Aggregate Demand, Output and the Exchange Rate in the Short Run. Prof. George Alogoskoufis Fletcher School, TuBs University

Transcription

1 Aggregate Demand, Output and the Exchange Rate in the Short Run Prof. George Alogoskoufis Fletcher School, TuBs University

2 Aggregate Demand and FluctuaFons in Output and the Exchange Rate We shall now focus on the simultaneous short run determinafon determinafon of fluctuafons in output (and employment) and the exchange rate. We shall 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 assumpfon is the basis of the Keynesian approach to macroeconomics and aggregate fluctuafons. 2

3 John Maynard Keynes ( ) English economist whose ideas fundamentally changed the theory and pracfce of macroeconomics and the economic policies of governments. He built on and greatly refined earlier work on the causes of business cycles, and is widely considered to be one of the most influenfal economists of the 20th century and the founder of modern macroeconomics. 3

4 The Role of Aggregate Demand When the price level does not adjust immediately, aggregate output ( GDP) and employment are determined by aggregate demand (consumpfon, investment, government spending and net exports). Unlike the prices of goods and services, which are assumed to adjust slowly, it is assumed that financial prices such as interest rates and the exchange rate adjust immediately so as to equilibrate the domesfc money market and internafonal foreign exchange markets. 4

5 Aggregate Demand and the Simultaneous DeterminaFon of Output and the Exchange Rate The short-run equilibrium of an open economy takes place at the level of GDP and the exchange rate where, for a given price level, expectafons about the future exchange rate and economic condifons in the rest of the world, two condifons are met: 1. The market for goods and services is in equilibrium, in the sense that the aggregate demand for goods and services is equal to the aggregate supply. What adjusts to equilibrate the market for goods and services in the short run is not the level of prices, but output and employment. 2. The domesfc money market and internafonal financial markets are in equilibrium, in the sense that the aggregate money demand is equal to the money supply, and that uncovered interest parity holds. What adjusts to equilibrate the domesfc money market and the foreign exchange market is the level of domesfc interest rates and the exchange rate. 5

6 Output and the Exchange Rate Adjust Simultaneously to Equilibrate the Market for Goods and Services and Financial Markets Output and the exchange rate in short-run equilibrium are determined so as, 1. To safsfy the equilibrium condifon in the market for goods and services, which implies a negafve relafonship between GDP and the exchange rate, and, 2. To safsfy the equilibrium condifon in financial markets (domesfc and internafonal), which implies a posifve relafonship between output and the exchange rate. 6

7 The Short Run Equilibrium CondiFon in the Market for Goods and Services Equilibrium in the Market for Goods and Services Y=C+I+G+X-M The Consumption Function C=C(Y-T) Aggregate Domestic Expenditure E=C+I+G=C(Y-T)+I+G Trade Balance (Current Account) CA=X-M=X(S,Y*)-M*(S,Y)/S=CA(S,Y,Y*) 7

8 The Aggregate Demand FuncFon The Aggregate Demand Function D=C(Y-T)+I+G+CA(S,Y,Y*)=D(Y,I,G,T,S,Y*) Short Run Equilibrium in the Market for Goods and Services Y=D(Y,I,G,T,S,Y*) 8

9 Aggregate Demand and the Short DeterminaFon of AggregateOutput 9

10 Changes in the Exchange Rate, Aggregate Demand and Output 10

11 Output and the Exchange Rate The Product Market Equilibrium CondiFon 11

12 An Increase in Public Expenditure and the Product Market Equilibrium CondiFon 12

13 An Increase in Foreign Output and the Product Market Equilibrium CondiFon 13

14 Equilibrium in Financial Markets Equilibrium in the Domestic Money Market M s /P=M d /P=L(Y,i) Equilibrium in the Foreign Exchange Market i=i*-(s e -S)/S 14

15 Financial Markets, Interest Rates, and the Exchange Rate and Output 15

16 Output, the Exchange Rate and the Financial Markets Equilibrium CondiFon 16

17 An Increase in the Money Supply and the Financial Markets Equilibrium CondiFon 17

18 A Rise in the Expected Future Exchange Rate and the Financial Markets Equilibrium CondiFon 18

19 Short Run Equilibrium in an Open Economy Equilibrium in the Domestic Output Market Y=D(Y,I,G,T,S,Y*) Equilibrium in Financial Markets M s /P=L(Y,i*-(S e -S)/S) 19

20 Short Run Equilibrium in an Open Economy Aggregate Output and the Exchange Rate 20

21 The Effects of a Temporary Increase in the Money Supply 21

22 The Effects of a Temporary Increase in Foreign Interest Rates 22

23 The Effects of a Temporary Increase in Government Expenditure 23

24 The Effects of a Temporary Fall in Output in the Rest of the World 24

25 The Effects of an Expected Future AppreciaFon of the Exchange Rate 25

26 The Effects of a Permanent Increase in the Money Supply 26

27 The Effects of a Permanent Increase in Government Expenditure 27

28 Conclusions about Short Run Macroeconomic Equilibrium in an Open Economy Short-run equilibrium in an open economy is determined at the level of output and the exchange rate where, 1. The market for goods and services is in equilibrium, in the sense that aggregate demand equals aggregate supply, and 2. The domesfc money market and internafonal financial markets are in equilibrium, in the sense that the demand for money equals the supply of money and uncovered interest parity holds. 28

29 Conclusions about the Short Run Effects of Monetary Policy on Output and the Exchange Rate 1. A temporary monetary expansion (increase in the money supply) causes a depreciafon of the exchange rate, and a temporary increase in GDP and employment. 2. A permanent monetary expansion (increase in the money supply), has the addifonal effect of causing an expected future depreciafon of the exchange rate. Thus, the current exchange rate depreciates both as a result of the fall of current nominal interest rates, and the expected future depreciafon. The impact of a permanent monetary expansion on the short exchange rate and output is thus even greater than a temporary one. 29

30 Conclusions about the Short Run Effects of Fiscal Policy on Output and the Exchange Rate 1. A temporary fiscal expansion (increase in government expenditure or reducfon in taxes) causes an appreciafon of the exchange rate, and a temporary increase in GDP and employment. 2. A permanent fiscal expansion has the addifonal effect of causing an expected future appreciafon of the exchange rate. Thus, the current exchange rate appreciates both as a result of the rise of current nominal interest rates, and the expected future appreciafon. The impact of a permanent fiscal expansion on the short exchange rate is thus even greater than a temporary one, but the impact on output is zero, as the exchange rate appreciafon fully crowds out the effects of the fiscal expansion on aggerage demand. 30

31 Robert Mundell (1932-) Nobel Prize-winning Canadian economist. Currently, he is a professor of economics at Columbia University and the Chinese University of Hong Kong. He received the Nobel Memorial Prize in Economics in 1999 for his pioneering work in internafonal monetary economics and opfmum currency areas. His adaptafon of the keynesian model to allow for perfect capital mobility in the early 1960s is known as the Mundell Fleming model and sfll serves as the basis for the analysis of short run stabilizafon policy in open economies. 31

32 The Role of Short Run StabilizaFon Policy This model can be used to analyze the role of short run stabilizafon policy. In principle, the government and the monetary authorifes could use either monetary or fiscal policy to counteract shocks that create a recession. In pracfve, monetary policy is much more flexible than fiscal policy, as it does not require a lengthy legislafve process, but simply a decision by the policy segng board of the central bank (the Fed in the case of the USA). We shall thus concentrate on the role of monetary policy in the short run. 32

33 Monetary Policy Response to a World Recession 33

34 Monetary Policy Response to a Financial Recession 34

35 Monetary Policy Response to a Price Shock 35