Lecture 8 - X =) E RP /S (K U $ M Lecture 8 Economic Policy...

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Lecture 8 Economic Policy Under Flexible Exchange Rates The Consumption Function: () ( ) d CC YT C Y =− = The Current Account Function : £$ (,) d CA CA R Y = where: £$ £$ (/ ) US UK RE P P is the real exchange rate; E £$ is the nominal exchange rate; P UK is the foreign (US) price level; and P UK is the domestic price level. Imports and Exports : £$ £$ US US P CA X E M X R M P =− × Note that imports from the US are expressed in terms of domestic output The Real Exchange Rate and the Current Account The UK price level attaches a high weight to domestically produced commodities and a smaller weight to foreign-produced (US) goods. So if R £$ rises, it means that the price of imports relative to home produced commodities goes up: £$ £$ ) US UK P P Domestic consumers substitute out of imports into home-produced commodities: . This is the volume effect on the CA. If the demand elasticity for imports is high, the value of imports also will fall; if the demand elasticity for imports is low, the value of imports will rise. The effect of a real depreciation on the value of UK imports is ambiguous : it depends on the elasticity of demand for imports. We assume that it improves the CA: the value of imports falls, following a real exchange rate depreciation. But foreign (US) consumers will find that their real exchange rate ( ) has appreciated: UK products are now relatively cheaper in the US: The value of exports falls, following a real exchange rate depreciation. For both reasons, a real exchange rate depreciation leads to an improvement in the current balance. Disposable Income and the Current Account An increase in disposable income causes the volume of imports to rise ( ) and CA to worsen. Suppose and P UK =£100 and P US =$150: then . This means that one would need 20% more £ to buy the US basket than one would need to buy the UK basket. So a real depreciation occurs when the value of R £$ rises. This means that the purchasing power of £ in the USA declines .
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Aggregate Demand and Product Market Equilibrium Aggregate Demand is the amount of a country’s goods and services demanded throughout the world. The aggregate demand equation is: (1) where: Y is National Income; T is taxes; I is Investment; and G is government expenditure. A real depreciation increases aggregate demand: An increase in national income, Y, increases Y d : this raises C but worsens CA through increasing imports: net effect is to increase D In Figure 8.1, a depreciation of the exchange rate, E £$ , raises aggregate demand and, hence, national income. The DD schedule (Figure 8.2) shows the E£$-Y combinations that result in equilibrium in the product market.
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Lecture 8 - X =) E RP /S (K U $ M Lecture 8 Economic Policy...

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