1 / 69

Output and the Exchange Rate in the Short Run

Output and the Exchange Rate in the Short Run. Introduction. How can we analyze the short run of an open economy? What are the impacts on a country’s imports and exports from changes in the real exchange rate? How much effect do changes in foreign trade have on growth rate of GDP?

washi
Download Presentation

Output and the Exchange Rate in the Short Run

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Output and the Exchange Rate in the Short Run

  2. Introduction • How can we analyze the short run of an open economy? • What are the impacts on a country’s imports and exports from changes in the real exchange rate? • How much effect do changes in foreign trade have on growth rate of GDP? • What is the importance of the real exchange rate in an open economy?

  3. Aggregate Demand • Relationship between total quantity demanded of goods and services in all sectors of the economy and the price level, holding all else constant • Total output of goods and services measured by real GDP – horizontal axis • Price level measured by GDP price deflator – vertical axis • AD curve slopes downward – as price level declines, quantity of goods demanded increases

  4. Aggregate Demand • Does not behave in the same manner as an ordinary demand curve • Price of product falls • Consumer’s real income rises – increases amount consumed for normal good (income effect) • Lower price induces consumers to purchase more of product b/c cheaper (substitution effect)

  5. Aggregate Demand • Neither the income or substitution effect are relevant to overall price level • If aggregate price level falls • Prices consumers pay are falling • Prices people receive as wages, rents, etc. are also falling • No change in demand

  6. Aggregate Demand • Price level is measure of prices in general, not a particular price • As price level falls there is no substitution effect b/c prices in general are falling, not the price of a particular good.

  7. Aggregate Demand • Why is AD negatively sloped? • As price level changes, value of individual’s real wealth changes – wealth effect • Increase in price level: • Reduces value of accumulated financial assets • Consumers reduce consumption of goods • Aggregate quantity demanded changes

  8. Aggregate Demand • Why is AD negatively sloped? (cont.) • Rise in price level increases interest rates – interest rate effect • Lower business investment • Lower consumer spending on housing and cars • Aggregate quantity demanded falls • Price level changes impact country’s total exports and imports – international substitution effect

  9. Aggregate Demand • Why is AD negatively sloped? (cont.) • Price level increase • Price of domestic goods rises relative to foreign goods • Foreign demand (exports) for domestic goods decreases • Domestic demand (imports) for foreign goods increases • Aggregate quantity demanded declines

  10. Aggregate Demand • All three effects lead to decreases in aggregate quantity demanded (output of goods and services) as price level increases (all else equal) • The opposite is also true • Inverse relationship is shown as movement along aggregate demand curve

  11. Aggregate Demand Curve

  12. Changes in Aggregate Demand • Changing one of the variables held constant along the AD curve will cause a shift in the curve • Increases (decreases) in AD will shift the curve to the right (left) • New AD curve shows at any given price level, society wants to buy more (less) goods and services

  13. Changes in Aggregate Demand • Expenditure approach to calculating GDP • Look at the four sectors of an open economy that buy real goods/services • Changes in any above factors, shifts AD

  14. Changes in Aggregate Demand

  15. Changes in Aggregate Demand • Consumption (C) • Consumer wealth • As consumer wealth increases (decreases), level of consumption increases (decreases) • Increase (decreases) in consumption shifts AD curve to right (left)

  16. Changes in Aggregate Demand • Consumer expectations • More confident consumers are about the future, more likely to consume today • Increased confidence increases AD (curve shifts right) • Reverse is also true

  17. Changes in Aggregate Demand • Degree of consumer indebtedness • High level of indebtedness from past consumption financed by borrowing • Must pay off existing dept • May need to reduce current consumption • Consumer spending falls • AD curve shifts left • Reverse is also true

  18. Changes in Aggregate Demand • Taxes • Higher taxes (or lower transfer payments) reduce society’s after tax income • Lower income leads to lower consumption spending • AD curve shifts left • Reverse is also true

  19. Changes in Aggregate Demand • Investment spending • Higher interest rates • Decreases business investment and public investment in housing • Aggregate demand decreases (shifts left) • Opposite is also true • Expectations of future economic conditions • Current economic conditions affect expectations of future in same direction thereby affecting investment spending

  20. Changes in Aggregate Demand • Investment spending (cont.) • Government changes in business taxation • Increasing (decreasing) business taxes raise (lower) investment spending and aggregate demand

  21. Changes in Aggregate Demand • Government Spending • Increasing in government spending on goods/services, increases aggregate demand • Opposite is also true • Government spending at federal, sate or local level

  22. Changes in Aggregate Demand • Exports and Imports • Exports sensitive to changes in income of foreign countries • Increases in foreign incomes increase exports which increases aggregate demand (and vice versa) • Faster foreign economic growth leads to greater changes in US aggregate demand • Slower foreign growth (recessions) negatively impacts US aggregate demand

  23. Changes in Aggregate Demand • Exports and Imports (cont.) • Movements in real exchange rate • As dollar depreciates • Foreign currency buys more US goods – increases exports • US currency buys fewer foreign goods – decreases imports • Aggregate demand increases • Opposite is also true

  24. Changes in Aggregate Demand

  25. Aggregate Supply • Relationship between the total quantity of goods/services an economy produces at various price levels, holding all other determinant of production unchanged. • Slopes upward to the right • As price level rises, quantity of goods and services economy produces increases

  26. Aggregate Supply • Why is AS positively sloped? • Represents entire economy’s total production • Higher price level is necessary to bring a higher level of total production • Assume short run labor force, capital stock, stock of natural resources, and level of technology are constant

  27. Aggregate Supply • Why is AS positively sloped? (cont.) • Related to both rising demand for output and rising unit costs as economy moves closer to full employment • As output expands, prices of some inputs rise before economy reaches full employment leading to rising unit costs • As some prices rise while others are constant, price level on average increases before reaching full employment

  28. Aggregate Supply • Why is AS positively sloped? (cont.) • Most important price in economy is price of labor • Hiring more labor decreases K/L ratio • MPL decreases and wage rate increases • Leads to rising production costs • Rising price level means higher prices are necessary to increase total output – upward sloping AS curve

  29. Aggregate Supply

  30. Aggregate Supply • Change in aggregate supply means per unit production costs are rising (falling) for some reason unrelated to an increase in production (output) • Increases in AS will shift the curve to right • At any given price level, firms are willing and able to produce more goods/services • Firms can produce same level of output at lower unit costs – unit costs have declined

  31. Changes in Aggregate Supply • Decreases in AS will shift the curve to the left • Unit costs of production have increased • Two types of changes or shifts in AS • Changes due to changes in potential real GDP • Changes in major determinants of AS curve held constant along the curve

  32. Changes in Aggregate Supply

  33. Changes in Aggregate Supply • Changes in potential real GDP • Factors of production • As factors of production (land, labor, capital, entrepreneurial ability) increase over time, AS curve will shift right • Productivity of factors of production • Increases in productivity reduce unit costs and shift AS curve to right • Synonymous with country’s long run economic growth

  34. Changes in Aggregate Supply • Determinants of aggregate supply • Input prices • Increases in input prices increase costs of production decreasing AS • EX: increases in wages, oil shock • Exchange rate shock • Large change in real value of a country’s currency in short period of time • Change change firm’s costs of production changing aggregate supply

  35. Changes in Aggregate Supply • Determinants of aggregate supply • Changes in business taxes • Increases in overall business taxes increases costs of production decreasing AS and vice versa • EX: sales taxes, excise taxes, payroll taxes • Public’s inflationary expectations • Perceived increases in future inflation cause adjustments in economic action today.

  36. Changes in Aggregate Supply • Public’s inflationary expectations (cont.) • Producers may attempt to increase prices today to stay ahead of anticipated inflation • Workers attempt to receive larger salary increases today to protect real wages and standards of living • Aggregate supply curve will decrease (left shift)

  37. Changes in Aggregate Supply

  38. Aggregate Equilibrium • Intersection of AS and AD determines the open economy’s equilibrium • Equilibrium level of real output (production and spending) for economy at Ye • Equilibrium price level for the economy at Pe • Shifts in AS or AD will change equilibrium level of output and price level

  39. Aggregate Equilibrium

  40. Aggregate Equilibrium • Note that changes in exchange rate shift both AD and AS curves • Changes in exchange rate can affect an open economy’s equilibrium level of output and price level • Not only are trade flows (exports and imports) affected, but there are noticeable impacts on entire economy

  41. Determinants of Current Account • Changes in AD and AS influence output • We will focus on one component of aggregate demand and supply – the current account • How does a change in the current account (exports minus imports) impacts the equilibrium level of output • Changes in other determinants of AD and AS will be ignored

  42. Changes in Current Account • Exports • Level of income in foreign countries, Yf • Exports change with changes in foreign incomes • Size of change determined by two factors • Size of change in foreign income • Larger income changes have larger effects on exports • Changes in foreign income that affect a country’s exports are weighted averages of changes in income among the countries trading partners

  43. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • Percentage change in a country’s exports relative to the percentage change in foreign income

  44. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • Elasticity is a positive number • As foreign incomes increase (decrease), a country’s exports increase (decrease) • Size of country’s foreign income elasticity depends on product mix of a country’s exports

  45. Changes in Current Account • Exports (cont.) • Income elasticity of demand for the country’s exports • If a country exports a high percentage of goods with high income elasticities of demand, they will tend to have a higher foreign income elasticity and vice versa • US close to 1, Germany and Japan greater than 1, Chile, South Africa less than 1

  46. Changes in Current Account • Exports (cont.) • Real exchange rate (RXR) • As the real value of country’s currency appreciates (depreciates, level of a country’s exports declines (increases) • Size of effect depends on • Size of change in real exchange rate • The larger the change in RXR, the larger the effect on exports

  47. Changes in Current Account • Exports (cont.) • Real exchange rate (RXR) • Price elasticity of demand for exports • Sensitivity of a country’s exports to changes in the real exchange rate • Sensitivity of a country’s exports is inversely related to changes in real exchange rate

  48. Changes in Current Account • Imports • Level of domestic income (Yd) • As domestic income rises, level of imports rises • Size of effect depends on two factors • Size of change in domestic income • Income elasticity of demand for imports

  49. Changes in Current Account • Imports • Level of domestic income (Yd) • Income elasticity of demand for imports (cont.) • Income elasticity is positive – increases in domestic income cause an increase in imports • May be equal to, greater than or less than 1 • Real Exchange rate • As currency appreciates, imports increase

  50. Changes in Current Account • Imports • Real Exchange rate (cont.) • Magnitude of effect depends on two factors • Size of change in real exchange rate – smaller changes have smaller effects • Price elasticity of demand for imports – percent change in imports relative to percent change in real exchange rate – direct relationship

More Related