expectations do not change, but

people may anticipate the effects of policy changes and modify their
behavior.
– Workers may require higher wages if they expect overtime and
easy employment, and producers may raise prices if they expect
high wages and strong demand due to monetary and fiscal
policies.
– Fiscal and monetary policies may therefore create price changes
and inflation, thereby preventing high output and employment:
inflationary bias.
Policies to Maintain Full Employment (3 of 3)
2. Economic data are difficult to measure and to understand.
– Policy makers cannot interpret data about asset markets and
aggregate demand with certainty, and sometimes they make
mistakes.
3. Changes in policies take time to be implemented and to affect the
economy.

– Because they are slow, policies may affect the economy after
the effects of an economic change have dissipated.

4. Policies are sometimes influenced by political or bureaucratic

interests.