Chapter 17 (6)

Output and the

Exchange Rate
in the Short Run
 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 and permanent changes in
monetary and fiscal policies
• Adjustment of the current account over time

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-2

 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 chapter 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-3

 Determinants of Aggregate
Demand
• 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

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-4

 Determinants of Aggregate
Demand (cont.)
• Determinants of consumption expenditure include:
– Disposable income: income from production (Y) minus
taxes (T).
– More disposable income means more consumption
expenditure.
– 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-5

 Determinants of
Aggregate Demand (cont.)

• Determinants of the current account include:

– 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.
– Disposable income: more disposable income means
more expenditure on foreign products (imports).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-6

 Table 17-1: Factors Determining the
Current Account

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-7

 How Real Exchange Rate Changes
Affect the Current Account

• The current account measures the value of

exports relative to the value of imports:
CA ≈ EX – IM.
– When the real exchange rate EP*/P rises, the prices
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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-8

 Fig. 17-1: Aggregate Demand as a
Function of Output

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-9

 Determinants of Aggregate Demand
(cont.)

• 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 spending or borrowing to finance
investment: the interest rate.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-10

 Determinants of Aggregate Demand
(cont.)

• Aggregate demand is therefore expressed as:

D = C(Y – T) + I + G + CA(EP*/P, Y – T)

Consumption Investment
Current account as
expenditure expenditure and
a function of the real
as a function government
exchange rate and
of disposable purchases, both
disposable income.
income exogenous
• Or more simply: D = D(EP*/P, Y – T, I, G)

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-11

 Determinants of Aggregate Demand
(cont.)

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-12

 Short-Run Equilibrium for Aggregate
Demand and Output

• Equilibrium is achieved when the value of

income from production (output) Y equals the
value of aggregate demand D.
Y = D(EP*/P, Y – T, I, G)

Aggregate demand as a function of the

Value of output real exchange rate, disposable income,
and income from investment expenditure and government
production purchases

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-13

 Fig. 17-2: The Determination of
Output in the Short Run

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-14

 Short-Run Equilibrium and the
Exchange Rate: DD Schedule

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-15

 Fig. 17-3: Output Effect of a Currency
Depreciation with Fixed Output Prices

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-16

 Fig. 17-4:
Deriving the
DD Schedule

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-17

 Short-Run Equilibrium and the
Exchange Rate: DD Schedule (cont.)

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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-18

 Shifting the DD Curve

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-19

Fig. 17-5:
Government
Demand and the
Position of the DD
Schedule

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-20

 Shifting the DD Curve (cont.)

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.
3. Changes in I: higher investment expenditure is
represented by shifting the DD curve right.
4. Changes in P relative to P*: lower domestic
prices relative to foreign prices are represented by
shifting the DD curve right.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-21

 Shifting the DD Curve (cont.)

5. Changes in C: willingness to consume more and

save less is represented by shifting the DD curve
right.
6. Changes in demand of domestic goods
relative to foreign goods: willingness to
consume more domestic goods relative to foreign
goods is represented by shifting the DD curve
right.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-22

 Short-Run Equilibrium in Asset
Markets

• We consider two sets of asset markets:

1. Foreign exchange markets
– interest parity represents equilibrium:
R = R* + (Ee – E)/E

2. Money market
– Equilibrium occurs when the quantity of real monetary
assets supplied matches the quantity of real monetary
assets demanded: Ms/P = L(R, Y)
– A rise in income from production causes the demand of
real monetary assets to increase.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-23

Fig. 17-6:
Output and
the Exchange
Rate in Asset
Market
Equilibrium

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-24

 Short-Run Equilibrium in Asset
Markets (cont.)

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-25

 Short-Run Equilibrium in Asset
Markets: AA Curve

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-26

 Fig. 17-7: The AA Schedule

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-27

 Shifting the AA Curve

1. Changes in Ms: 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).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-28

 Shifting the AA Curve (cont.)

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).
3. Changes in the demand of real monetary
assets: if domestic residents are willing to hold a
lower amount of real money assets, interest rates
would fall, leading to a depreciation of the domestic
currency (a rise in E): the AA curve shifts
up (right).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-29

 Shifting the AA Curve (cont.)

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).
5. Changes in Ee: 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).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-30

 Putting the Pieces Together:
the DD and AA Curves

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-31

 Putting the Pieces Together:
the DD and AA Curves (cont.)

• 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

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-32

 Fig. 17-8: Short-Run Equilibrium: The
Intersection of DD and AA

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-33

 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-34

 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-35

 Fig. 17-10: Effects of a Temporary
Increase in the Money Supply

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-36

 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).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-37

 Fig. 17-11: Effects of a
Temporary Fiscal Expansion

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-38

 Policies to Maintain Full
Employment

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-39

 Fig. 17-12: Maintaining Full Employment
after a Temporary Fall in World Demand for
Domestic Products

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-40

 Fig. 17-13: Policies to Maintain Full
Employment after a Money Demand
Increase

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-41

 Policies to Maintain Full Employment
(cont.)

• 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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-42

 Policies to Maintain Full Employment
(cont.)

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.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-43

 Permanent Changes in Monetary and
Fiscal Policy

• “Permanent” policy changes are those that are

assumed to modify people’s expectations about
exchange rates in the long run.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-44

 Permanent Changes in Monetary
Policy

• A permanent increase in the quantity of monetary

assets supplied has several effects:
– It lowers interest rates in the short run and makes people
expect future depreciation of the domestic currency,
increasing the expected rate of return on foreign currency
deposits.
– The domestic currency depreciates (E rises) more than is
the case when expectations are constant (Econ Chapter
14/Finance Chapter 3 results).
– The AA curve shifts up (right) more than is the case when
expectations are held constant.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-45

 Fig. 17-14: Short-Run Effects of a
Permanent Increase in the Money Supply

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-46

 Effects of Permanent Changes in
Monetary Policy in the Long Run

• With employment and hours above their normal

levels, there is a tendency for wages to rise over
time.
• With strong demand for goods and services and
with increasing wages, producers have an incentive
to raise prices over time.
• Both higher wages and higher output prices are
reflected in a higher level of average prices.
• What are the effects of rising prices?

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-47

 Fig. 17-15: Long-Run Adjustment to a
Permanent Increase in the Money Supply

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-48

 Effects of Permanent Changes in
Fiscal Policy

• A permanent increase in government purchases or

reduction in taxes
– increases aggregate demand
– makes people expect the domestic currency to appreciate
in the short run due to increased aggregate demand,
thereby reducing the expected rate of return on foreign
currency deposits and making the domestic currency
appreciate.

• The first effect increases aggregate demand of

domestic products (DD shifts to right) , the second
effect it causes a long-run appreciation (AA shifts to
the left).

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-49

 Effects of Permanent Changes in
Fiscal Policy (cont.)

• If the change in fiscal policy is expected to

be permanent, the first and second effects
exactly offset each other, so that output
remains at its potential or natural (or long
run) level.
• We say that an increase in government
purchases completely crowds out net
exports, due to the effect of the appreciated
domestic currency.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-50

 Fig. 17-16: Effects of a Permanent
Fiscal Expansion

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-51

 Macroeconomic Policies and the
Current Account

• To determine the effect of monetary and fiscal

policies on the current account,
– derive the XX curve to represent the combinations of
output and exchange rates at which the current account is
at its desired level.
• As income from production increases, imports
increase and the current account decreases when
other factors remain constant.
• To keep the current account at its desired level, the
domestic currency must depreciate as income from
production increases: the XX curve should slope
upward.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-52

 Fig. 17-17: How Macroeconomic
Policies Affect the Current Account

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-53

 Macroeconomic Policies and the
Current Account (cont.)

• The XX curve slopes upward but is flatter than the

DD curve.
– DD represents equilibrium values of aggregate demand and
domestic output.
– As domestic income and production increase, domestic
saving increases, which means that aggregate demand
(willingness to spend) by domestic residents does not rise
as rapidly as income and production.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-54

 Macroeconomic Policies and the
Current Account (cont.)

• Policies affect the current account through their

influence on the value of the domestic currency.
– An increase in the quantity of monetary assets supplied
depreciates the domestic currency and often increases the
current account in the short run.
– An increase in government purchases or decrease in taxes
appreciates the domestic currency and often decreases the
current account in the short run.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-55

 Liquidity Trap

• Is a trap because once an economy nominal

interest rate falls to zero, the central bank
cannot reduce if further by increasing the
money supply.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-56

 Fig. 17-19: A Low-Output Liquidity
Trap

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-57

 Summary

1. Aggregate demand is influenced by disposable

income and the real exchange rate.
2. The DD curve shows combinations of exchange
rates and output where aggregate demand =
aggregate output.
3. The AA curve shows combinations of exchange
rates and output where the foreign exchange
markets and money market are in equilibrium.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-58

 Summary (cont.)

4. In the DD-AA model, we assume that a

depreciation of the domestic currency leads to an
increase in the current account and aggregate
demand.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-59

 Summary (cont.)

5. A temporary increase in the money supply is

predicted to increase output and depreciate the
domestic currency.
6. A permanent increase does both to a larger
degree in the short run, but in the long run
output returns to its normal level.
7. A temporary increase in government purchases is
predicted to increase output and appreciate the
domestic currency.
8. A permanent increase in government purchases is
predicted to completely crowd out net exports,
and therefore to have no effect on output.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 17-60