6-62 RECAP: fiscal and monetary policy • DD ∩ AA = a short-run equilibrium for the economy as a whole = short-run because output prices are fixed! • use DD-AA model to study how government macroeconomic policies can affect output and the exchange rate • two types of policies: monetary & fiscal • first temporary policy shifts (then permanent) = no impact on long-run E e temporary monetary expansion (Fig. 6-10) => AA shifts up => E ↑ , Y ↑ (DD not affected) temporary fiscal expansion (Fig. 6-11) => DD shifts right => E ↓ , Y ↑ (AA not affected)
32 6-63 6.9. Permanent policy shifts (p. 194) = impact on long-run E => on E e => different effects, even in short run • permanent monetary expansion (Fig. 6-14, 6-15) • short run • long run • permanent fiscal expansion (Fig. 6-16) ! graphically … ! We start in full-employment ! 6-64 Permanent policy shifts: monetary expansion • short-run effects (Fig. 6-14) => AA shifts up => E ↑ , Y ↑ ! by more than in case of temporary increase !
33 6-65 DD 1 Output, Y Exchange Rate, E AA 2 Y 2 E 2 2 AA 1 1 E 1 Y f 3 Fig. 6-14: Short-Run Effects of a Permanent Increase in the Money Supply A permanent increase in the money supply decreases interest rates and causes people to expect a future depreciation, leading to a large actual depreciation 6-66 Permanent policy shifts: monetary expansion (2) • short-run effects ( continued ): why is impact greater? • our LR-model shows that in the long-run increase in M s must eventually lead to a proportional rise in E => E e rises. • Fig. 3-12 shows that this leads to an extra increase in E in the short run (overshooting!) IP: R = R * + (E e - E)/E (3-2) R comes down + E e increases => E must rise sharper (to lower RHS) • this rise shifts AA up even more (in the short-run) [alternative interpretation of Figure 6-14 (as two-step)]
34 6-67 DD 2 Output, Y Exchange Rate, E DD 1 AA 2 AA 3 Y f 3 E 3 AA 1 Y 2 E 2 2 E 1 1 Fig. 6-15: Long-Run Adjustment to a Permanent Increase in the Money Supply 6-68 In the long run, output returns to its normal level, and we also see overshooting: E 1 < E 3 < E 2 Higher prices make domestic products more expensive relative to foreign goods: reduction in aggregate demand Higher prices reduce real money supply, Increasing interest rates, leading to a domestic currency appreciation Fig. 6-15: Long-Run Adjustment to a Permanent Increase in the Money Supply
35 6-69 Permanent monetary expansion • what if we do not start in FE? • long-run neutrality of money 6-70 Permanent policy shifts: fiscal expansion (p . ) • short-run effects (Fig. 6-16) • as before : impact of increased government spending on output markets => DD shifts right => E ↓ , Y ↑ [cf. temporary shock: (money market) raises transactions demand for real money holdings; prices are fixed => R upward => (foreign exchange market) IP: no impact on E e => E must come down immediately to increase expected appreciation of foreign currency] • extra impact : permanent ↑ relative demand for home products => E e ↓ (recall Ch. 5 on real exchange rates) => AA shifts down => E ↓ , Y ↓ • overall impact: appreciation reduces impact of policy!
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