365 Topic6 - ECO365 Topic 6 Output and Exchange Rate in the...

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Output and Exchange Rate in the Short Run ECO365 Topic 6
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Overview Until now, our study of exchange rates has been largely disconnected from the rest of the economy. In particular, we took the economy’s level of output as given. In this chapter, we shall try to build a complete model, in which exchange rates and output are determined simultaneously. 2 ECO365
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Overview 1. Demand in the Short Run 2. Goods market equilibrium 3. IS curve 4. LM curve 5. The IS-LM-FX model 6. Macroeconomic policies 7. Applications 3 ECO365
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Demand in the Short Run For the economy to be in a short run equilibrium, three markets must be in equilibrium : 1. Money market 2. Foreign exchange market 3. Goods market 4 ECO365
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Demand in the Short Run Assumptions 2 countries: home & “rest of the world” (ROW) Home and foreign price levels are fixed. Prices are sticky. Government spending G and taxes T are fixed. ROW goods market and money market conditions are fixed and taken as given. GDP is taken to be the equivalent to GNDI. NFIA = NUT = 0 => TB = CA. 5 ECO365
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Demand in the Short Run Demand has the following components : Consumption Investment Government expenditure Trade balance 6 ECO365
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Demand in the Short Run Consumption C = C(Y-T) Keynesian consumption function. Y-T is disposable income. Slope of the consumption function is the marginal propensity to consume (MPC), 0 < MPC < 1. 7 ECO365
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Demand in the Short Run Consumption 8 ECO365
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Demand in the Short Run Investment Firms engage in investment projects only if real return on the project > cost of borrowing. Firm’s borrowing cost is expected real interest rate: r e = i - π e Assume that π e = 0 => r e = i. As i rises, r e rises, so the volume of projects that are profitable declines and investment declines. 9 ECO365
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Demand in the Short Run Investment 10 ECO365
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Demand in the Short Run Government expenditure G is government expenditure on goods and services. G does not include government transfer programs. Fiscal policy : Choose G and T. Government’s budget is G – T. If G- T = 0, government’s budget is balanced. If G-T > 0, government has a budget deficit. If G-T < 0, government has a budget surplus. 11 ECO365
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Demand in the Short Run Trade Balance The real exchange rate, q, is defined as : Changes in q lead to expenditure switching between home and foreign goods and services. q => foreign goods relatively more expensive => home exports and home imports, TB 12 ECO365
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Demand in the Short Run Trade Balance Changes in home income, Y T. (Y T) => home country increases spending => home country imports rise, TB Changes in foreign income, Y* T*. (Y* T*) => foreign country increases spending => home country exports rise, TB 13 ECO365
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Demand in the Short Run Trade Balance Combining the three factors above (expenditure switching, home disposable income and foreign disposable income), we can write the Trade Balance as: 14 ECO365
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Demand in the Short Run Trade Balance The relation between trade balance, q and Y.
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This note was uploaded on 03/23/2012 for the course ECO 365 taught by Professor Jordimondria during the Spring '08 term at University of Toronto- Toronto.

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365 Topic6 - ECO365 Topic 6 Output and Exchange Rate in the...

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