Aggregate Demand, Output, and the Current Account in the Short Run

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1 Fletcher School, Tufts University Aggregate Demand, Output, and the Current Account in the Short Run Prof. George Alogoskoufis

2 Aggregate Demand, Output Determination and the Exchange Rate We shall now focus on short run determination determination of output (and employment and the current account, and the effects of the exchange rate on the output market. We shall continue to assume that in the short-run the price level is predetermined as the adjustment of the prices of goods and services in very gradual. This assumption is the basis of the Keynesian approach to macroeconomics and aggregate fluctuations. As we have already seen in an open economy, aggregate demand for domestic output is not the same as aggregate domestic expenditure C+I+G, as part of domestic expenditure is directed towards imports, which are produced abroad, and part of the demand for domestic output comes from abroad, in the form of exports. 2

3 Aggregate Demand in an Open Economy Aggregate demand for domestic output D is equal to domestic expenditure on goods and services (consumption, investment, and government spending, which we shall now denote by Z, plus the trade balance (exports minus imports, which we shall denote by NX. Aggregate domestic expenditure is defined by, and refers to aggregate expenditure by domestic residents. Z=C+I+G Because part of the domestic expenditure is on imports M, imports must be substracted. In addition, part of the demand for domestic output comes from abroad, in the form of demand for exports X. Thus, exports must be added to the demand for domestic output. The difference of exports from imports defines the trade balance (or net exports, Thus, aggregate demand in an open economy is given by, NX=X-M D= Z+NX = C+I+G + X-M In order to analyze the determinants of aggregate demand, we must consider the determinants of imports and exports, in addition to the components of domestic expenditure, such as consumption, investment and government purchases, which we have already analyzed. 3

4 The Short Run Determinants of Exports: Foreign Income and the Real Exchange Rate Exports are the part of foreign demand that falls on domestic goods. We shall assume that they depend on two factors in the short run. First, they depend on foreign income: Higher foreign income means higher foreign demand for all goods, both foreign and domestic. So higher foreign income leads to higher domestic exports. Second, they also depend on the real exchange rate: The higher the price of domestic goods in terms of foreign goods, the lower the foreign demand for domestic goods. In other words, the higher the real exchange rate, the lower are exports. Therefore, the demand for exports function can be written as, X=X(Y*,Q (+, - where Y* is real foreign income and Q is the real exchange rate, defined as, Q=SP/P* where S is the nominal exchange rate (units of foreign currency per unit of domestic currency, P is the domestic price level and P* is the foreign price level (in foreign currency units. The export demand function is a behavioral equation which suggests that an increase in foreign income, Y *, leads to an increase in exports, and that an appreciation (increase in the real exchange rate, Q, leads to a decrease in exports. 4

5 The Short Run Determinants of Imports: Domestic Income and the Real Exchange Rate Imports are the part of domestic expenditure that falls on foreign goods. We shall assume that they depend on two factors in the short run. First, they clearly depend on domestic income: Higher domestic income leads to a higher domestic demand for all goods, both domestic and foreign. So a higher domestic income leads to higher imports. Second, as with exports, they also clearly depend on the real exchange rate the price of domestic goods in terms of foreign goods: The more expensive domestic goods are relative to foreign goods equivalently, the cheaper foreign goods are relative to domestic goods the higher is the domestic demand for foreign goods. So a higher real exchange rate leads to higher imports. Thus, we write the demand for the volume of imports, expressed in foreign currency, as, M*=M*(Y,Q (+,+ where Y is real domestic income and Q is the real exchange rate, defined as, Expressed in domestic currency, the volume of imports is given by, Q=SP/P* M=P*M*/SP=M*(Y,Q/Q=M(Y,Q (++ - (+? Thus, the volume of imports expressed in domestic currency is a positive function of the domestic real income Y, but the effects of the real exchange rate are ambiguous. There is a positive effect from an increase in the real exchange rate on the volume of imports expressed in foreign currency, but also a negative effect from the lower valuation of a given value of foreign imports in terms of domestic currency. The two effects of changes in the exchange rate on the volume and the valuation of imports thus point to different directions. 5

6 The Short Run Determinants of the Trade Balance The trade balance, NX is defined as exports minus imports, both expressed in domestic currency. Hence it is given by, NX=X(Y*,Q-M(Y-Q Clearly, ceteris paribus, an increase in foreign income causes an improvement in the trade balance, as it results in higher exports. Equally clearly, ceteris paribus, an increase in domestic income causes a deterioration in the trade balance, as it results in higher imports. The effects of a change in the real exchange rate are not so clear, because of the ambiguity concerning imports. Clearly, a real exchange rate appreciation reduces the volume of exports and increases the volume of imports in foreign currency. These two effects tend to cause a deterioration in the trade balance. However, a real exchange rate appreciation reduces the value of any volume of imports in domestic currency. This valuation effect tends to improve the trade balance. One can show that a real exchange rate appreciation will cause a deterioration of the trade balance if the sum of the elasticities of the demand for exports and imports with respect to the real exchange rate is higher than unity. In this case, the effects from the decrease in the volume of exports and the increase in the volume of imports will exceed the valuation effect and the trade balance will deteriorate following a real exchange rate appreciation. Equivalently, a real exchange rate depreciation will cause an improvement of the trade balance if the sum of the elasticities of the demand for exports and imports with respect to the real exchange rate is higher than unity. In this case, the effects from the increase in the volume of exports and the decrease in the volume of imports will exceed the valuation effect. This condition on the elasticities of the demand for exports and imports is called the Marshall Lerner and will be generally assumed to hold. In addition, since we are focusing on the short run, with domestic and foreign prices P and P* assumed fixed, we shall normalize them to unity (P=1, P*=1. This implies that Q=S, i.e that a change in the nominal exchange rate brings about a change in the real exchange rate. 6

7 Domestic Output and the Trade Balance Trade Balance, NX NX(Y*,S NX 1 0 Y 1 Y 0 Y 2 NX 2 Aggregate Output Υ 7

8 The Exchange Rate and the Trade Balance Trade Balance, NX NX(Y*,S 2 S 1 >S 0 >S 2 NX(Y*,S 0 NX(Y*,S 1 0 Y 1 Y 0 Y 2 Aggregate Output Υ 8

9 Foreign Output and the Trade Balance Trade Balance, NX NX(Y 2 *,S 0 Y 2 *>Y 0 *>Y 1 * NX(Y 0 *,S 0 NX(Y 1 *,S 0 0 Y 1 Y 0 Y 2 Aggregate Output Υ 9

10 The Determinants of Aggregate Demand in an Open Economy The Consumption Function C=C(Y-T ( + The Investment Function I(Y,i (+,- The Trade Balance Function NX=X(Y*,S-M*(Y,S/S=NX(Y,Y*,S (+, - (+,+, - (- + - Foreign Output and Income Y* is assumed exogenous Government Expenditures and Taxes G T are both assumed exogenous 10

11 The Aggregate Demand Function Aggregate Domestic Expenditure plus the Trade Balance The Aggregate Domestic Expenditure Function Z=C(Y-T+I(Y,i+G=Z(Y,i,G,T The Trade Balance Function NX=X(Y*,S-M*(Y,S/S=NX(Y,Y*,S The Aggregate Demand Function D=Z+NX=Z(Y,i,G,T+NX(Y,Y*,S 11

12 Diagrammatic Derivation of the Aggregate Demand Function Z, NX, D Z(G,T,i D(G,T,i,Y*,S Y 0 NX(Y*,S Aggregate Output Υ 12

13 The Trade Balance and Aggregate Demand Net exports, or the trade balance, are the difference between imports and exports TB=X(Y*,S-M*(Y,S/S An improvement in the trade balance increases aggregate demand, because in implies higher exports relative to imports and vice versa. An increase in domestic output and income causes a deterioration in the trade balance, as it causes an increase in the demand for imports for given exports. Hence, the aggregate demand curve has a lower slope than the domestic expenditure curve in an open economy An increase in foreign output and income causes an improvement in the trade balance, as it causes an increase in the demand for exports for given imports. Thus, an increase in foreign output causes an increase in aggregate demand, through the demand for exports. A depreciation of the exchange rate bring about an improvement in the trade balance, under the assumption that the demand for exports and imports is sufficiently elastic with respect to changes in the exchange rate. In fact, what is required is the Marshall Lerner condition, which implies that the sum of the elasticities of the demand for exports and imports with respect to the exchange rate must unity, so as to overcome the negative valuation effect from the exchange rate depreciation on the domestic value of a given volume of imports. This condition on the elasticities of the demand for exports and imports is usually assumed to hold. 13

14 The Aggregate Demand Function and Short Run Equilibrium in the Output Market The Aggregate Demand Function D=C(Y-T+I(Y,i+G+NX(Y, Y*,S ( Short Run Equilibrium in the Output Market Y=D The determination of equilibrium can be analyzed with the help of diagram, in the same way as for the closed economy. The aggregate demand function has a slope which is less that one, because the marginal propensity to consume, the marginal propensity to invest minus the marginal propensity to import imply than an increase in output and income increase aggregate demand by less than one for one. 14

15 Aggregate Demand and the Short Determination of AggregateOutput Aggregate Demand D E Y=D D(G,T,i,Y *,S 45 o Y E NX(Y *,S Aggregate Output Υ 15

16 Changes in the Exchange Rate, Aggregate Demand and Output Aggregate Demand D D 2 2 D=Y Depreciation D(S 2 D(S 0 Appreciation D(S 1 D 0 0 D 1 1 Y 1 Y 0 Y 2 NX(S 1 NX(S 0 NX(S 2 Aggregate Output Υ 16

17 The Exchange Rate and the IS Curve Nominal Interest Rate, i S 1 > S 0 > S 2 IS (T 0,G 0,S 2,Y* 0 IS (T 0,G 0,S 0,Y* 0 IS (T 0,G 0,S 1,Y* 0 Real Output Y 17

18 The J Curve Up to now we have been assuming that the volume of imports and exports responds immediately to changes in the exchange rate, or domestic and foreign income. However, in actual fact, the volume of imports and exports does not immediately react to changes in the exchange rate or incomes. The time lag from the time of the decision up to the time of the implementation of an export or an import order implies that initially the change in the volume of imports and exports following a depreciation of the exchange rate is very small. Thus, due to the increase in the domestic currency value of imports, a depreciation of the exchange rate initially causes a deterioration of the current account, as the very short run elasticities of import and export demand are low, and the Marshall Lerner condition is not immediately satisfied. Over time, imports and exports respond more elastically to the change in the exchange rate, and the current account improves. This phenomenon is called the J curve and can be depicted with the help of a diagram. 18

19 The J Curve and the Evolution of the Current Account over Time Following an Exchange Rate Depreciation 19