University:
California State University, Northridge
Course:
ECON 405 | International Trade
Academic year:

2024
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313

Pages:

14
Author:

Gavaudanvpb

Topic 10 Output and the Exchange Rate in the Short Run Part 4 Fig. 16: LR Adjustment to a Permanent Increase in the Money Supply After a permanent money supply increase, a steadily increasing price level shifts the DD and AA schedules inward until the new LR equilibrium is reached at point 3. A permanent increase in the money supply eventually causes all money prices to rise in proportion (including E, Ee, and P). However, it has no lasting effects on output, relative prices, or interest rates. Effects of Permanent Changes in Fiscal Policy • A permanent increase in government purchases or reduction in taxes ♦ increases aggregate demand ♦ makes people expect the domestic currency will appreciate in the SR due to increased aggregate demand, thereby reducing the expected rate of return on foreign currency deposits and making the domestic currency appreciate. • The increase in G raises aggregate demand for domestic products, but the subsequent currency appreciation lowers aggregate demand for domestic products (by making exports more expensive). Effects of Permanent Changes in Fiscal Policy (cont.) • If the rise in G is permanent, then the fall in net exports exactly offsets the increase in G, so that output remains at its full-employment level. • We say that an increase in government purchases completely crowds out net exports, due to the effect of the appreciated domestic currency. Fig. 17: Effects of a Permanent Fiscal Expansion A permanent increase in G causes a LR appreciation of the currency. The resulting fall in Ee shifts AA down. Point 2 is the SR equilibrium where the currency has appreciated from E1 to E2 and output remains unchanged at Yf. By contrast, a comparable temporary increase in G would leave the economy at point 3 (with higher output). A temporary change in G does not alter Ee and therefore does not shift AA. Note that prices (P) do not change because MS and L(R,Y) do not change. Macroeconomic Policies and the Current Account • To determine the effect of monetary and fiscal policies on the current account, ♦ derive the XX curve to represent the combinations of output and exchange rates at which the current account is at its desired level. • As income from production increases, imports increase and the current account decreases when other factors remain constant. • To keep the current account at its desired level, the domestic currency must depreciate as income from production increases: the XX curve should slope upward. Fig. 18: How Macroeconomic Policies Affect the CA Along XX, the CA is constant and equal to a desired level, X. Temporary monetary expansion shifts AA out and moves the economy to point 2 and thus raises the CA balance. Temporary fiscal expansion shifts DD out and moves the economy to point 3. Permanent fiscal expansion shifts DD out and AA in and moves the economy to point 4. The CA balance falls with any fiscal expansion. Macroeconomic Policies and the Current Account (cont.) • The XX curve slopes upward but is flatter than the DD curve. ♦ DD represents equilibrium values of aggregate demand and domestic output. ♦ As domestic income and production increase, domestic saving increases, which means that aggregate demand (willingness to spend) by domestic residents does not rise as rapidly as income and production. Macroeconomic Policies and the Current Account (cont.) ♦ As domestic income and production increase, the domestic currency must depreciate to entice foreigners to increase their demand for domestic products in order to keep the current account (only one component of aggregate demand) at its desired level—on the XX curve. ♦ As domestic income and production increase, the domestic currency must depreciate more rapidly to entice foreigners to increase their demand for domestic products in order to keep aggregate demand (by domestic residents and foreigners) equal to production—on the DD curve. Macroeconomic Policies and the Current Account (cont.) • Policies affect the current account through their influence on the value of the domestic currency. ♦ An increase in the quantity of money supplied depreciates the domestic currency and often increases the current account in the SR. ♦ An increase in government purchases or decrease in taxes appreciates the domestic currency and often decreases the current account in the SR. Value Effect, Volume Effect, and the J-curve • If the volume of imports and exports is fixed in the SR, a depreciation of the domestic currency ♦ will not affect the volume of imports or exports, ♦ but will increase the value/price of imports in domestic currency and decrease the current account: CA ≈ EX – IM. ♦ The value of exports in domestic currency does not change. • The current account could immediately decrease after a currency depreciation, then increase gradually as the volume effect begins to dominate the value effect. Fig. 19: The J-Curve volume effect dominates value effect Immediate effect of real depreciation on the CA J-curve: value effect dominates volume effect Six months to one year Value Effect, Volume Effect, and the Jcurve (cont.) • Pass through from the exchange rate to import prices measures the percentage by which import prices change when the value of the domestic currency changes by 1%. • In the DD-AA model, the pass through rate is 100%: import prices in domestic currency exactly match a depreciation of the domestic currency. • In reality, pass through may be less than 100% due to price discrimination in different countries. ♦ E.g., foreign firms selling in the U.S. may not want to raise their U.S. prices by 10% when the dollar depreciates by 10% because they do not want to lose market share. Value Effect, Volume Effect, and the Jcurve (cont.) • If prices of foreign products in domestic currency do not change much because of a pass through rate less than 100%, then the ♦ value of imports will not rise much after a domestic currency depreciation, and the current account will not fall much, making the J-curve effect smaller. ♦ volume of imports and exports will not adjust much over time since domestic currency prices do not change much. • Pass through of less than 100% dampens the effect of depreciation or appreciation on the current account.

Output and the Exchange Rate in the Short Run, Part 4

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