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Chapter Nineteen

Chapter Nineteen. Prices and Output in an Open Economy. Introduction Apples vs. GDP: Supply in Micro- and Macroeconomics Aggregate Demand under Fixed Exchange Rates Long-Run Aggregate Supply Medium-Run Aggregate Supply Combining Aggregate Demand and Aggregate Supply.

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Chapter Nineteen

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  1. Chapter Nineteen Prices and Output in an Open Economy

  2. Introduction Apples vs. GDP: Supply in Micro- and Macroeconomics Aggregate Demand under Fixed Exchange Rates Long-Run Aggregate Supply Medium-Run Aggregate Supply Combining Aggregate Demand and Aggregate Supply Chapter Nineteen Outline

  3. Macroeconomic Policy under Fixed Exchange Rates Aggregate Demand under Flexible Exchange Rates Macroeconomic Policies under Flexible Exchange Rates Supply Shocks Chapter Nineteen Outline

  4. Introduction • We have examined the effects of macroeconomic policies in the short- and long-run. Now it is time to study those effects in the medium-run. • Two definitions: • A sustained rise of the overall price level defines inflation. • A sustained fall in the price level, rarely observed, represents deflation. • Need to distinguish between the supply, or production, side of the economy and the demand, or expenditure, side.

  5. Apples vs. GDP: Supply in Micro- and Macroeconomics See Figure19.1 • The effects of changes of price and supply in the apple market is shown in Figure 19.1: • In panel (a), the supply curve for apples is perfectly horizontal. • The price of apples is fixed, and demand determines quantity. • In panel (b), the supply curve for apples is upward sloping, reflecting the movement of resources into and out of apple production in response to relative price changes.

  6. Figure 19.1: Price and Supply in the Apple Market P P apples apples S P 1 P = P S P 0 1 0 D D 1 1 D D 0 0 0 Q Q Q 0 Q Q Q 0 1 apples 0 1 apples (a) (b)

  7. Aggregate Demand under Fixed Exchange Rates • An economy’s aggregate demand curve represents the relationship between the quantity demanded of domestic goods and the domestic price level. • The quantity examined represents the economy’s total output of goods and services, or GDP. • The relevant price represents the overall domestic price level, the GDP deflator.

  8. Aggregate Demand under Fixed Exchange Rates • The slope of the aggregate demand curve. • Slopes downward like a microeconomic demand curve, but for different reasons: • A rise in the domestic price level raises the price of domestic goods relative to that of foreign ones. • The quantity demanded of real money balances depends positively on real income and negatively on the interest rate.

  9. Aggregate Demand under Fixed Exchange Rates • The effects of a rise in the price level in the money market is shown in Figure 19.2: • A rise in the price level from P0 to P1 reduces the real money stock (M/P), assuming that the nominal money stock (M) is held constant. • The equilibrium interest rate rises to reduce the quantity demanded of real money balances to equal the new, smaller stock.

  10. Figure 19.2: Effect of a Rise in the Price Level in the Money Market i (M /P ) (M /P ) 0 1 0 0 (P > P ) 1 0 i 1 i 0 L(Q , i) 0 0 (M /P ) (M /P ) Quantity of Real 0 1 0 0 Money Balances

  11. Shifts in the Aggregate Demand Curve • A change in nominal money stock, fiscal policy variables, the nominal exchange rate, or foreign price level alters the demand for domestic goods at each domestic price level, and therefore, shifts the aggregate demand curve. • Figure 19.3 illustrates the various shifts in the aggregate demand curve (next slide).

  12. Figure 19.3: Shifts in the Aggregate Demand Curve Fall in e (revaluation) P Decrease in M Decrease in G or increase in taxes Fall in P * Rise in e (devaluation) Increase in M Increase in G or decrease in taxes Rise in P * AD 2 AD 0 AD 1 0 Q

  13. Shifts in the Aggregate Demand Curve • The demand for domestically produced goods is reduced at each domestic price level by revaluation of domestic currency, decline in domestic nominal money stock, decrease in government purchases, rise in taxes, or a fall in foreign price level.

  14. Shifts in the Aggregate Demand Curve • Demand for domestically produced goods increases at each domestic price level due to devaluation of domestic currency, rise in domestic money stock, an increase in government purchases, reduction in taxes, or a rise in foreign price level. • Changes in the domestic price level itself, other things being equal, cause movements along a single aggregate demand curve rather than shifts in it.

  15. Long-Run Aggregate Supply • Aggregate supply refers to the relationship between an economy’s price level and the total quantity of goods and services produced. • Quantity of available resources and existing technology constrain the total quantity of output an economy can produce. • The short, medium, and long runs • Short run: period during which the price level remains fixed in response to economic shocks or policy changes, so aggregate demand alone determines real output.

  16. Long-Run Aggregate Supply • Medium run: the period during which the price level begins to respond to shocks or policy changes, but individuals or firms may remain unaware of some price changes or may find it too costly due to contracts or other rigidities to adjust their behavior in response to those changes. • Long run: denotes the time over which everyone in the economy knows the price level and has had time to adjust production decisions accordingly.

  17. The Vertical Long-Run Aggregate Supply Curve • The long-run aggregate supply (LRAS) curve is a simple vertical line at the economy’s full-employment output, implying that changes in the price level have no effect on the quantity of output supplied. • Figure 19.4: in the long-run, the quantity of output does not depend on the price level. • The economy’s quantity of resources and technology determine the horizontal placement of the LRAS curve.

  18. Figure 19.4: Long-Run Aggregate Supply P LRAS P 2 P 1 0 Q

  19. Medium-Run Aggregate Supply • Medium-run aggregate supply (MRAS) curve captures the behavior of individuals and firms when lack of information about the price level, stickiness of some prices, or inability to adjust quickly to a change in the price level causes behavior to differ from what it would be with full information and instantaneous adjustment.

  20. Medium-Run Aggregate Supply • The slope of MRAS curve is represented in Figure 19.5: • A rise in the price level causes an increase in the quantity of output supplied. • This is captured by the upward-sloping portion of the MRAS curve. • At some point, the economy reaches the constraint of resources and technology, causing the medium-run aggregate supply curve to become vertical.

  21. Figure 19.5: Medium-Run Aggregate Supply P LRAS MRAS P 0 0 Q

  22. Shifts in the MRAS Curve • Each MRAS curve is drawn for given values of input prices and of firms’ expectations about prices other than those of their own products. • If price level rises, but contractual rigidities keep some input prices constant and firms do not immediately alter their expectations about other prices, firms will perceive relative prices of their outputs as having risen and will increase output. • This causes the economy to move up along a given MRAS curve, as depicted in Figure 19.6.

  23. Figure 19.6: Vertical Shift in the Medium-Run Aggregate Supply Curve LRAS P e MRAS(W , P ) 1 1 e MRAS(W , P ) 0 0 e e (W > W , P > P ) 1 0 1 0 3 P 2 1 P 1 0 P 2 0 Q

  24. Combining Aggregate Demand and Aggregate Supply • Assume perfectly mobile capital: • Portfolio owners, in deciding where to put their funds, consider only interest rates, exchange rates, and expected changes in exchange rates. • No government regulations restrict capital flows among countries. • In the medium-run, as shown in figure 19.7, the economy must be at the intersection of AD curve and MRAS curve. • In long-run, this intersection must occur also on the LRAS.

  25. Figure 19.7: Medium-Run and Long-Run Equilibrium P LRAS MRAS Medium run: AD = MRAS P Long run: AD = MRAS = LRAS 1 P 0 AD 1 AD 0 0 Q Q Q 0 1

  26. Macroeconomic Policy under Fixed Exchange Rates • Without fixed price levels, the economy contains automatic adjustment mechanisms for reaching long-run equilibrium. • Mechanisms that do not require active responses from policy makers. • At this equilibrium, the following statements are true: • The quantity demanded of domestic goods equals the quantity supplied at full employment; and • BOP equilibrium prevails.

  27. Macroeconomic Policy under Fixed Exchange Rates • Primary shortcoming of automatic adjustment mechanisms is their lack of speed. • In the medium-run, fiscal policy can alter income, but monetary policy cannot. • Neither policy can affect real output in the long-run, although fiscal policy continues to affect the price level.

  28. Macroeconomic Policy under Fixed Exchange Rates • Fiscal policy, prices, and output • The effects of an expansionary fiscal policy with flexible prices, fixed exchange rates, and perfectly mobile capital are shown in Figure 19.8: • Beginning from a long-run equilibrium at point 1, output is raised temporarily. • As firms and individuals adjust to the rise in the price level, the increase in output is offset, and the long-run effect is merely a rise in the price level and there is no effect on real output.

  29. Figure 19.8: Effects of Expansionary Fiscal Policy P LRAS MRAS 2 MRAS 1 3 P 2 2 P 1 1 AD 3 AD 2 AD 1 0 Q

  30. Macroeconomic Policy under Fixed Exchange Rates • Fiscal policy, prices, and output (cont.) • Two alternative paths to long-run equilibrium are compared in Figure 19.9: • Expansionary fiscal policy vs. automatic adjustment: • Beginning at point 1, expansionary fiscal policy brings the economy to a new long-run equilibrium at point 2b. • Automatic adjustment leads to a long-run equilibrium at point 2a. • In either case, the location of the LRAS curve determines output. • The equilibrium price level is higher in the case of expansionary fiscal policy (P2) than in that of automatic adjustment (P0).

  31. Figure 19.9: Expansionary Fiscal Policy versus Automatic Adjustment P LRAS MRAS 1 MRAS 0 P 2b 2 P 1 1 P 2a 0 AD 2 AD 1 0 Q

  32. Macroeconomic Policy under Fixed Exchange Rates • Monetary policy, prices, and output. • Monetary policy cannot affect income with a fixed price level, a fixed exchange rate, and perfectly mobile capital. • Conclusion continues to hold when we introduce price flexibility. • When the economy operates at less than full-employment and as long as the price level is flexible, the price adjustment mechanism pushes output toward its long-run level. • As for the BOP, the fixed exchange rate implies that the money stock adjusts – through changes in FX reserves – to equate the BOP.

  33. Macroeconomic Policy under Fixed Exchange Rates • Exchange rate policy, prices, and output. • Third type of possible macroeconomic policy involves a permanent change in exchange rate, such as a devaluation (Figure 19.10). • Beginning at point 1, the devaluation lowers the relative price of domestic goods and switched expenditure toward them. • The AD curve shifts right from AD1 to AD2. • At point 2, the BOP is in surplus due to the devaluation. Intervention in the FX market increase domestic money supply, and the AD curve shifts further right. • MRAS curve moves upward. • Long-run equilibrium is restored at point 3.

  34. Figure 19.10: Effect of a Devaluation with Flexible Prices . . . Perfectly Mobile Capital P LRAS MRAS 3 MRAS 1 P 3 3 P 2 2 P 1 AD 1 3 AD 2 AD 1 0 Q

  35. Aggregate Demand under Flexible Exchange Rates • Just as it does under a fixed exchange rate regime, the AD curve under a flexible regime captures the negative relationship between the domestic price level and the quantity demanded of domestic goods and services. • Slope of AD curve:downward for same reasons as under a fixed regime. • Rise in price level raises the relative price of domestic goods and shifts expenditure toward foreign goods. • Rise in domestic price level lowers real money stock, raises domestic interest rate, lowers investment, and causes capital inflows and currency appreciation.

  36. Aggregate Demand under Flexible Exchange Rates • Shifts in AD curve. • Situation 1: Permanent increase in money stock… • Raises real money stock and lowers interest rate; causes capital outflow, which depreciates domestic currency and lowers relative price of domestic goods. • Implies larger quantity of domestic goods at each price level – AD curve shifts right. • Situation: Permanent rise in government purchases…

  37. Aggregate Demand under Flexible Exchange Rates • Shifts in AD curve. • Situation 2: Permanent rise in government purchases… • This change has no effect on aggregate demand under a flexible regime and perfect capital mobility. • Interest rate rises to make individuals content to hold only the available stock of real balances. • Capital flows in, domestic currency appreciates, and relative price of domestic goods rise. • Net exports fall enough to offset initial increase in government purchases. • Total demand remains unchanged.

  38. Macroeconomic Policies under Flexible Exchange Rates • Automatic adjustment mechanisms • When both the price level and the exchange rate are flexible, the economy contains automatic adjustment mechanisms for bringing it into equilibrium on the long-run supply curve with balance payments. • Price level adjusts to equate the quantity demanded of domestic goods with quantity supplied at full employment. • Exchange rate adjusts to bring the BOP into equilibrium.

  39. Macroeconomic Policies under Flexible Exchange Rates • Macroeconomic policy, prices, and output. • The effects of expansionary monetary policy with flexible prices, flexible exchange rates and perfectly mobile capital are depicted in Fig. 19.11: • Beginning from a point of long-run equilibrium at point 1, expansionary monetary policy can raise output, but only temporarily. • As individuals and firms adjust to accompanying rise in price level, output falls back to original level. • Policy’s long-run effect consists solely of a proportional rise in price level and proportional depreciation of domestic currency.

  40. Figure 19.11: Effect of Expansionary Monetary Policy . . . Perfectly Mobile Capital P LRAS MRAS 2 MRAS 1 P 3 2 2 P 1 1 AD 2 AD 1 0 Q

  41. Macroeconomic Policies under Flexible Exchange Rates • Exchange rate overshooting: occurs when a variable responds to a disturbance more in the medium-run than it does in the long-run. • Tends to occur when some variables adjust more quickly than others. • Figure 19.12 contrasts expansionary monetary policy with automatic adjustment: • Beginning from point 1, expansionary monetary policy leads to a long-run equilibrium at point 2a with price level P1. • Automatic adjustment leads to long-run equilibrium at 2b with price level P2.

  42. Figure 19.12: Expansionary Monetary Policy versus Automatic Adjustment P LRAS MRAS 1 MRAS 2 P 2a 1 1 P 2b 2 AD 2 AD 1 0 Q

  43. Supply Shocks • Supply shocks: include any event that alters the economy’s long-run equilibrium productive capacity. • Examples include earthquakes, floods, wars, and oil embargoes. • Definition of stagflation: combination of rising prices and declining output.

  44. Supply Shocks • Effects of an adverse supply shock and potential policy responses are illustrated in Figure 19.13: • Shock shifts MRAS and LRAS curves left. • Policy makers have several options: • Can leave AD unchanged at AD0; new long-run equilibrium at point 3a. • Expand AD to AD1 to speed the economy’s return to full employment at point 3b; prices rise. • Aggressively expand AD to AD2 and push output back to its pre-shock level; much higher prices at 4c. • Contract AD to AD3 and restore long-run equilibrium at point 4d; keeps prices down but may require higher unemployment. • Regardless of choice, the new long-run, full-employment output is at the lower Q1.

  45. Figure 19.13: An Adverse Supply Shock and Potential Policy Responses P LRAS LRAS 1 0 MRAS 1 MRAS 4c P 2 c MRAS 0 3c P 3b b P 2 AD 2 2 P 3d 3a a P 1 AD 1 1 P 4d d AD 0 AD 3 0 Q Q Q 1 0

  46. Note for Case 1: Unemployment – Structural and Cyclical • Figure 19.14: 1999 unemployment rates for 21 developed-country members of the OECD plus for the 11-member euro area. • Each country’s actual unemployment rate (illustrated by the red line) can be decomposed into a structural component (the blue bars) and a cyclical component (difference between the height of the bar and that of the line).

  47. Figure 19.14: Unemployment Rates’ Structure and Cyclical Components, 1999 (% Labor Force)

  48. Note for Case 2: Government Budgets – Structural and Cyclical • Figure 19.15 illustrates the Japanese fiscal policy indicators for 1990-90. • The country’s fiscal policy stance turned contractionary in 1997 when the government increased taxes. • The Japanese economy already stood at the brink of a recession, and the fiscal contraction pushed further in that direction.

  49. Figure 19.15: Japanese Fiscal Policy Indicators, 1990-1999 (Percent)

  50. Note on the Appendix: The Aggregate Demand Curve • Figure 19A.1 represents the derivation of aggregate demand curve from IS-LM-BOP with perfectly mobile capital. • Real output and the price level are negatively-related along an aggregate demand curve.

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