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A Short-Run Model of an Open Economy

MBA 774Macroeconomics

Class Notes - Part 4

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Aggregate Demand

• Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world – Recall GDP = C + I + G + EX - IM = D– Each of these components has various sources that

determine demand for that factor– We will concentrate here on consumption and CA– Specifically, let’s assume

C = C(YD)and

CA = CA(E, YD)

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Aggregate Demand and CA

• To see how a change in E effects CA we look at EX and IM Separately. Assume an increase in E– This results in an increase in EX since domestic

goods look cheaper to foreigners– This can result in an increase or decrease in IM.

Why?(for now assume an increase in E results in a decrease of

IM)

• An increase in YD will decrease CA. Why?

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Aggregate Demand

• We can now write a more general function for D

D = C(Y-T) + I + G + CA(E , Y-T)

whereConsumption demand (C) is a function of YD YD = Y - T (T = aggregate taxes)

or more generally

D = D(E , Y-T, I, G)

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Aggregate Demand

• Let’s review D = D(E , Y-T, I, G)

• Increasing the real exchange rate increases D through the current account

• Increasing income will – increase D through increases in consumption demand – decrease D through increasing import demand – The consumption demand effect will be greater then the

import demand effect so an increase in income will increase aggregate demand

• Increasing investment demand I increases D • Increasing government demand G increases D

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Aggregate Demand and Output

Aggregate Demand (D)

Real Income (Y)

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Aggregate DemandD(E ,Y-T, I, G)

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Equilibrium in the Output Market

• Equilibrium in the domestic output market will occur when aggregate demand equals output (real income)

• In the short-run we consider prices fixed

• In the long-run prices will adjust

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Equilibrium in the Output Market

Aggregate Demand (D)

Output (Y)

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Aggregate DemandD(E ,Y-T, I, G)

Aggregate Demand (D) = Aggregate Output (Y)

Y1Y2 Y3

D1

D2

D3

1

2

3

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The DD Schedule

• Now we need to derive the relationship between the exchange rate and output (the DD schedule) when the output market is in equilibrium

• To do this consider an increase in the nominal exchange rate from E1 to E2

• This will increase aggregate demand. Why?

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Equilibrium Output after Currency Depreciation

Aggregate Demand (D)

Output (Y)

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Aggregate DemandD(E1 ,Y-T, I, G)

Y1 Y2

D1

D2

1

2

Aggregate DemandD(E2 ,Y-T, I, G)

Currency Depreciation

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Deriving the DD Schedule

• By noting the short-run equilibrium level in the output market for all levels of the nominal exchange rate we derive the DD schedule

• Intuitively, the DD schedule allows us to see how short-run fluctuations in the nominal exchange rate impact aggregate domestic demand

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Deriving the DD Schedule

D

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Y1 Y2

D1

D2

1

2

D(E2)

D(E1)

Nominal Exchange Rate (E)

Y1 Y2

E1

E2

1

2

Output

DD

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What Factors Shift the DD Curve?

• Recall where the DD curve comes from

D(E ,Y-T, I, G)• So all of the following can shift the DD curve

– Disposable income– Investment– Government spending (and taxes)– The consumption function– A demand shift between foreign and domestic

consumption

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Example: Increase in Government Spending

Nominal Exchange Rate (E)

Y1 Y2

1 2

DD1 DD2

E0

Output

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The AA Schedule

• The AA schedule relates exchange rates and output levels that keep the money and foreign exchange (asset) markets in equilibrium

• We start with the interest parity condition (with RFC and Ee held constant),

RLC = RFC + (Ee-E)/E

and the equilibrium money market equationMS/PLC = L(RLC,Y)

• Now recall money and exchange rate market equilibrium from chapter 14 and an increase in output (Y)

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The AA Schedule

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The AA Schedule

So in the short run, an increase in output decreases the exchange rate

Nominal Exchange Rate (E)

Y1 Y2

1

2

AA

E1

Output

E2

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The AA Schedule

• The AA schedule describes how exchange rates fall as output increases

• Changes in output will result in a movement along this curve

• Anything that changes the stacked graphs – the foreign exchange market and money market – except output will shift the curve– A change in MS for a fixed level of Y – A change in Ee

– A change in the foreign interest rate RFC

– A change in the real money demand function L(RLC, Y)

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Short-Run Equilibrium

• We now have separate models for exchange-rate equilibrium in the – Output market (the DD schedule)– Asset market (the AA schedule)

• We can combine these to get a short-run equilibrium for the whole economy– This will be the intersection of the AA and DD

schedules

• To see why this is the equilibrium consider an exchange rate above the AA schedule and on the left of the DD schedule

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Short-Run equilibrium

Nominal Exchange Rate (E)

Y1

1

2

AA

E2

Output

E1

DD

3E3

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Applications of DD-AA Model

• Now that we have a general model of short-run equilibrium we can use it to explore the impact of various economic changes such as

– Changes in fiscal and monetary policy

– Changes in world demand for domestic products

– Changes in money-demand

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Monetary Policy

• How does a temporary increase in the domestic money supply affect the equilibrium of an open economy?

E

Y1

1

2

AA1

E2

Output

E1

DD

Y2

AA2

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Fiscal Policy

• How does a temporary fiscal expansion (higher G and/or lower T) affect the equilibrium of an open economy?

E

Y1

1

2

AA

E2

Output

E1

DD1

Y2

DD2

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Fall in World Demand for Domestic Products

How can monetary policy be used to restore the economy to its full-employment output level after a decline in the world demand for domestic products?

E

Yf

1

2

AA1

E3

Output

E1

DD1

Y2

DD2

3

E2

AA2

Drop in World Demand

Monetary Expansion