I then ca ca ep p z y t z ex ep p z im ep p z y t z i

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I Then CA = CA ( EP * / P | {z } + , Y - T | {z } - ) = EX ( EP * / P | {z } + ) - IM ( EP * / P | {z } - , Y - T | {z } + ) I A real exchange rate depreciation increases the current account. I An increase in disposable income decreases the current account. 9/43
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Determinants of Aggregate Demand (cont.) I Determinants of government demand (and taxes): I taken as given I Determinants of investment demand: I taken as given for now I So, total aggregate demand is: D = C ( Y - T )+ I + G + CA ( EP * / P , Y - T ) = D ( Y - T , EP * / P , I , G ) 10/43
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Aggregate Demand and the Determination of Output in the Short Run I The output market is in equilibrium when real output Y equals aggregate demand for domestic output: Y = D ( EP * / P , Y - T , I , G ) = C ( Y - T )+ I + G + CA ( EP * / P , Y - T ) I This condition is an equilibrium condition (and not to be confused with the national income identity Y = C + I + G + CA !!) 11/43
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The Determination of Output in the Short Run 12/43
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The Determination of Output in the Short Run (cont.) I The unique output level at which D equals Y is Y 1 . I Off-equilibrium dynamics: I At output level Y 2 excess demand for domestic output ( D 2 > Y 2 ): I firms’ actual I is below planned I (firms are running down inventories) I firms increase production to meet excess demand I output expands until Y 1 (and I planned = I actual ) I At output level Y 3 excess supply of domestic output ( Y 3 > D 3 ): I firms’ actual I is above planned I (firms are accumulating inventories) I firms cut back production I output falls until Y 1 (and I planned = I actual ) 13/43
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Short-Run Model of Exchange Rates I The short-run model of exchange rates has now 3 equilibrium relationships and determines 3 endogenous variables ( E , R , and Y ): R = R * + E e - E E M s P = L ( R , Y ) Y = C ( Y - T )+ I + G + CA ( EP * / P , Y - T ) 14/43
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Short-Run Model of Exchange Rates (cont.) I Solution of the model: I We collapse the 3 relationships into 2, relating E and Y . I The first one gives the set of ( E , Y ) combinations for which the goods market is in equilibrium (DD curve). I The second one gives the set of ( E , Y ) combinations for which both the foreign exchange market and the money market are in equilibrium (AA curve). 15/43
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The Short-Run Model: DD curve I We want to solve for the set of ( E , Y ) combinations for which the goods market is in equilibrium. I Suppose the goods market is in equilibrium for ( E 1 , Y 1 ) . I Consider now a higher exchange rate E 2 > E 1 : foreign goods and services become more expensive relative to domestic ones (recall prices are sticky in the short run); aggregate demand is now higher for each level of output equilibrium output level increases from Y 1 to Y 2 16/43
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The Short-Run Model: DD curve (cont.) 17/43
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The Short-Run Model: DD curve (cont.) 18/43
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The Short-Run Model: DD curve (cont.) I Factors that shift the DD curve: 1. Changes in G : I for every E , higher G causes higher aggregate demand and output in equilibrium; I DD shifts right; 2. Changes in T : I higher T lowers disposable income and aggregate demand and causes equilibrium output to fall; I DD shifts left; 19/43
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The Short-Run Model: DD curve (cont.) 20/43
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The Short-Run Model: DD curve (cont.) 3. Changes in I : I same as G ; 4. Changes in P : I higher P
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