1 Chapter 6 Output and the Exchange Rate in the Short Run 6-2 Aim of Chapter? • model that explains the short-run behaviour of all important macroeconomic variables in an open economy = simultaneous equilibrium on asset and output markets => new in this Ch: SR model of output market => combination with our asset markets models • use this model - the DD-AA model - to study how government macroeconomic policies can affect output and the exchange rate ? from short-run to long-run, and back again ?
2 6-3 My grand scheme of ER models © SHORT RUN LONG RUN (Ch 3) <fxm> R US = R EU + (E e - E)/ E R US , R EU exo E e exo (Ch 4) <mm> M s /P = L(R, Y) Y, P exo (Ch 5) <monetary approach> E USD/EUR = P US / P EU <asset approach> <general model> E USD/EUR = q USD/EUR * P US / P EU (Ch 6) <output> Y = D = C + I + G + CA Summary = DD-AA 6-4 What Determines a Country ’ s Output Level? (p. 173) • in the long run • economy is at full employment (why?) • domestic output depends only on available supplies of factors of production • in the short run • productive factors may be over/under-employed (why?) • (shifts in) aggregate demand important • conclusion • determinants of output --> determinants of aggregate demand
3 6-5 What Determines Aggregate Demand? ( p. 174) • definition of aggregate demand = the amount of a country's goods and services demanded by households and firms throughout the world 6-6 What Determines Aggregate Demand? • national income identity (from Ch. 2): • closed economy Y = C + I + G • open economy Y = C + I + G + EX – IM (2-1) Y = C + I + G + CA • hence: aggregate demand is the sum of • consumption demand (C) <-- • investment demand (I) assumed given • government demand (G) assumed given • net export demand (CA) <--
4 6-7 Determinants of C ( p. 174) • determinants of consumption demand only disposable income Y d (= Y - T) (abstraction is made of real wealth, real interest rate, ...) + C = C (Y d ) 6-8 Determinants of CA ( p. 175-177) • determinants of current account CA = CA (q, Y d ) where E = nominal exchange rate CA = CA (E*P * /P, Y d ) P* = foreign price level P = domestic price level • note: EX and IM are measured in terms of domestic output !! cf. Y = C + I + G + EX - IM CA = EX - IM IM = EX * * (home basket/foreign basket) = EX * * (real exchange rate) = EX * * (EP * /P)
5 6-9 Determinants of CA • effect of increase in real exchange rate: q ↑ ? (= real depr.) • impact on EX? home products cheaper relative to foreign => EX ↑ • impact on IM? foreign products more expensive relative to domestic EX * * (real exchange rate)= IM ↓ ↑ ? domestic consumers each foreign product buy fewer units of is more expensive foreign products ( volume effect) ( value effect) • overall impact on CA? for now: assume that volume effect > value affect => IM ↓ improvement of current account 6-10 Determinants of CA • effect of increase in disposable income: Y d ↑ ? • increases spending on all goods => IM ↑ EX = (why? ) • worsening of the current account
6 6-11 Table 6-1: Factors Determining the Current Account 6-12 6.2. The Equation of Aggregate Demand (p. 177) • equation: D = C + I + G + CA D = C(Y d ) + I + G + CA(EP*/P, Y d ) D = C(Y-T) + I + G + CA(EP*/P, Y-T) D = D(EP*/P, Y-T, I, G) T, I, G given • effect of increase in real exchange rate? (real
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