# 4550ch16

Published on April 11, 2008

Author: Lindon

Source: authorstream.com

CHAPTER 16:  CHAPTER 16 OUTPUT AND THE EXCHANGE RATE IN THE SHORT RUN Slide2:  Previous analysis: Y is treated as an exogenous variable in exchange rate determination. In reality both Y and E are determined simultaneously. Purpose: To develop a short-run model where E and Y are determined simultaneously. Slide3:  DETERMINATION OF “Y” IN THE SHORT RUN The goods (output) market is in equilibrium when real output (Y) equals aggregate demand. Aggregate demand (D) can be expressed as follows: Increases in EP*/P, Y-T, I, and G increases D. The equality of Y and D determines the short-run equilibrium output level. Figure 1 Slide4:  Simultaneous determination of E and Y requires 1. Equilibrium in the Output Market (The DD schedule), 2. Equilibrium in the Asset Market (The AA schedule). Output Market Equilibrium and the DD Schedule An increase in E, holding P and P* constant, increases EP*/P, which increases D. That is, D shifts up and Y increases. The positive correlation between E and Y is shown by the upward sloping DD curve. Figure 2. Slide5:  Example: Slide6:  Factors that shift the DD Schedule 1. An increase in G shifts the DD curve right. (An increase in G increases aggregate expenditures, holding E constant, and shifts DD right). Figure 3 2. An increase in T shifts the DD curve left. 3. An increase in I shifts the DD curve right. 4. An increase in P shifts the DD curve left. Slide7:  5. An increase in P* shifts the DD curve right. 6. An increase in consumer and business optimism shifts the DD curve right. 7. An increase in demand for home goods (change in tastes) shifts the DD curve right. Slide8:  Asset Market Equilibrium in the Short Run: The AA Schedule For asset markets to remain in equilibrium, a rise in Y must be accompanied by an appreciation of E. This can be shown as follows. Figure 4. Example: Slide9:  Factors that Shift the AA Schedule 1. An increase in M shifts the AA schedule up. (Increase in M increases M/P, reduces R at each output level and increases E. AA shifts up.) Figure 5 2. An increase in P shifts the AA schedule down. 3. An increase in expected E shifts AA up 4. An increase in foreign interest rates shifts AA up Slide10:  5. An increase in L(R,Y) shifts AA down. SHORT-RUN EQUILIBRIUM FOR AN OPEN ECONOMY: AA AND DD SCHEDULES Short-run equilibrium is achieved when the output and asset markets are both in equilibrium. That is, when AA=DD. Figure 6 Slide11:  TEMPORARY CHANGES IN MONETARY AND FISCAL POLICY How do changes in monetary and fiscal policies affect Y and E? The answer to this question depends on whether the change is temporary or permanent. In our analysis we assume that P is fixed in the short run and R* and P* are not affected by domestic events and policies. The basic difference between temporary and permanent changes is that temporary changes in policy do not affect the expected E but permanent changes do. Slide12:  Monetary Policy A temporary increase in M shifts the AA curve up but does not affect the DD curve. Both E and Y increase in the short run. Figure 7 Fiscal Policy A temporary increase in G or a decrease in T shifts the DD curve right but does not affect the AA curve. While Y increases, E falls (i.e., the US\$ appreciates). Figure 8 Slide13:  Policies to Maintain Full Employment Temporary disturbances that lead to a recession or over-expansion can be offset by temporary monetary or fiscal policies. Suppose the economy is initially at full employment, but a temporary fall in world demand shifts the DD left causing a recession. In this case, either a temporary monetary or a fiscal expansion restores full employment. The two policies differ in their exchange rate effects. Figure 9 Slide14:  Suppose the economy is at full employment and is faced with a temporary increase in money demand. What happens to E and Y? Which policies can be used to restore full employment? Figure 10 Slide15:  INFLATION BIAS AND OTHER PROBLEMS OF POLICY FORMULATION 1. With rational expectations expansionary policies may cause an increase in prices with no change in output. 2. In practice it is hard to know whether the disturbance originates in the asset market or the goods market. 3. There is a bias towards using monetary policy even though the disturbance requires using fiscal policy. 4. Policy reversal may not be politically feasible. 5. The time lag between the time the disturbance occurs and the time the policy affects the economy is variable and long. Slide16:  PERMANENT SHIFTS IN MONETARY AND FISCAL POLICY A permanent policy shift affects the long run exchange rate. This affects the expected exchange rate. A Permanent Increase in the Money Supply A permanent increase in the money supply increases the expected exchange rate. Therefore, a permanent increase in M of the same magnitude as a temporary increase shifts the AA curve further to the right. Figure 11 Slide17:  Adjustment to A Permanent Increase in the Money Supply in the Long Run In the short run, starting from full employment, an increase in M increases output beyond the full employment level. In the long run the economy returns to its full employment level. How? Figure 12 Slide18:  A Permanent Fiscal Expansion If the economy is at full employment, a permanent increase in G or a decrease in T has no effect on output neither in the short run, nor in the long run. For example, a permanent increase in G shifts DD right. It also reduces the expected exchange rate, which shifts AA left. Therefore, E appreciates but output remains at full employment level. Figure 13

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