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George Alogoskoufis, International Macroeconomics and Finance

Chapter 5 Aggregate Demand, Output and the Exchange Rate in the Short Run

In the short run, exchange rates are determined by uncovered interest parity, i.e. the condition that the expected returns on deposits in different currencies, when expressed in a common currency, must be equal. This arbitrage condition, can be seen as the short run equilibrium condition for the foreign exchange market.

In the short run, nominal interest rates are determined by the equality of the demand and the supply of money in the domestic money market. This, can be seen as the short run equilibrium condition for the domestic money market.

In an open economy, these two short run conditions must be satisfied simultaneously.

However, in order to determine non financial variables, such as output and employment, one must also examine the functioning of the market for goods and services. This market must also be in equilibrium in an open economy, in the sense that aggregate demand for goods and services must be equal to aggregate supply.

Thus, to determine the short run evolution of an open economy, at least three equilibrium conditions must be analyzed. Equilibrium in the foreign exchange market, equilibrium in the domestic money market and equilibrium in the domestic output market.

The nominal exchange rate is the variable that adjusts to bring about short run equilibrium in the foreign exchange market, the nominal interest rate is the variable that adjusts to bring about short run equilibrium in the domestic money market, and, in the absence of full flexibility of the prices of goods and services, output (and employment) are the variables that adjust to bring about short run equilibrium in the domestic output market.

This view of the short run adjustment process in open economies has its roots in keynesian macroeconomics, which are based on the assumption that the prices of goods and services are not flexible enough in the short run to equilibrate the domestic output market. When the price level does not adjust immediately to clear the output market, aggregate output is determined by aggregate demand (consumption, investment, government spending and net exports). 1

The keynesian view has its roots in the General Theory of Keynes (1936). Hicks (1937) cast the General 1

Theory in a general equilibrium setting, with output adjusting to equilibrate the market for goods and services, and the nominal interest rate adjusting to equilibrate the money market. Meade (1951) provided a synthesis of the keynesian approach to the balance of payments focussing on the current account. Mundell (1963) introduced the equilibrium condition in the foreign exchange market, while Dornbusch (1976) extended the model to allow for the gradual adjustment of the price level and for rational expectations.

George Alogoskoufis, International Macroeconomics and Finance Ch. 5

According to the keynesian approach, the short-run equilibrium of an open economy takes place at the level of output and the exchange rate where, for a given price level, for given expectations about the future exchange rate, for given government expenditure and taxes, for given monetary conditions at home and abroad, and, for given economic conditions in the rest of the world, two requirements are met simultaneously:

1. The market for goods and services is in equilibrium, in the sense that the aggregate demand for goods and services is equal to aggregate supply.

2. The domestic money market is in equilibrium, in the sense that the aggregate money demand is equal to the money supply, and the foreign exchange market is in equilibrium in the sense that uncovered interest parity holds.

5.1 The Conditions for Short Run Equilibrium in Financial Markets

For short run equilibrium in financial markets two conditions must hold simultaneously. First, uncovered interest parity must hold in the foreign exchange market, and, second, the domestic money supply must be equal to the domestic money demand.

We shall first examine what the simultaneous satisfaction of these two conditions means for the relationship between output and the exchange rate.

5.1.1 Short Run Equilibrium in the Foreign Exchange Market

As we analyzed in Chapter 2, the short run equilibrium condition in the foreign exchange market is uncovered interest parity, an arbitrage condition, which requires that,

! (5.1)

S is the exchange rate (units of foreign currency per unit of domestic currency), Se is the expected future exchange rate, assumed as given, i* is the foreign currency nominal interest rate, and i is the domestic nominal interest rate.

This equilibrium condition implies a positive relation between the exchange rate and the domestic nominal interest rate. A rise in the domestic interest rate causes the exchange rate to appreciate, i.e S to rise in order for uncovered parity to be satisfied. The equilibrium relation between the exchange rate and the domestic interest rate is depicted in Figure 5.1, as the UIP curve. If domestic interest rates rise from i0 to i1 then the exchange rate appreciates from S0 to S1. If domestic interest rates fall from i0 to i2 then the exchange rate depreciates from S0 to S2.

As we analyzed in Chapter 2, an increase in foreign interest rates shifts the UIP curve downwards, reducing its slope too, and causing the exchange rate to depreciate for any given domestic interest rate (Figure 5.2). A reduction in foreign interest rates has the opposite effect, causing the domestic exchange rate to appreciate for any given domestic interest rate. On the other hand, an expected future depreciation of the exchange rate causes the current exchange rate to depreciate immediately, shifting the UIP curve downwards in a parallel fashion (Figure 5.3). A expected future appreciation of the exchange rate has the opposite effect, causing the domestic exchange rate to appreciate.

S = Se 1+ i1+ i*

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5.1.2 Short Run Equilibrium in the Domestic Money Market

We next turn to short run equilibrium in the domestic money market. The equilibrium is defined as the equality of the money supply with money demand. For a given price level P and a given level of aggregate income Y, the equilibrium relation between the money supply and the domestic nominal interest rate is determined by,

! (5.2)

where M is the money supply.

As we analyzed in Chapter 3, this equilibrium condition implies a negative short relation between the money supply and the nominal interest rate, because, for given income and the price level, an increase in the money supply requires a fall in the nominal interest rate for the increased money stock to be willingly held. This is the short run liquidity effect.

The negative short run relation between the domestic money supply and the domestic nominal interest rate is depicted diagrammatically in Figure 5.4. An increase in the money supply from M0 to M1 reduces the domestic nominal interest rate from i0 to i1, while a decrease in the money supply from M0 to M2 increases the domestic nominal interest rate from i0 to i2.

This relationship depends on the level of aggregate income Y. An increase in aggregate income Y shifts the short run equilibrium relationship upwards, as, for a given money supply, money demand rises when income rises, and interest rates have to rise too, in order to reduce money demand and restore short run equilibrium in the domestic money market. The shift in the domestic money market equilibrium condition when aggregate income changes is depicted in Figure 5.5. For a given money supply M0, a rise in real income from Y0 to Y1, causes the nominal interest rate to rise from i0

to i1.

Thus, for a given level of the money supply and a given price level, equilibrium in the domestic money market implies a positive short run relation between real income and the nominal interest rate. This positive relation is known in macroeconomics as the LM curve, and is depicted in Figure 5.6. An increase in the domestic money supply shifts the LM curve to the right, allowing for an increase in income and/or a fall in nominal interest rates. A decrease in the money supply has the opposite effect, shifting the LM curve to the left.

5.1.3 Simultaneous Equilibrium in the Foreign Exchange and the Domestic Money Market.

We are now in a position to study the combinations of output and the exchange rate that are consistent with simultaneous equilibrium in the foreign exchange market and the domestic money market.

For given expectations about the future nominal exchange rate, and for given foreign interest rates, uncovered interest parity, the equilibrium condition in foreign exchange markets, implies a positive relation between domestic interest rates and the exchange rate. This is depicted as the UIP curve in Figure 5.1.

M = PL(Y ,i)

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For a given level of the domestic money supply, and a given price level, the equality of money demand with the money supply, which is the equilibrium condition in the domestic money market, implies a positive relation between domestic output and the nominal interest rate. This is depicted as the LM curve in Figure 5.6.

The simultaneous satisfaction of these two conditions implies equilibrium in both financial markets. This, as we demonstrate in Figure 5.7, implies a positive relation between domestic output and the exchange rate, the AA curve. An increase in domestic output will, ceteris paribus, require an increase in the domestic interest rate for equilibrium in the domestic market to be maintained. But an increase in the domestic interest rate will require an appreciation of the nominal exchange rate if uncovered interest parity is to be maintained. Hence, the positive relation between domestic output and the exchange rate as a condition for simultaneous equilibrium in both financial markets.

The AA curve depicts the combinations of domestic output and the exchange rate that maintain this simultaneous equilibrium. The rationale for its positive slope is that when output increases, interest rates and the exchange rate have to increase too in order for both the domestic money market and the international foreign exchange market to remain in equilibrium.

The AA curve is depicted separately in Figure 5.8. It is straightforward to show that an increase in the domestic money supply or an increase in the foreign nominal interest rate will shift the AA curve to the right. On the other hand, an expected future appreciation of the exchange rate, an increase in Se, will shift the AA curve to the left.

Having analyzed the combinations of output and the exchange rate that maintain equilibrium in financial markets, we next turn to the market for goods and services.

5.2 The Conditions for Short Run Equilibrium in the Market for Goods and Services

In the long run, the market for goods and services reaches equilibrium through the adjustment of the prices of goods and services, i.e the price level. However, as Keynes argued in the General Theory, the price level does not fully adjust in the short run. Hence, output will have to adjust to the level of aggregate demand to maintain short run equilibrium in the product market.

5.2.1 The Determinants of Aggregate Demand for Domestic Goods and Services

Aggregate demand in a open economy is determined by the sum of consumption, investment and government expenditure, net of the difference between exports and imports. Thus, it is defined by,

! (5.3)

where D denotes aggregate demand for domestic goods and services, C aggregate private consumption, I aggregate private investment, G total government expenditures, X total exports and M total imports. All variables are expressed in domestic currency, and, since it is assumed that the price level is given, they are measured in real terms (constant prices).

In the simplest keynesian model it is assumed that aggregate consumption is a positive function of disposable income, that exports are a positive function of world income and a negative function of the exchange rate, and that imports are a positive function of domestic income and the exchange

D = C + I +G + X −M

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rate. Investment is treated as autonomous (exogenous) in the simplest version of the keynesian model, and so is real government expenditure.

The aggregate consumption is determined by,

! (5.4)

where T denotes total taxes, also assumed exogenous.

The theory behind the consumption function is that as the disposable income of households increases, households will spend a part, and not all of their additional income on higher consumption. The rest will go into savings. It is thus assumed that the first derivative of the consumption function (5.4), called the marginal propensity to consume, is between zero and unity. A increase in income results in a less than one to one increase in consumption.

!

The aggregate export function is determined by,

! (5.5)

The theory behind the export demand function is straightforward. When S increases, domestic goods become more expensive in foreign currency, and hence foreign demand for them and total domestic exports go down. On the other hand, an increase in foreign output and income Y* is partly spent on foreign imports, which results in an increase in the volume of domestic exports. Obviously, the increase in domestic exports is smaller than the increase in foreign income. Thus, we assume that,

! and !

The aggregate import function is determined by,

! (5.6)

The theory behind the import demand function is straightforward. When S increases, foreign goods become less expensive in domestic currency, and hence domestic demand for them increases and total imports go up. On the other hand, an increase in domestic output and income Y is partly spent on imports. Obviously, the increase in imports is smaller than the increase in domestic income. Thus, we assume that,

! and !

We can use the properties of the consumption function, the export demand function and the import demand function, to derive an aggregate demand function. Aggregate demand will be a positive

C = C(Y −T )

0 < ∂C∂(Y −T )

<1

X = X(S,Y*)

∂X∂S

< 0 0 < ∂X∂Y *

<1

M = M (S,Y )

∂M∂S

> 0 0 < ∂M∂Y

<1

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function of domestic income, a positive function of domestic investment and domestic government expenditure, a negative function of domestic taxes, a negative function of the exchange rate, and a positive function of foreign income. The aggregate demand function can thus be written as,

! (5.7)

Because the marginal propensity to consume is less than one, and because the marginal propensity to import is positive, an increase in domestic output and income will result in a less than one to one increase in aggregate demand. Hence, the marginal propensity to spend out of domestic income will be less than one to one.

The aggregate demand curve, as a function of domestic income, is depicted diagrammatically in Figure 5.9. It is relatively flat, because as domestic income increases, aggregate demand increases by less than one to one. An increase in autonomous investment, government expenditure and foreign income shifts the aggregate demand curve upwards, while an appreciation of the exchange rate (rise in S) and an increase in taxes shifts the aggregate demand curve downwards.

Thus, the position of the aggregate demand curve depends on exogenous variables, such as autonomous investment, government expenditure, taxes and foreign income, but also on the exchange rate. An exchange rate appreciation causes a decrease in aggregate demand, by reducing exports and increasing imports, while an exchange rate depreciation causes an increase in aggregate demand by increasing exports and reducing imports.

5.2.2 Equilibrium in the Market for Goods and Services

We can now turn to the equilibrium condition in the market for goods and services. Equilibrium occurs when aggregate demand is equal to aggregate output. The presumption in keynesian models is that output adjusts in the short run to equilibrate the market for goods and services, as prices are inflexible in the short run. Thus, when firms see an increase in the demand for their products, they simply produce more and employ more workers to do so.

The equilibrium condition is thus simply that,

! (5.8)

Equilibrium in the market for goods and services is depicted diagrammatically in Figure 5.10. The 45o line is the condition that Y=D. Equilibrium occurs at the point where the aggregate demand curve crosses the 45o line. At this point, aggregate demand is equal to aggregate output.

Obviously, shifts to the aggregate demand curve result in shifts in equilibrium output. An upward shift in the aggregate demand curve, say because of an increase in autonomous investment, or government expenditure, or foreign income, or a reduction in taxes, results in higher domestic output and employment in the short run. An downward shift in the aggregate demand curve, say because of an decrease in autonomous investment, or government expenditure, or foreign income, or an increase in taxes, results in lower domestic output and employment in the short run.

A crucial variable that affects the position of the aggregate demand curve is the exchange rate S. An exchange rate appreciation (increase in S), by making domestic goods more expensive relative to

D = D(Y , I ,G,T ,S,Y*)

Y = D(Y , I ,G,T ,S,Y*)

!6


foreign goods, causes a downward shift in aggregate demand, and a reduction in aggregate output and employment. An exchange rate depreciation (reduction in S), by making domestic goods less expensive relative to foreign goods, causes an upward shift in aggregate demand, and an increase in aggregate output and employment.

These effects are presented in Figure 5.11. A depreciation from S0 to S1 causes an upward shift in aggregate demand and an increase in equilibrium output, while an appreciation from S0 to S2 causes a downward shift in aggregate demand and a decrease in equilibrium output.

Short run equilibrium in the market for goods and services thus implies a negative relation between output and the exchange rate. By reducing aggregate demand, a higher exchange rate results in lower output and employment, and vice versa. This negative relation is depicted as the DD curve in Figure 5.12. The DD curve depicts the combinations of output and the exchange rate that result from equilibrium in the market for goods and services, for given autonomous investment, government expenditure, taxes and foreign income.

Obviously, changes in exogenous variables like autonomous investment, government expenditure, taxes and foreign income cause shifts in the position of the DD curve. Changes that cause an increase in aggregate demand, such as an increase in government expenditure or a cut in taxes, shift the DD curve to the right. Changes that cause a decrease in aggregate demand, such as an decrease in government expenditure or an increase in taxes, shift the DD curve to the left.

5.2.3 Simultaneous Short Run Equilibrium in Financial Markets and Goods and Services Markets

Equilibrium in financial markets is not sufficient to determine both output and the exchange rate, as it is consistent with any combination of the two that lies along the upward sloping AA curve in Figure 5.8.

On the other hand, equilibrium in the market for goods and services is not sufficient to determine both output and the exchange rate either, as it is consistent with any combination of the two that lies along the downward sloping DD curve in Figure 5.12.

To determine the short run level of output and the exchange rate we need to consider simultaneous equilibrium in both financial markets and the market for goods and services. This is depicted in Figure 5.13. In the short run, output and the exchange rate are determined at the point of intersection of the AA curve and the DD curve. It is only at this point that all markets are simultaneously in equilibrium. At this point (E0 in Figure 5.13) output and the exchange rate are uniquely determined.

From now on we shall proceed assuming that, in the short run, output and the exchange rate are always determined at the point of intersection of the AA curve (short run equilibrium in financial markets) and the DD curve (short run equilibrium in the market for goods and services).

5.2.4 Macroeconomic Shocks and Monetary and Fiscal Policy under Floating Exchange Rates

The AA-DD model can be used to analyze the short run effects of macroeconomic shocks and the role of monetary and fiscal policy on output and the exchange rate.

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Let us first consider the effects of a temporary domestic monetary expansion. The effects can be analyzed with the help of Figure 5.14.

A temporary monetary expansion, i.e. a temporary increase in the money supply from M0 to M1, shifts the AA curve to the right, without affecting the position of the DD curve. In the new equilibrium, output is higher, as it has increased from Y0 to Y1 and the exchange rate has depreciated from S0 to S1.

The reason is that a temporary monetary expansion causes a reduction in domestic nominal interest rates, which for uncovered interest parity to hold must cause a depreciation of the exchange rate. The depreciation of the exchange rate causes an increase in aggregate demand, which brings about an increase in output and employment. The increase in output in turn mitigates the reduction in domestic nominal interest rates and the depreciation of the exchange rate. In the new equilibrium the depreciation of the exchange rate and the increase in output are such, as to ensure short run equilibrium in both the financial markets and the market for goods and services.

In Figure 5.15 we analyze the effects of a temporary increase in foreign interest rates i*. Such an external shock also causes the exchange rate to depreciate and domestic output to increase.

The reason is that a temporary increase in foreign interest rates causes a depreciation of the domestic exchange rate. The depreciation of the exchange rate causes an increase in aggregate demand, which brings about an increase in output and employment. The increase in output in turn causes domestic nominal interest rates to rise as well and mitigates the depreciation of the exchange rate. In the new equilibrium the depreciation of the exchange rate and the increase in output are such, as to ensure short run equilibrium in both the financial markets and the market for goods and services.

In Figure 5.16 we analyze the effects of a temporary increase in domestic government expenditure. A temporary increase in government expenditure causes the DD curve to shift to the right, without affecting the position of the AA curve. Such a policy shock causes the exchange rate to appreciate and domestic output to increase.

The reason is that a temporary fiscal expansion causes an increase in aggregate demand and therefore output. The increase in output, causes the domestic nominal interest rate to rise, in order to maintain equilibrium in the domestic money market. The rise in the domestic nominal interest rate causes the exchange rate to appreciate, in order to maintain equilibrium in the foreign exchange market (uncovered interest parity). The appreciation of the exchange rate, by reducing net exports, mitigates the increase in output caused by the fiscal expansion. In the new equilibrium the appreciation of the exchange rate and the increase in output are such, as to ensure short run equilibrium in both the financial markets and the market for goods and services.

In Figure 5.17 we analyze the effects of a temporary reduction in foreign output. A temporary reduction of foreign output causes the DD curve to shift to the left, by reducing the demand for exports, without affecting the position of the AA curve. Such a policy shock causes the exchange rate to depreciate and domestic output to decrease.

The reason is that a temporary fall in foreign output causes a decrease in aggregate demand, through lower exports, and therefore causes domestic output to fall. The fall in domestic output, causes the

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domestic nominal interest rate to fall, in order to maintain equilibrium in the domestic money market. The fall in the domestic nominal interest rate causes the exchange rate to depreciate, in order to maintain equilibrium in the foreign exchange market (uncovered interest parity). The depreciation of the exchange rate, by increasing net exports, mitigates the decrease in domestic output caused by the reduction in foreign output and exports. In the new equilibrium the depreciation of the exchange rate and the decrease in output are such, as to ensure short run equilibrium in both the financial markets and the market for goods and services.

In Figure 5.18 we analyze the effects of a shift in expectations about the future exchange rate. In particular we consider the effects of a shift that results in an expected future appreciation of the exchange rate. Such a shock, causes the AA curve to shift to the left, without affecting the position of the DD curve. It causes the current exchange rate to appreciate, and current output to fall.

The reason is that the expected future depreciation of the exchange rate causes the current exchange rate to appreciate, in order to maintain equilibrium in the foreign exchange market (uncovered interest parity). The appreciation of the exchange rate causes a decrease in aggregate demand, through lowering net exports, and therefore causes domestic output to fall. The fall in domestic output, causes the domestic nominal interest rate to fall, in order to maintain equilibrium in the domestic money market. The fall in the domestic nominal interest rate mitigates the appreciation of the exchange rate, in order to maintain equilibrium in the foreign exchange market, and so on. In the new equilibrium the appreciation of the exchange rate and the decrease in output are such, as to ensure short run equilibrium in both the financial markets and the market for goods and services.

In Figure 5.19 we consider the effects of a permanent monetary expansion. The difference between a temporary and a permanent shock is that a permanent shock also affects expectations about the future exchange rate. A permanent monetary expansion (increase in the money supply), has the additional effect of causing not only a current, but also an expected future depreciation of the exchange rate. Thus, the current exchange rate depreciates both as a result of the fall of current nominal interest rates, and the expected future depreciation. Output increases more in the short run, because of the higher depreciation of the exchange rate. Thus, the impact of a permanent monetary expansion on the short exchange rate and output is thus even greater than a temporary one.

In Figure 5.20 we consider the effects of a permanent fiscal expansion. A permanent fiscal expansion (increase in government expenditure or tax cut), compared to a temporary one, has the additional effect of causing not only a current, but also an expected future appreciation of the exchange rate. Thus, the current exchange rate appreciates both as a result of the rise of current nominal interest rates, and the expected future appreciation. Output does not rise even in the short run, because of the appreciation of the exchange rate causes a reduction of net exports that fully counteracts the effects of the fiscal expansion on aggregate demand. Thus, the impact of a permanent fiscal expansion on the short run exchange rate are higher than a temporary one, but aggregate demand and output are not affected.

5.2.4 Monetary and Fiscal Policy Responses to External and Financial Shocks

This model can be used to analyze the role of short run stabilization policy. In principle, the government and the monetary authorities could use either monetary or fiscal policy to counteract shocks that create a recession. In practice, monetary policy is much more flexible than fiscal policy, as it does not require a lengthy legislative process, but simply a decision by the policy setting board

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of the central bank, i.e the Fed in the case of the USA and the European Central Bank in the case of the Eurozone.

We shall thus concentrate on the role of monetary policy in the short run.

In Figure 5.21 we analyze the case of a recession caused by a temporary reduction in foreign output. A temporary reduction of foreign output causes the DD curve to shift to the left, by reducing the demand for exports, without affecting the position of the AA curve. Such a policy shock causes the exchange rate to depreciate and domestic output to decrease.

What is the optimal monetary policy to such a shock, if counteracting the recession is the goal of monetary policy? The optimal response involves engineering a domestic monetary expansion that would shift the AA curve to the right, returning output and employment to their original level, and causing a further depreciation of the exchange rate. This is the case presented in Figure 5.21.

In Figure 5.22 we analyze the case of a recession caused by a temporary financial shock, such as a decrease in foreign interest rates, or an autonomous increase in money demand. A temporary financial shock causes the AA curve to shift to the left, increasing domestic interest rates and causing an appreciation of the exchange rate. The exchange rate appreciation causes a fall in aggregate demand and output, along the DD curve, and causes a temporary recession

What is the optimal monetary policy to such a shock, if counteracting the recession is the goal of monetary policy? The optimal response involves engineering a domestic monetary expansion that would shift the AA curve back to its original position. This would ensure that output and employment, and the nominal exchange rate, return to their original level,. This is the case presented in Figure 5.22.

5.3 Conclusions

In the short run, when the prices of goods and services have not had time to adjust to equilibrate the market for goods and services, equilibrium in an open economy is determined at the level of output and the exchange rate where,

1. The market for goods and services is in equilibrium, in the sense that aggregate demand equals aggregate supply,

2. The domestic money market and international financial markets are in equilibrium, in the sense that the demand for money equals the supply of money and uncovered interest parity holds.

A temporary monetary expansion (increase in the money supply) causes a depreciation of the exchange rate, and a temporary increase in GDP and employment. A permanent monetary expansion (increase in the money supply), has the additional effect of causing an expected future depreciation of the exchange rate. Thus, the current exchange rate depreciates both as a result of the fall of current nominal interest rates, and the expected future depreciation. The impact of a permanent monetary expansion on the short exchange rate and output is thus even greater than a temporary one.

A temporary fiscal expansion (increase in government expenditure or reduction in taxes) causes an appreciation of the exchange rate, and a temporary increase in output and employment. A

!10


permanent fiscal expansion has the additional effect of causing an expected future appreciation of the exchange rate. Thus, the current exchange rate appreciates both as a result of the rise of current nominal interest rates, and the expected future appreciation. The impact of a permanent fiscal expansion on the short exchange rate is thus even greater than a temporary one, but the impact on output is zero, as the exchange rate appreciation fully crowds out the effects of the fiscal expansion on aggregate demand.

This model has been used to analyze the role of short run stabilization policy. In principle, the government and the monetary authorities could use either monetary or fiscal policy to counteract shocks that create a recession. In practice, monetary policy is much more flexible than fiscal policy, as it does not require a lengthy legislative process, but simply a decision by the policy setting board of the central bank.

!11


References

Dornbusch R. (1976), “Expectations and Exchange Rate Dynamics”, Journal of Political Economy,84, pp. 1161-76.

Fleming M. (1962), “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, IMF Staff Papers, 9, pp. 369-379.

Hicks J.R. (1937), “Mr Keynes and the Classics: A Suggested Interpretation”, Econometrica, 5, pp. 147-159.

Keynes J.M. (1936), The General Theory of Employment, Interest and Money, London, Macmillan. Meade J. (1951), The Balance of Payments, London, Oxford University Press. Mundell R. (1963), “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange

Rates”, Canadian Journal of Economics and Political Science, 29, pp. 475-85.

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Figure 5.1 Short Run Equilibrium in the Foreign Exchange Market

The Exchange Rate and the Domestic Interest Rate

!13


Figure 5.2 Short Run Equilibrium in the Foreign Exchange Market

An Increase in Foreign Interest Rates

!14


Figure 5.3 Short Run Equilibrium in the Foreign Exchange Market An Expected Future Depreciation of the Exchange Rate

!15


Figure 5.4 The Negative Short Run Equilibrium Relationship between the Money Supply and

the Nominal Interest Rate

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Figure 5.5 Shifts in the Level of Aggregate Income and the Nominal Interest Rate

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Figure 5.6 Equilibrium in the Domestic Money Market and the LM Curve

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Figure 5.7 Simultaneous Short Run Equilibrium in the Foreign Exchange and Domestic Money

Markets: The AA Curve

!

!19


Figure 5.8 Short Run Equilibrium in Financial Markets: The AA Curve

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Figure 5.9 The Aggregate Demand Curve

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Figure 5.10 Equilibrium in the Domestic Market for Goods and Services

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Figure 5.11 Aggregate Demand, Output and the Exchange Rate

!23


Figure 5.12 The Equilibrium Condition in the Domestic Market for Goods and Services

The DD Curve

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Figure 5.13 Short Run Equilibrium Output and the Exchange Rate in an Open Economy

!25


Figure 5.14 The Effects of a Temporary Monetary Expansion

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Figure 5.15 The Effects of a Temporary Increase in Foreign Interest Rates

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Figure 5.16 The Effects of a Temporary Fiscal Expansion

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Figure 5.17 The Effects of a Temporary Reduction in Foreign Output

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Figure 5.18 The Effects of an Expected Future Appreciation of the Exchange Rate

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Figure 5.19 The Effects of a Permanent Monetary Expansion

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Figure 5.20 The Effects of a Permanent Fiscal Expansion

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Figure 5.21 Monetary Policy Response to a Recession in the Rest of the World

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Figure 5.22 Monetary Policy Response to a Negative Financial Shock

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