ECON303 Topic 3 - TOPIC 3 The MundellFleming model under f...

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TOPIC 3 The Mundell Fleming model under flexible exchange rates (AA DD model) & sticky prices 1
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troduction Introduction Long run models are useful when all prices of inputs and outputs have time to adjust. In the short run, some prices of inputs and outputs may not have time to adjust, due to labour contracts, costs of adjustment or imperfect information about market demand. 2
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eterminants of Aggregate Demand Determinants of Aggregate Demand 1. consumption expenditure – depends on: a. (+) disposable income, Y T b. possibly ( ) interest rate, R and (+) wealth C = C(Y T) 2. investment expenditure – depends on: a. possibly ( ) R b. possibly (+) Y I = I 0 (exogenous for now) 3. government purchases – exogenous G = G 0 4. net expenditure by foreigners : the current account depends on: a. (+) real exchange rate EP*/P (Marshall Lerner condition) b. ( ) Y T c. possibly (+) Y* T* CA = CA(EP*/P, Y T) (/ , ) 3
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How Real Exchange Rate Changes Affect the Current Account The current account measures the value of exports relative to the value of imports: CA = EX–IM (+nfi) 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. Marshall Lerner condition : for short run equilibrium (approx 1 year) volume effects dominate value effect Therefore, we assume that a real depreciation leads to an increase in the , p current account 4
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Determinants of Aggregate Demand (cont.) Aggregate demand is therefore expressed as: D = C ( Y T ) + I + G + CA ( EP */ P , Y T ) Investment and government purchases, both Current account as a function of the real exchange rate and Consumption as a function of disposable r more simply: exogenous disposable income. income Or more simply: D = D ( EP */ P , Y T , I , G ) 5
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Determinants of Aggregate Demand (cont.) Determinants of aggregate demand include: Real exchange rate : an increase in the real exchange rate increases the current account, and therefore increases aggregate demand for domestic products. isposable income an increase in the disposable income increases Disposable income : an increase in the disposable income increases consumption, but decreases the current account. Since total consumption expenditure is usually greater than expenditure on foreign products, the first effect dominates the second effect. As income increases for a given level of taxes, aggregate consumption and aggregate demand increases by less than income. 6
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Short Run Equilibrium for Aggregate Demand and Output Equilibrium is achieved when the value of output Y (and income from production) equals aggregate ( p) q gg g demand D.
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This note was uploaded on 05/26/2010 for the course ECON 1160 taught by Professor Byrke during the Spring '10 term at Macomb Community College.

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ECON303 Topic 3 - TOPIC 3 The MundellFleming model under f...

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