Chapter 17 - Output and the Exchange Rate in the Short Run Flashcards
How is aggregate output determined?
Aggregate output is determined through the intersection of aggregate demand and aggregate supply.
What are the determinants of aggregate demand? (4)
Aggregate demand is the aggregate amount of goods and services that individuals and institutions are willing to buy: 1) Consumption expenditure. 2) Investment expenditure. 3) Government purchases. 4) Net expenditure by foreigners: the current account.
What is the current account? What is the effect of a rise in the real exchange rate? (3)
The current account measures the value of exports relative to the value of imports: CA = EX - IM. When the real exchange rate EP*/P rises, the prices of foreign products rise relative to the prices of domestic products. 1) The volume of exports that are bought by foreigners rises. 2) The volume of imports that are bought by domestic residents falls. 3) The value of imports in terms of domestic products rises: the value/price of imports rises, since foreign products are more valuable/expensive.
Explain the volume and value effect of a change in real interest rate on the current account. (4)
1) If the volumes of imports and exports do not change much, the value effect may dominate the volume effect when the real exchange rate changes. 2) For example, contract obligations to buy fixed amounts of products may cause the volume effect to be small. 3) However, evidence indicates that for most countries the volume effect dominates the value effect after one year or less. 4) Let’s assume for now that a real depreciation leads to an increase in the current account: the volume effect dominates the value effect.
Which determinants of aggregate demand are exogenous? (3)
For simplicity, we assume that exogenous political factors determine government purchases G and the level of taxes T. For simplicity, we currently assume that investment expenditure I is determined by exogenous business decisions.
How would a depreciation of the exchange rate affect the short-run equilibrium of aggregate demand and output? (3)
1) With fixed domestic and foreign levels of average prices, a depreciation of the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services. 2) A domestic currency depreciation increases aggregate demand for domestic products. 3) In equilibrium, production will increase to match the higher aggregate demand.
Explain the DD schedule. (2)
1) Shows the combinations of output and the exchange rate at which the output market is in short-run equilibrium (such that aggregate demand = aggregate output). 2) Slopes upward because a depreciation/rise in the exchange rate causes aggregate demand and aggregate output to rise.
What factors bring about a shift in the DD curve? (5)
1) Changes in T: lower taxes generally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right. 2) Changes in I: higher investment expenditure is represented by shifting the DD curve right. 3) Changes in P relative to P*: lower domestic prices relative to foreign prices are represented by shifting the DD curve right. 4) Changes in C: willingness to consume more and save less is represented by shifting the DD curve right. 5) Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve right.
What factors would bring about a shift in the AA curve?
1) Changes in Ms: an increase in the money supply reduces the interest rates in the short run, causing the domestic currency to depreciate (a rise in E) for every Y: the AA curve shifts up (right). 2) Changes in P: An increase in the level of average domestic prices decreases the supply of real monetary assets, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA curve shifts down (left). 3) Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of real money assets and more non-monetary assets, interest rates in non monetary assets would fall, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up (right).
What are the characteristics of a short-run equilibrium between AA and DD? (3)
A short-run equilibrium means a nominal exchange rate and level of output such that. 1) Equilibrium in the output markets holds: aggregate demand equals aggregate output. 2) Equilibrium in the foreign exchange markets holds: interest parity holds. 3) Equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded.
What is monetary policy? What is monetary policy assumed to affect first?
Monetary policy: policy in which the central bank influences the supply of monetary assets. Monetary policy is assumed to affect asset markets first.
What is fiscal policy? What is fiscal policy assumed to affect first?
Fiscal policy: policy in which governments (fiscal authorities) influence the amount of government purchases and taxes. Fiscal policy is assumed to affect aggregate demand and output first.
What can be said about temporary policy changes and expectations about exchange rates in the long run?
Temporary policy changes are expected to be reversed in the near future and thus do not affect expectations about exchange rates in the long run.
How can aggregate demand be expressed?
Show graphically, aggregate demand as a function of output.
How can short-run equilibrium between output and aggregate demand be expressed?
Show graphically, the determination of output in the short run.
Show graphically, the effect on output of a currency depreciation with fixed output prices.
Show graphically, the DD schedule.
Show graphically, the effect of an increase in governement expenditure on the short run equilibrium of aggregate demand and output and the DD curve.
Explain short-run equilibrium in asset markets.
What two markets are important?
Show graphically, the effect of an increase in output on the asset market equilibrium.
Show graphically, the AA schedule.
Show graphically, the intersection of the AA curve and DD curve.
Show graphically, the effect of a temporary increase in money supply on the intersection between the AA and DD curves.
Show graphically, the effects of a temporary fiscal expansion on the intersection between the AA and DD curves.
Show graphically, how full employment is maintained after a temporary fall in world demand for domestic products.
A temporary fall in world demand shifts DD to the left, a reduction in output and causing currency to depreciate.
Temporary fiscal expansion can restore full employment by shifting the DD curve back to its original position. Temporray monetary expansion can restore full employment by shifting the AA curve.
Fiscal policy would restore the exchange rate back to its original position. Whereas, monetary policy would shift the exchange rate to E3.
