prices and output in the open economy: aggregate supply and demand copyright © 2010 by the...
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Prices and Output in the Open Economy:
Aggregate Supply and Demand
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 27Chapter 27
27-2
Learning Objectives Explain the fundamental links between
international transactions and aggregate supply and aggregate demand.
Demonstrate how economic shocks and policies affect prices and output.
Differentiate between macroeconomic adjustment under fixed exchange rates and under flexible exchange rates.
Distinguish between short-run and long-run effects of macro policies on output and prices.
27-3
Aggregate Demand in the Closed Economy
In the closed economy, macroeconomic equilibrium occurs where IS and LM curves intersect.
When prices change, IS curve is not affected.
When prices change, real money supply changes, shifting the LM curve.
We can trace out the aggregate demand (AD) curve by seeing how Y changes as P changes.
Derivation of Aggregate Demand Curve: Closed Economy
i
Y Y
P
IS
LM0(P0)
Y0
i0
P0
Y0
LM1(P1)
Y1
i1
P1
LM2(P2)
Y2
i2
Y1Y2
P2
AD
27-4
27-5
Aggregate Demand in the Closed Economy
The more elastic IS or LM are, the more elastic AD will be.
If IS shifts right (left), AD shifts right (left).
An increase in the tax rate makes IS and AD steeper.
When LM shifts right (left), AD shifts right (left).
27-6
Aggregate Supply in the Closed Economy
AS is determined by: • level of technology,• quantity of resources available,• efficiency with which resources are used, and• level of employment of resources.
In the short run, the first 3 are assumed fixed.
Employers hire workers up to the point where wage equals the marginal revenue product: W=P•MPPN.
Aggregate Production and the Demand for Labor
Y
N N
W, MPPN
IS
N0
Y0
W0
N0N1
Y1
N2
Y2
Y1Y2
MRPN0
MRPN1MRPN2
27-7
27-8
Aggregate Supply in the Closed Economy
Suppose W is fixed – this mean firms can hire as much labor as they wish at the going wage (labor supply is perfectly elastic).
If P increases, MRPN shifts rightwards. This leads to a higher level of
employment and thus output. Therefore P and Y are directly related.
27-9
The Aggregate Supply Curve With a Fixed Wage
P
YY2 Y0
P0
P2
Y1
P1
AS
27-10
Aggregate Supply in the Closed Economy
However, labor supply is probably not perfectly elastic – to induce a greater quantity of labor supplied, wages must rise.
The resulting AS curve will be steeper.
Variable Wages and the Aggregate Supply Curve
W, MRP
Y
P
N0
W0 P0
Y0N1
W1
N2
W2
Y1Y2
MRP1MRP0MRP2
P2
P1
ASNS
27-11
27-12
Aggregate Supply in the Closed Economy
In fact, the quantity of labor supplied depends on the real wage.
Once workers realize that P has risen they will demand a higher wage.
This means that an increase in P may temporarily “fool” workers into supplying a higher quantity labor (and thus produce more output), but labor supply will shift leftwards eventually; Y returns to natural level of income.
27-13
Labor Market Adjustment to Higher Prices
P
Y
MRPN
W0
W2
MRP'N
W1
SN
S'N
N0 N1
27-14
Equilibrium in the Closed Economy
Putting aggregate supply and aggregate demand together allows us to see equilibrium output and price level.
If for whatever reason AD increases, there will be a temporary increase in output and prices.
Once workers realize P has increased, they will decrease labor supply.
This will shift AS leftwards, leaving us with the original Y but a higher price level.
27-15
Equilibrium in the Closed Economy
P
YY0
P0
P2
Y1
P1
ASSR0
AD0
AD1
ASSR1
ASLR
27-16
Equilibrium in the Closed Economy
The short run AS curve is upward-sloping. The long run AS curve is a vertical line.
27-17
Aggregate Demand in the Open Economy Under Fixed
Rates When the economy is open, we must also
consider the BP curve when deriving AD. If P increases:
• LM shifts leftwards.• BP shifts leftwards.• IS shifts leftwards.
Ultimately, a new equilibrium will occur at a lower level of Y.
Aggregate Demand in the Open Economy Under Fixed Rates
i
Y Y
P
ISP0
Y0
i0 P0
Y0Y1
i1
Y1
P1
AD
LMP0
BPP0
LMP1
BPP1
ISP1
27-18
27-19
Aggregate Demand in the Open Economy Under
Flexible Rates If P increases:
• LM shifts leftwards.• BP shifts leftwards.• IS shifts leftwards.
An incipient surplus or deficit may ensue, causing exchange rate adjustment and further shifts of BP and IS.
Ultimately, a new equilibrium will occur at a lower level of Y.
27-20
Effect of Exogenous Shocks on AD Curve Under Fixed and
Flexible RatesFixed Flexible
Δ in partner-country variable that increases home-country exports
AD shifts right
No effect on AD
Δ in partner-country variable that alters short-term capital flows in partner-country’s favor
AD shifts left
AD shifts right
Δ in home-country variable that reduces home-country exports
AD shifts left
No effect on AD
Δ in home-country variable that stimulates short-term capital inflows
AD shifts right
AD shifts left
Expansionary monetary policy No effect on AD
AD shifts right
Expansionary fiscal policy AD shifts right
Little effect on AD
27-21
Monetary Policy in AS/AD Framework: Flexible Rates
Since monetary policy in the presence of fixed rates has limited effect on AD, we focus on a flexible rate regime.
Expansionary monetary policy shifts AD rightwards, with higher Y and P.
Eventually, workers realize P is higher and decrease labor supply.
This shifts AS leftwards. The economy return to the original level
of Y, but with higher P.
27-22
Monetary Policy in AS/AD Framework: Flexible Rates
P
YY0
P0
P2
Y1
P1
ASSR0
AD0
AD1
ASSR1
ASLR
27-23
Fiscal Policy in AS/AD Framework: Fixed Rates
Since fiscal policy in the presence of flexible rates has limited effect on AD (esp. if capital is relatively mobile), we focus on a fixed rate regime.
Expansionary fiscal policy shifts AD rightwards, with higher Y and P.
Eventually, workers realize P is higher and decrease labor supply.
This shifts AS leftwards. The economy return to the original level
of Y, but with higher P.
27-24
Fiscal Policy in AS/AD Framework: Fixed Rates
P
YY0
P0
P2
Y1
P1
ASSR0
AD0
AD1
ASSR1
ASLR
27-25
Economic Policy and Supply Considerations
Some policies can also affect AS. For example, suppose a tax cut not only
expands AD, but also causes AS to shift to the right, as supply-side economists predict?
The tax cut will end up increasing Y, but the ultimate effect on P is ambiguous.
27-26
Economic Policy and Shifts in the Long-Run AS Curve
P
YY0
P0
Y1
ASSR0
AD0
AD1
ASSR1
ASLR AS'LR
?
?
27-27
External Shocks: Increase in Price of Imported Input
What if a critical imported input (e.g., crude oil) increases in price?
In a flexible exchange rate system, this causes• a depreciation of the home currency,• an expansion of AD, and• a leftward shift of short- and long-run AS.
The result may be stagflation: simultaneous decreases in income coupled with rising prices.
27-28
Effect of a Price Shock of an Imported Input
P
YY0
P0
Y1
P1
ASSR0
AD0
AD1
ASSR1
ASLR0
ASLR1
Y2
27-29
External Shocks: Foreign Financial Shock
What if a foreign financial shock triggers an inflow of short-term capital?
In a flexible exchange rate system, this causes• an appreciation of the home currency,• an contraction of AD, and• lower income and prices.
The economy could return to original Y by expansionary monetary or fiscal policy, or wait for the LR adjustment.
27-30
External Shocks: Foreign Financial Shock
P
YY0
P0
Y1
P1
ASSR0
AD0
AD1
ASLR0
27-31
External Shocks: Technological Change
What if technological change occurs? SR AS shifts rightwards, temporarily giving us a
new equilibrium with higher income and lower prices (at P1 and Y1).
But LR AS also shifts rightwards, perhaps to the right of Y1.
Now the economy is below its new natural level, Y2.
The economy will adjust by a further rightward shift of SR AS, or expansionary monetary or fiscal policy could be employed.
27-32
External Shocks: Technological Change
P
YY0
P0
Y1
P1
ASSR0-W0
AD0
AD1
ASLR0
ASSR1-W0ASLR1
Y2
P2
ASSR1-W1