Chapter 11: Keynesian Approach to Output Market Equilibrium

Question 1

Objective of chapter

Answer 1

want to explain how a country’s output is related to exchange rate in the short run.

Question 2

What is consumption expenditure determined by

Answer 2

1) disposable income Y -T

2) real interest rate and wealth
- real interest rate affects consumption because it affects investment demand I

Question 3

What is a country desired consumption level?

Answer 3

C=C(Yd)

where Yd = Y-T

Disposable income and consumption are positively related, but Y d ↑ is followed by less
than proportional C ↑. We will return to this later.

Question 4

What are some determinants of the current account CA= EX - IM

Answer 4

1) The real exchange rate:
prices of foreign products relative to prices of domestic products –> EP*/P

2) Disposable income:
More disposable income means more expenditure on imports

Question 5

What happens when real exchange rate and disposable income move and what are their effects on CA?

Answer 5

real exchange rate increase –> CA increase
real exchange rate decrease –> CA decrease

dispoable income increase –> CA Decrease (due to rise in imports)
disposable income decrease –> CA increase

Question 6

Why is it important to assume MLC holds in this case?

Answer 6

Effect of real depreciation on CA is ambiguous/ Only if import demand and export demand elastic, then depreciation helps to improve current account

Question 7

What is the marshall lerner condition

Answer 7

ex + em > 1

ex and em refer to the elasticity of demand for exports and imports w.r.t real exchange rate

Question 8

Recap: What is the J curve

Answer 8

When a real depreciation occurs –> current account starts to worsen immediately, then stand to improve

Export and import orders are often set months in advance. Therefore, there can be no or little immediate adjustment on traded quantity. Instead, the value of the already decided upon imports increases in terms of domestic goods, and exports measured in domestic output remains the same.

(value of imports increase while export remains same) –> lead to fall in CA

Question 9

What is the impact of real exchange rate increase and disposable income increase on aggregate demand

Answer 9

real exchange rate increase –> CA increase –> AD increase

Disposable income increase–> CA decrease (since more imports) but consumption also increase

• since consumption expenditure domestically greater than expenditure on foreign products, first effect dominates second effect
• as income increases for a given level of taxes, aggregate consumption expenditure and AD increase less than income

Question 10

What is the short run equilibrium for output market

Answer 10

Equilibrium is achieved when the value of output and income from production (output) Y equals the value of aggregate demand D (as a function of real exchange rate, disposable income, investment expenditure and government purchases). The equilibrium condition for the output market is:

Y=C(Yd)+I+G+CA(EP*/P,Yd)

Question 11

What happens to short run equilibrium (DD schedule when there is a currency depreciation

Answer 11

A rise in the nominal exchange rate E (currency depreciation) makes foreign goods and services more expensive relative to the domestic one

The domestic currency depreciation increases aggregate demand of domestic products.

As such in equilibrium, production will increase to match AD

Question 12

What happens to equilibrium when there is a rise in the real exchange rate on output

Answer 12

Any rise (fall) in the real exchange rate EP∗/P will cause an upward (downward) shift in the aggregate demand function and an expansion (contraction) of output, all else equal.

Question 13

How do you derive the DD schedule

Answer 13

DD schedule shows all the combinations of output and the exchange rate at which the output market is in short run equilibrium (given that there is a fix in P and P* in the short run)

Aggregate Demand = Aggregate Output at every point of the DD schedule

The DD schedule slopes upward because a rise in the exchange rate (domestic currency depreciation) causes aggregate demand and aggregate output to rise.

Assumed P and P* are fixed in the short run

Question 14

What are factors that shift the DD schedule

Answer 14

1. Change in G
   - more G cause higher AD and output
   -thus for a given exchange rate , to allow increase in output, DD curve shifts right
2. Change in T
   - lower tax increase consumption expenditure, increase AD and output in equilibrium at every exchange rate –> DD curve shifts right
3. Changes in P relative to P*
   -lower domestic price relative to foreign price cause real exchange rate to increase–> exports more valuable, DD curve shift right
4. Changes in C:
   willingness to consumer more and save less cause DD curve to shift right

Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods (increase C + increase in CA)

Conclusion: any distrubance that increases AD for domestic output shift DD curve to right

Question 15

Recap: Interest parity determines equilibrium in foreign exchange market equilibrium

Answer 15

R=R* + (E(e) -E)/E

Question 16

What is the money market equilibrium

Answer 16

Money market equilibrium occurs when the quanitity of real monetary assets supplied matches quantity of real monetary assets demanded

Question 17

Recap: What happens when there is a rise in income from production on short run equilibrium in assets market

Answer 17

When there is an increase in income –> money demand increases –> Real return on asset increases (domestic interest rate increase), domestic currency appreciate

Question 18

What is the AA schedule

Answer 18

The AA schedule represents all the combinations of output Y and exchange rate E that ensures equilibrium in assets markets, i.e. foreign exchange market equilibrium and money market equilibrium.

Can think of it as how output causes exchange rate movement and need to ensure equilibrium

Question 19

What are factors that shift the AA curve

Answer 19

Changes in Money supply:
- increase in money supply reduce interest rate in short run, cause depreciation of currency, AA curve shift up

Changes in P:
- an increase the average domestic price (P) decreases supply of real monetary assets –> causes interest rate R to increase, cause domestic currency to appreciate –> AA curve shift down

Change in Expected exchange rate
- if market expects domestic currency to depreciate (Ee) increases, foreign currency deposits become more attractive, cause AA curve to shift up

Changes in R*
- increase in foreign interest rate makes foreign currency deposits more attractive–. lead to depreciation of domestic currency

Changes in demand of real monetary assets
- willing to hold lower amount of real money assets –> fall in money demand–> interest rate decreases–> currency depreciate –> AA curve shift up

conclusion : AA curve look at whether E increase or decrease. E Increase, AA curve move up, if E decrease, AA curve move down

Question 20

What does it mean for a short run equilibrium

Answer 20

1) equilibrium in output market holds
- aggregate demand = aggregate output

2) equilibrium in foreign exchange market
- interest parity holds

3) equilibrium in money market holds
- quantity of real monetary assets supplied = monetary asset damanded

Short run equilibrium occurs at the intersection of the DD and AA curves: output markets are in equilibrium on the DD curve, market are in equiibrium on the AA curve

Note: in the short run equilibrium, domestic output prices are temporary fixed

Question 21

How do markets adjust to equilibrium?

Assume current economy where neither market is in equilibrium

Answer 21

Considerations:

1) Rate of which E is expected to fall is high relative to rate that maintain interest parity

2) High expected future appreciation of domestic currency means that will be a likely excess demand for domestic currency

3) Cheap E makes domestic goodds cheap for foreigners–> excess demand for domestic output

Process:

1) excess demand for domestic currency causes fall of E to E3 such that return on foreign and domestic assets are equalized (ensure interest rate parity) achieved, E move to point 3

2) At point 3, excess demand for domestic output above DD curve, firm increases output, economy move along AA curve until aggregate demand = aggregate supply

3) moving along AA curve, rising output leads to increased money demand, rising interest rate, cause it to move back to DD schedule

Question 22

Recap: What is monetary policy and Fiscal Policy

Answer 22

Monetary policy: policy in which the central bank influences the supply of monetary assets (Ms).
􏰀 Monetary policy is assumed to affect asset markets first.

Fiscal policy: policy in which governments (fiscal authorities) influence the amount of government purchases (G) and taxes (T).
􏰀 Fiscal policy is assumed to affect aggregate demand and output first.

Question 23

What does it mean for policies to be temporary?

Answer 23

Temporary policy changes are expected to be reversed in the near future and thus do not affect expectations about exchange rate in the long run.

Question 24

What are the effects of a temporary increase in money supply

Answer 24

Increase in monetary assets supplied lowers domestic interest rate R in the short run cause domestic currency to depreciate

AA curve shift up

Given domestic products relative to foreign products are cheaper–> AD and output increase until new short run equilibrium (output increase)

Question 25

What are the effects of a temporary increase in fiscal expansion

Answer 25

Increase in G or decrease in T increases AD and output in the short run

DD curve shifts right

Higher output increase demand for monetary assets
(L(R,Y)) increase, thereby increasing domestic interest rate causing domestic currency to appreciate

Question 26

How can resources be over-under employed. What are the consequences as such

Answer 26

􏰀 When resources are not used effectively, resources are underemployed: high unemployment, few hours worked, idle equipment, lower than normal production of goods and services.

􏰀 When resources are not used sustainably, resources is over-employed: low unemployment, many overtime hours, over-utilized equipment, higher than normal production of goods and services.

Question 27

How to maintain full employment after temporary fall in world demand

Answer 27

When there is a fall in world demand, this shift DD to the left, cause output to fall, exchange rate goes up , currency depreciation

Through temporary fiscal expansion (increase G) can restore employment by shifting DD schedule back to original position and restore original exchange rate

Through temporary monetary expansion (increase money supply) shift AA curve to the right, lead to further depreciation tho

Question 28

How to maintain full employment after temporary increase in money demand

Answer 28

Since money demand, cause shift in AA curve to left (currency appreciate)

Through temp fiscal expansion, shift DD curve to right cause appreciation of currency

Through temp monetary expansion, , can restore output by shifting AA curve back to AA 1 and restore exchange rate E1

Question 29

Problems with fiscal and monetary policies

Answer 29

monetary and fiscal policies create price changes and inflation in order to prevent high output and employment

lead to potential inflationary bias**

Lag time on policies means that they take time to be implemented and to affect economy

Question 30

What happens when policies now become permanent

Answer 30

Permanent policy changes are those that are assumed to modify people’s expectations about exchange rate in the long run.

Question 31

Explain the short run effects of a permanent increase in money supply

Answer 31

permanent increase in quantity of monetary assets supplied lowers R in the short run and makes currency depreciate –> AA curve shift right

in the short run, domestic currency depreciate more than when expectations are held constant (AA curve move right more than expected)

As a result economy is now overheated since output past full employment

Question 32

What happens when there is a permanent change in fiscal policy

Answer 32

• permanent increase in G or reduce in T cause DD to shift right
• increase DD right
• makes people expect domestic currency to appreciate in short run due to increased AD, reduce expected rate of return on foreign deposits and make domestic currency appreciate –> shift AA curve to the left

In SR equilibrium, economy still at yf but has now appreciated

the exchange rate expectations crowds out expansionary effect of G increase as domestic goods become more expensive compared to foreign goods

Question 33

What is the XX curve

Answer 33

To determine the effects of monetary and fiscal policies on CA, use XX curve that represents combinations of output and exchange rate where current account is at desirable level X

Rmb CA(real exchange rate, disposable income)=X

Question 34

How do macropolicies affect CA

1) Increase in money supply
2) Temp increase in govt purchases
3) Permanent fiscal expansion

Answer 34

Increase in money supply – > cause rate of return to decrease –> cause depreciation of currency –> increase CA in short run

Temporary increase in government purchases (increase in G) (decrease in T) –> shift DD curve rightwards, cause an appreciation in domestic currency–> CA balance falls

Permanent increase in G and decrease in T also cause AA curve to shift left, since there is an expectation of a reduced rate of return on foreign currency deposits –> cause further appreciation –> Overall CA < X

Question 35

What is the keynesian multiplier in the model

Answer 35

In the Keynesian model, an increase in G (or another of the exogenous components of national income) leads to an infinite series of income increases (with a finite sum since in each round, some of the income increase is saved and some is spent on imported goods).

If increase in G leads to increase in interest rate and discourages spending on C and I, then the multiplier is small