2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-1,Chapter 16 OUTPUT AND THE EXCHANGE RATE IN THE SHORT RUN,Chapter 16 combines the theory of exchange rate determination with the theory of output determination in the short run.,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-2,Introduction,The model developed in this chapter takes into account the fact that change exchange rates, interest rates and price levels may also affect output (i.e., output is endogenously determined). Therefore, it gives us a more complete picture of how macroeconomic changes affect an open economy.,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-3,Overview,The goods market and aggregate demand Goods market equilibrium: DD curve Asset market equilibrium: AA curve Overall equilibrium Policy analysis with the model,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-4,Determinants of Aggregate Demand in an Open Economy,Aggregate demand The amount of a countrys goods and services demanded by households and firms throughout the world. D = C + I + G + CA For simplicity, we assume that I and G are exogenously determined.,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-5,Determinants of Consumption Demand Consumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level. C = C(Yd), where Yd= Y T (Yd= disposable income), The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-6,Determinants of the Current Account The CA balance is viewed as the demand for a countrys exports (EX) less that countrys own demand for imports (IM). The CA balance is determined by two main factors: The domestic currencys real exchange rate against foreign currency (q = EP*/P) Domestic disposable income (Yd) CA=CA(q = EP*/P, Yd =Y T),Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-7,How do changes in Disposable Income affect the Current Account? An increase in disposable income increases domestic consumers spending on all goods, including imports from abroad. That will lead to a decrease in the current account.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-8,How do changes in the Real Exchange Rate affect the Current Account? It affects both exports and imports. An increase in q raises EX and improves the domestic countrys CA. Each unit of domestic output now purchases fewer units of foreign output, therefore, the foreign country will demand more exports.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-9,However, an increase in q can raise or lower the value of imports measured in terms of domestic output. Therefore, the final effect of an increase in q on the current account is AMBIGUOUS.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-10,There are two effects of a real exchange rate: Volume effect The effect of consumer spending shifts on export and import quantities Value effect It changes the domestic output worth of a given volume of foreign imports.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-11,Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant. We assume that the volume effect of a real exchange rate change always outweighs the value effect.,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-12,Assuming for now that the volume effect always outweighs the value effect, we have that: “other things equal, a real depreciation of the currency improves the CA and a real appreciation of the currency worsens the CA”. As we will see later, this assumption requires that import and export demands be relatively elastic with respect to the real exchange rate (Marshall-Lerner Condition).,Determinants of Aggregate Demand in an Open Economy,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-13,Determinants of Aggregate Demand in an Open Economy,Table 16-1: Factors Determining the Current Account,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-14,The four components of aggregate demand are combined to get the total aggregate demand: D = C(Y T) + I + G + CA(EP*/P, Y T) This equation shows that aggregate demand for home output can be written as: D = D(EP*/P, Y T, I, G),The Equation of Aggregate Demand,2019/4/17,Lectured by Dr Jin Hongfei,Slide 16-15,The Real Exchange Rate and Aggregate Demand An increase in q raises CA and D. It makes domestic goods and services cheaper relative to foreign goods and services. It shifts both domestic and foreign spending from foreign goods to domestic goods. Other things equal, a real depreciation of the home currency raises aggregate demand for home output. Similarly, a real appr