output and the exchange rate in the short run. introduction how can we analyze the short run of an...

Output and the Exchange Rate in the Short Run

Introduction How can we analyze the short run of an

open economy? What are the impacts on a country’s

imports and exports from changes in the real exchange rate?

How much effect do changes in foreign trade have on growth rate of GDP?

What is the importance of the real exchange rate in an open economy?

Aggregate Demand Relationship between total quantity

demanded of goods and services in all sectors of the economy and the price level, holding all else constant

Total output of goods and services measured by real GDP – horizontal axis

Price level measured by GDP price deflator – vertical axis

AD curve slopes downward – as price level declines, quantity of goods demanded increases

Aggregate Demand Does not behave in the same

manner as an ordinary demand curve

Price of product falls Consumer’s real income rises –

increases amount consumed for normal good (income effect)

Lower price induces consumers to purchase more of product b/c cheaper (substitution effect)

Aggregate Demand Neither the income or substitution

effect are relevant to overall price level

If aggregate price level falls Prices consumers pay are falling Prices people receive as wages, rents,

etc. are also falling No change in demand

Aggregate Demand Price level is measure of prices in

general, not a particular price As price level falls there is no

substitution effect b/c prices in general are falling, not the price of a particular good.

Aggregate Demand Why is AD negatively sloped?

1. As price level changes, value of individual’s real wealth changes – wealth effect

Increase in price level: Reduces value of accumulated financial

assets Consumers reduce consumption of goods Aggregate quantity demanded changes

Aggregate Demand Why is AD negatively sloped? (cont.)

2. Rise in price level increases interest rates – interest rate effect

Lower business investment Lower consumer spending on housing and cars Aggregate quantity demanded falls

3. Price level changes impact country’s total exports and imports – international substitution effect

Aggregate Demand Why is AD negatively sloped? (cont.)

Price level increase Price of domestic goods rises relative to

foreign goods Foreign demand (exports) for domestic

goods decreases Domestic demand (imports) for foreign

goods increases Aggregate quantity demanded declines

Aggregate Demand All three effects lead to decreases

in aggregate quantity demanded (output of goods and services) as price level increases (all else equal)

The opposite is also true Inverse relationship is shown as

movement along aggregate demand curve

Aggregate Demand Curve

Changes in Aggregate Demand Changing one of the variables held

constant along the AD curve will cause a shift in the curve

Increases (decreases) in AD will shift the curve to the right (left)

New AD curve shows at any given price level, society wants to buy more (less) goods and services

Changes in Aggregate Demand Expenditure approach to calculating

GDP Look at the four sectors of an open

economy that buy real goods/services

)( IXGICGDP Changes in any above factors,

shifts AD

Changes in Aggregate Demand


I. Consumption (C)A. Consumer wealth As consumer wealth increases

(decreases), level of consumption increases (decreases)

Increase (decreases) in consumption shifts AD curve to right (left)


B. Consumer expectations More confident consumers are about

the future, more likely to consume today

Increased confidence increases AD (curve shifts right)

Reverse is also true


C. Degree of consumer indebtedness High level of indebtedness from past

consumption financed by borrowing Must pay off existing dept May need to reduce current consumption Consumer spending falls AD curve shifts left

Reverse is also true


D. Taxes Higher taxes (or lower transfer

payments) reduce society’s after tax income

Lower income leads to lower consumption spending

AD curve shifts left Reverse is also true


II. Investment spendingA. Higher interest rates

Decreases business investment and public investment in housing

Aggregate demand decreases (shifts left) Opposite is also true

B. Expectations of future economic conditions

Current economic conditions affect expectations of future in same direction thereby affecting investment spending


II. Investment spending (cont.)C. Government changes in

business taxation Increasing (decreasing) business

taxes raise (lower) investment spending and aggregate demand


III. Government Spending Increasing in government spending

on goods/services, increases aggregate demand

Opposite is also true Government spending at federal,

sate or local level


IV. Exports and ImportsA. Exports sensitive to changes in

income of foreign countries Increases in foreign incomes increase

exports which increases aggregate demand (and vice versa)

Faster foreign economic growth leads to greater changes in US aggregate demand

Slower foreign growth (recessions) negatively impacts US aggregate demand


IV. Exports and Imports (cont.)B. Movements in real exchange rate As dollar depreciates

Foreign currency buys more US goods – increases exports

US currency buys fewer foreign goods – decreases imports

Aggregate demand increases Opposite is also true

Aggregate Supply Relationship between the total

quantity of goods/services an economy produces at various price levels, holding all other determinant of production unchanged.

Slopes upward to the right As price level rises, quantity of goods

and services economy produces increases

Aggregate Supply Why is AS positively sloped?

Represents entire economy’s total production

Higher price level is necessary to bring a higher level of total production

Assume short run labor force, capital stock, stock of natural resources, and level of technology are constant

Aggregate Supply Why is AS positively sloped? (cont.)

Related to both rising demand for output and rising unit costs as economy moves closer to full employment

As output expands, prices of some inputs rise before economy reaches full employment leading to rising unit costs

As some prices rise while others are constant, price level on average increases before reaching full employment

Aggregate Supply Why is AS positively sloped? (cont.)

Most important price in economy is price of labor

Hiring more labor decreases K/L ratio MPL decreases and wage rate increases Leads to rising production costs

Rising price level means higher prices are necessary to increase total output – upward sloping AS curve

Aggregate Supply

Aggregate Supply Change in aggregate supply means per

unit production costs are rising (falling) for some reason unrelated to an increase in production (output)

Increases in AS will shift the curve to right At any given price level, firms are willing and

able to produce more goods/services Firms can produce same level of output at

lower unit costs – unit costs have declined

Changes in Aggregate Supply Decreases in AS will shift the curve

to the left Unit costs of production have increased

Two types of changes or shifts in AS Changes due to changes in potential

real GDP Changes in major determinants of AS

curve held constant along the curve

Changes in Aggregate Supply

Changes in Aggregate SupplyI. Changes in potential real GDP

A. Factors of production As factors of production (land, labor,

capital, entrepreneurial ability) increase over time, AS curve will shift right

B. Productivity of factors of production Increases in productivity reduce unit

costs and shift AS curve to right Synonymous with country’s long

run economic growth

Changes in Aggregate SupplyII. Determinants of aggregate supply

A. Input prices Increases in input prices increase costs

of production decreasing AS EX: increases in wages, oil shock

B. Exchange rate shock Large change in real value of a country’s

currency in short period of time Change change firm’s costs of

production changing aggregate supply


II. Determinants of aggregate supplyC. Changes in business taxes

Increases in overall business taxes increases costs of production decreasing AS and vice versa

EX: sales taxes, excise taxes, payroll taxes

D. Public’s inflationary expectations Perceived increases in future inflation cause

adjustments in economic action today.


D. Public’s inflationary expectations (cont.) Producers may attempt to increase

prices today to stay ahead of anticipated inflation

Workers attempt to receive larger salary increases today to protect real wages and standards of living

Aggregate supply curve will decrease (left shift)

Aggregate Equilibrium Intersection of AS and AD determines

the open economy’s equilibrium Equilibrium level of real output (production

and spending) for economy at Ye

Equilibrium price level for the economy at Pe

Shifts in AS or AD will change equilibrium level of output and price level

Aggregate Equilibrium

Aggregate Equilibrium Note that changes in exchange rate

shift both AD and AS curves Changes in exchange rate can affect

an open economy’s equilibrium level of output and price level

Not only are trade flows (exports and imports) affected, but there are noticeable impacts on entire economy

Determinants of Current Account

Changes in AD and AS influence output We will focus on one component of

aggregate demand and supply – the current account

How does a change in the current account (exports minus imports) impacts the equilibrium level of output

Changes in other determinants of AD and AS will be ignored

Changes in Current AccountI. Exports

A. Level of income in foreign countries, Yf Exports change with changes in foreign

incomes Size of change determined by two factors1. Size of change in foreign income

Larger income changes have larger effects on exports

Changes in foreign income that affect a country’s exports are weighted averages of changes in income among the countries trading partners

Changes in Current Account

I. Exports (cont.)2. Income elasticity of demand for the

country’s exports Percentage change in a country’s

exports relative to the percentage change in foreign income

f

Yf Yin

Xin

%

%)(



country’s exports Elasticity is a positive number As foreign incomes increase (decrease),

a country’s exports increase (decrease) Size of country’s foreign income

elasticity depends on product mix of a country’s exports



country’s exports If a country exports a high percentage of

goods with high income elasticities of demand, they will tend to have a higher foreign income elasticity and vice versa

US close to 1, Germany and Japan greater than 1, Chile, South Africa less than 1


I. Exports (cont.)B. Real exchange rate (RXR) As the real value of country’s currency

appreciates (depreciates, level of a country’s exports declines (increases)

Size of effect depends on1. Size of change in real exchange rate

The larger the change in RXR, the larger the effect on exports


I. Exports (cont.)B. Real exchange rate (RXR)

2. Price elasticity of demand for exports Sensitivity of a country’s exports to

changes in the real exchange rate Sensitivity of a country’s exports is

inversely related to changes in real exchange rate

RXRin

XinRXR

%

%)(


II. Imports A. Level of domestic income (Yd)

As domestic income rises, level of imports rises

Size of effect depends on two factors1. Size of change in domestic income2. Income elasticity of demand for imports

d

Yd Yin

Min

%

%)(


II. Imports A. Level of domestic income (Yd)

2. Income elasticity of demand for imports (cont.)

Income elasticity is positive – increases in domestic income cause an increase in imports

May be equal to, greater than or less than 1

3. Real Exchange rate As currency appreciates, imports increase


II. Imports 3. Real Exchange rate (cont.)

Magnitude of effect depends on two factors1. Size of change in real exchange rate – smaller

changes have smaller effects2. Price elasticity of demand for imports – percent

change in imports relative to percent change in real exchange rate – direct relationship

RXRin

MinPMR

%

%)(

Effects on Open Economy AD is link between current account

balance and output Since real exchange rates effect

current account, we can link them to changes in domestic output

Effects on Open EconomyI. Exchange Rate Appreciation

Equilibrium exchange rate equates inflows and outflows of foreign exchange at XRe

Assume rate is associate with purchasing power parity (PPP)

Initial level of AD is also determined Assume no capital flows between countries,

foreign trade is balanced at FXe, and economy has equilibrium output of Ye

Effects on Open Economy

I. Exchange Rate AppreciationA. Assume real exchange rate changes

– currency appreciates to XR1 Assume caused by rightward shift of

supply of foreign exchange Exports would fall and imports would

rise resulting in a current account deficit

Equal to difference between M and X in figure 15.6 (a)

Effects on Open Economy Effects of current account deficit on

real economy1. Domestic economy’s AD will decrease as

exports fall and imports rise AD shifts to left (15.6 b) Equilibrium level of output (real GDP) falls

2. Price level falls as AD decreases Price of imports falls Price of US produced goods that compete with

imports may fall


II. Exchange Rate DepreciationA. Demand for foreign exchange increases

Assuming no capital flows, we are in balanced trade

Assume PPP exchange rate As exchange rate depreciates, current account

surplus would occur (M’ to X’) Exports increase as price of domestic goods

falls Imports decrease and domestic price of

imported goods increases

Effects on Open Economy Effects of current account surplus

on economy Economy’s aggregate demand

increase as exports increase and imports decrease

Domestic real GDP increases as total output increases

Country’s price level rises


III. Exchange Rate Shocks Assume a 75% depreciation of a

country’s currency in one week Demand for foreign exchange has

increased and supply has decreased Exchange rate goes from XRe to XR’’ Could have been capital flight out of

country due to domestic crisis or due to exchange rate being fixed at inappropriate level for long period of time


III. Exchange Rate Shocks (cont.) If depreciation is large, effects on AS can

be very large as well For an open economy, depreciation

causes a large short-run increases in costs of production

AS shifts left decreasing output significantly leading to recession

Price level increases significantly Common for developing countries

Effects on Composition of Output How does the composition of output

change in the long run due to changes in exchange rate?

Distinction between1. Tradeable goods – products commonly

sold in international markets2. Non-tradeable goods – goods for which

selling between countries is too costly

Effects on Composition of Output

Assume currency appreciates Open economy’s equilibrium output

and price level change Overall production of tradeable goods

falls Exports decline and imports rise

Decline in price of tradeable goods makes non-tradeable goods relatively more expensive

Effects on Composition of Output Resources will flow to industry with

higher prices – non-tradable industry If operating at full employment,

resources flow from sector that is declining to sector that is expanding

Positive effect on economy’s non-tradable goods sector

Occurred in US in early 1980’s as economy shifted production away from tradeable goods to non-tradeable goods

Effects on Composition of Output Opposite occurs when country’s currency

depreciates Prices in tradeable goods sector increase

and output of tradeable goods increases Exports increase and imports fall

Resources flow from production of non-tradeable goods to production of tradeable goods

Changes in real exchange rate can have critical impact on the mix of production in an economy

output and the exchange rate in the short run. introduction how can we analyze the short run of an...

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