Chapter 11: Keynesian Approach to Output Market Equilibrium Flashcards
Objective of chapter
want to explain how a country’s output is related to exchange rate in the short run.
What is consumption expenditure determined by
1) disposable income Y -T
2) real interest rate and wealth
- real interest rate affects consumption because it affects investment demand I
What is a country desired consumption level?
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.
What are some determinants of the current account CA= EX - IM
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
What happens when real exchange rate and disposable income move and what are their effects on CA?
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
Why is it important to assume MLC holds in this case?
Effect of real depreciation on CA is ambiguous/ Only if import demand and export demand elastic, then depreciation helps to improve current account
What is the marshall lerner condition
ex + em > 1
ex and em refer to the elasticity of demand for exports and imports w.r.t real exchange rate
Recap: What is the J curve
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
What is the impact of real exchange rate increase and disposable income increase on aggregate demand
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
What is the short run equilibrium for output market
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)
What happens to short run equilibrium (DD schedule when there is a currency depreciation
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
What happens to equilibrium when there is a rise in the real exchange rate on output
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.
How do you derive the DD schedule
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
What are factors that shift the DD schedule
- 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 - Change in T
- lower tax increase consumption expenditure, increase AD and output in equilibrium at every exchange rate –> DD curve shifts right - 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 - 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
Recap: Interest parity determines equilibrium in foreign exchange market equilibrium
R=R* + (E(e) -E)/E
What is the money market equilibrium
Money market equilibrium occurs when the quanitity of real monetary assets supplied matches quantity of real monetary assets demanded
Recap: What happens when there is a rise in income from production on short run equilibrium in assets market
When there is an increase in income –> money demand increases –> Real return on asset increases (domestic interest rate increase), domestic currency appreciate
What is the AA schedule
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
What are factors that shift the AA curve
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
What does it mean for a short run equilibrium
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
How do markets adjust to equilibrium?
Assume current economy where neither market is in equilibrium
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
Recap: What is monetary policy and Fiscal Policy
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.
What does it mean for policies to be temporary?
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.
What are the effects of a temporary increase in money supply
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)
What are the effects of a temporary increase in fiscal expansion
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
How can resources be over-under employed. What are the consequences as such
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.
How to maintain full employment after temporary fall in world demand
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
How to maintain full employment after temporary increase in money demand
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
Problems with fiscal and monetary policies
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
What happens when policies now become permanent
Permanent policy changes are those that are assumed to modify people’s expectations about exchange rate in the long run.
Explain the short run effects of a permanent increase in money supply
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
What happens when there is a permanent change in fiscal policy
- 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
What is the XX curve
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
How do macropolicies affect CA
1) Increase in money supply
2) Temp increase in govt purchases
3) Permanent fiscal expansion
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
What is the keynesian multiplier in the model
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
