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1、Slides prepared by Thomas BishopCopyright 2009 Pearson Addison-Wesley. All rights reserved.Chapter 16Output and the Exchange Rate in the Short RunPreviewDeterminants of aggregate demand in the short runA short run model of output markets A short run model of asset marketsA short run model for both o
2、utput markets and asset markets Effects of temporary and permanent changes in monetary and fiscal policiesAdjustment of the current account over timeIS-LM model2Copyright 2009 Pearson Addison-Wesley. All rights reserved.IntroductionLong run models are useful when all prices of inputs and outputs hav
3、e time to adjust.In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about willingness of customers to pay at different prices.This chapter builds on the short run and long models of exchange rates to
4、explain how output is related to exchange rates in the short run.It shows how macroeconomic policies can affect production, employment, and the current account.3Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate DemandAggregate demand is the aggregate amount of good
5、s and services that individuals and institutions are willing to buy:1.consumption expenditure2.investment expenditure3.government expenditure by foreigners: the current account4Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate DemandDeterminants of consumption exp
6、enditure include:Disposable income: income from production (Y) minus taxes (T). More disposable income means more consumption expenditure, but consumption typically increases less than the amount that disposable income increases.Real interest rates may influence the amount of saving and spending on
7、consumption goods, but we assume that they are relatively unimportant here.Wealth may also influence consumption expenditure, but we assume that it is relatively unimportant here.5Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate Demand (cont.)Determinants of the c
8、urrent account include:Real exchange rate: prices of foreign products relative to the prices of domestic products, both measured in domestic currency: EP*/PAs the prices of foreign products rise relative to those of domestic products, expenditure on domestic products rises, and expenditure on foreig
9、n products falls.Disposable income: more disposable income means more expenditure on foreign products (imports)6Copyright 2009 Pearson Addison-Wesley. All rights reserved.How Real Exchange Rate Changes Affect the Current AccountThe current account measures the value of exports relative to the value
10、of imports: CA EX IM.When the real exchange rate EP*/P rises, the prices of foreign products rise relative to the prices of domestic products.1.The volume of exports that are bought by foreigners rises.2.The volume of imports that are bought by domestic residents falls.3.The value of imports in term
11、s of domestic products rises: the value/price of imports rises, since foreign products are more valuable/expensive.7Copyright 2009 Pearson Addison-Wesley. All rights reserved.How Real Exchange Rate Changes Affect the Current Account (cont.)If the volumes of imports and exports do not change much, th
12、e value effect may dominate the volume effect when the real exchange rate changes.For example, contract obligations to buy fixed amounts of products may cause the volume effect to be small. However, evidence indicates that for most countries the volume effect dominates the value effect after one yea
13、r or less.Lets assume for now that a real depreciation leads to an increase in the current account: the volume effect dominates the value effect.8Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate DemandDeterminants of the current account include:Real exchange rate:
14、 an increase in the real exchange rate increases the current account.Disposable income: an increase in the disposable income decreases the current account.9Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate Demand (cont.)For simplicity, we assume that exogenous poli
15、tical factors determine government purchases G and the level of taxes T.For simplicity, we currently assume that investment expenditure I is determined by exogenous business decisions.A more complicated model shows that investment depends on the cost of spending or borrowing to finance investment: t
16、he interest rate.10Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate Demand (cont.)Aggregate demand is therefore expressed as:D = C(Y T) + I + G + CA(EP*/P, Y T)Or more simply: D = D(EP*/P, Y T, I, G)(16-1)Investment expenditure andgovernment purchases, bothexogeno
17、usCurrent account asa function of the realexchange rate and disposable income.Consumptionexpenditure as a functionof disposableincome11Copyright 2009 Pearson Addison-Wesley. All rights reserved.Determinants of Aggregate Demand (cont.)Determinants of aggregate demand include:Real exchange rate: an in
18、crease in the real exchange rate increases the current account, and therefore increases aggregate demand of domestic products.Disposable income: an increase in the disposable income increases consumption expenditure, but decreases the current account. Since consumption expenditure is usually greater
19、 than expenditure on foreign products, the first effect dominates the second effect.As income increases for a given level of taxes, aggregate consumption expenditure and aggregate demand increase by less than income.12Copyright 2009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium f
20、or Aggregate Demand and OutputEquilibrium is achieved when the value of income from production (output) Y equals the value of aggregate demand D.Y = D(EP*/P, Y T, I, G)Value of outputand income from productionEquilibrium conditionAggregate demand as a function of the real exchange rate, disposable i
21、ncome, investment expenditure and government purchases13Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-2: The Determination of Output in the Short RunAggregatedemand isgreater thanproduction: firms increaseoutput Production is greaterthan aggregate demand: firmsdecrease output14C
22、opyright 2009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium and the Exchange Rate: DD ScheduleHow does the exchange rate affect the short run equilibrium of aggregate demand and output?With fixed domestic and foreign levels of average prices, a rise in the nominal exchange rate m
23、akes foreign goods and services more expensive relative to domestic goods and services.A rise in the nominal exchange rate (a domestic currency depreciation) increases aggregate demand of domestic products.In equilibrium, production will increase to match the higher aggregate demand.15Copyright 2009
24、 Pearson Addison-Wesley. All rights reserved.Fig. 16-3: Output Effect of a Currency Depreciation with Fixed Output Prices16Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-4: Deriving the DD Schedule17Copyright 2009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium
25、and the Exchange Rate: DD Schedule (cont.) DD schedule shows combinations of output and the exchange rate at which the output market is in short run equilibrium (such that aggregate demand = aggregate output).slopes upward because a rise in the exchange rate causes aggregate demand and aggregate out
26、put to rise.18Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the DD CurveChanges in the exchange rate cause movements along a DD curve. Other changes cause it to shift:1.Changes in G: more government purchases cause higher aggregate demand and output in equilibrium. Output incre
27、ases for every exchange rate: the DD curve shifts right.19Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-5: Government Demand and the Position of the DD Schedule20Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the DD Curve (cont.)2.Changes in T: lower taxes g
28、enerally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right.3.Changes in I: higher investment expenditure is represented by shifting the DD curve right.4.Changes in P relative to P*: lower domestic prices relativ
29、e to foreign prices are represented by shifting the DD curve right.21Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the DD Curve (cont.)5.Changes in C: willingness to consume more and save less is represented by shifting the DD curve right.6.Changes in demand of domestic goods r
30、elative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve right.22Copyright 2009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium in Asset MarketsWe consider two sets of asset markets:1.Foreign exchange mar
31、kets interest parity represents equilibrium: R = R* + (Ee E)/E 2.Money market Equilibrium occurs when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded: Ms/P = L(R, Y) A rise in income from production causes the demand of real monetary assets to incr
32、ease.23Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-6: Output and the Exchange Rate in Asset Market Equilibrium24Copyright 2009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium in Asset Markets (cont.)When income and production increase, demand of real monetary
33、 assets increases, leading to an increase in domestic interest rates,leading to an appreciation of the domestic currency.Recall that an appreciation of the domestic currency is represented by a fall in E.When income and production decrease, the domestic currency depreciates and E rises.25Copyright 2
34、009 Pearson Addison-Wesley. All rights reserved.Short Run Equilibrium in Asset Markets: AA CurveThe inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium is summarized as the AA curve.26Copyright 2009 Pearson Addison-We
35、sley. All rights reserved.Fig. 16-7: The AA Schedule Equilibrium exchange rate in foreign exchange market;Equilibrium output in money market.27Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the AA Curve1.Changes in Ms: an increase in the money supply reduces interest rates in th
36、e short run, causing the domestic currency to depreciate (a rise in E) for every Y: the AA curve shifts up (right).28Copyright 2009 Pearson Addison-Wesley. All rights reserved. Increase in domesticmoney supplyMS2 PR22E22Decrease in return on domestic currency depositsE11Return on domestic depositsEx
37、pectedreturn onforeign depositsL(R, Y1)Domestic real money holdingsDomestic rates of return, interest rateExchange rate, ER11Domestic real money supplyMS1 P0Shifting the AA Curve29Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the AA Curve (cont.) Output, Y Exchange rate, EAAY1Y
38、2AA30Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the AA Curve (cont.)2.Changes in P: An increase in the level of average domestic prices decreases the supply of real monetary assets, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA
39、curve shifts down (left).3.Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of real money assets and more non-monetary assets, interest rates on non-monetary assets would fall, leading to a depreciation of the domestic currency (a rise in E): th
40、e AA curve shifts up (right).31Copyright 2009 Pearson Addison-Wesley. All rights reserved.Shifting the AA Curve (cont.)4.Changes in R*: An increase in the foreign interest rates makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a rise in E): the AA
41、curve shifts up (right).5.Changes in Ee: if market participants expect the domestic currency to depreciate in the future, foreign currency deposits become more attractive, causing the domestic currency to depreciate (a rise in E): the AA curve shifts up (right).32Copyright 2009 Pearson Addison-Wesle
42、y. All rights reserved.Putting the Pieces Together: the DD and AA CurvesA short run equilibrium means a nominal exchange rate and level of output such that:1.equilibrium in the output markets holds: aggregate demand equals aggregate output.2.equilibrium in the foreign exchange markets holds: interes
43、t parity holds.3.equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded.33Copyright 2009 Pearson Addison-Wesley. All rights reserved.Putting the Pieces Together: the DD and AA Curves (cont.)A short run equilibrium occ
44、urs at the intersection of the DD and AA curvesoutput markets are in equilibrium on the DD curveasset markets are in equilibrium on the AA curve34Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-8: Short-Run Equilibrium: The Intersection of DD and AA35Copyright 2009 Pearson Addison
45、-Wesley. All rights reserved.Fig. 16-9: How the Economy Reaches Its Short-Run EquilibriumThe domestic currency appreciates and output increases until output markets are in equilibrium. Exchange rates adjust immediately so that asset markets are in equilibrium.36Copyright 2009 Pearson Addison-Wesley.
46、 All rights reserved.Temporary Changes in Monetary and Fiscal PolicyMonetary policy: policy in which the central bank influences the supply of monetary assets.Monetary policy is assumed to affect asset markets first.Fiscal policy: policy in which governments (fiscal authorities) influence the amount
47、 of government purchases and taxes.Fiscal policy is assumed to affect aggregate demand and output first.Temporary policy changes are expected to be reversed in the near future and thus do not affect expectations about exchange rates in the long run.37Copyright 2009 Pearson Addison-Wesley. All rights
48、 reserved.Temporary Changes in Monetary PolicyAn increase in the quantity of monetary assets supplied lowers interest rates in the short run, causing the domestic currency to depreciate (a rise in E).The AA shifts up (right).Domestic products relative to foreign products are cheaper so that aggregat
49、e demand and output increase until a new short run equilibrium is achieved.38Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-10: Effects of a Temporary Increase in the Money Supply39Copyright 2009 Pearson Addison-Wesley. All rights reserved.Temporary Changes in Fiscal PolicyAn inc
50、rease in government purchases or a decrease in taxes increases aggregate demand and output in the short run.The DD curve shifts right.Higher output increases demand of real monetary assets, thereby increasing interest rates,causing the domestic currency to appreciate (a fall in E).40Copyright 2009 P
51、earson Addison-Wesley. All rights reserved.Fig. 16-11: Effects of a Temporary Fiscal Expansion41Copyright 2009 Pearson Addison-Wesley. All rights reserved.Policies to Maintain Full EmploymentResources used in the production process can either be over-employed or underemployed.When resources are used
52、 effectively and sustainably, economists say that production is at its potential or natural level.When resources are not used effectively, resources are underemployed: high unemployment, few hours worked, idle equipment, lower than normal production of goods and services.When resources are not used
53、sustainably, labor is over-employed: low unemployment, many overtime hours, over-utilized equipment, higher than normal production of goods and services.42Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-12: Maintaining Full Employment After a Temporary Fall in World Demand for Dom
54、estic ProductsTemporary fiscal policy could reverse the fall in aggregate demand and outputTemporary fall in world demand for domestic products reduces output below its normal levelTemporary monetaryexpansion could depreciate the domestic currency43Copyright 2009 Pearson Addison-Wesley. All rights r
55、eserved.Fig. 16-13: Policies to Maintain Full Employment After a Money Demand IncreaseIncrease in moneydemand raises interest rates and appreciates the domestic currencyTemporary fiscal policy could increaseaggregate demand and outputTemporary monetary policy couldincrease money supply to matchmoney
56、 demand44Copyright 2009 Pearson Addison-Wesley. All rights reserved.Policies to Maintain Full Employment (cont.)Policies to maintain full employment may seem easy in theory, but are hard in practice.1.We have assumed that prices and expectations do not change, but people may anticipate the effects o
57、f policy changes and modify their behavior.Workers may require higher wages if they expect overtime and easy employment, and producers may raise prices if they expect high wages and strong demand due to monetary and fiscal policies.Fiscal and monetary policies may therefore create price changes and
58、inflation thereby preventing high output and employment: inflationary bias 45Copyright 2009 Pearson Addison-Wesley. All rights reserved.Policies to Maintain Full Employment (cont.)2.Economic data are difficult to measure and to understand. Policy makers can not interpret data about asset markets and
59、 aggregate demand with certainty, and sometimes they make mistakes.3.Changes in policies take time to be implemented and to affect the economy.Because they are slow, policies may affect the economy after the effects of an economic change have dissipated.4.Policies are sometimes influenced by politic
60、al or bureaucratic interests.46Copyright 2009 Pearson Addison-Wesley. All rights reserved.Permanent Changes in Monetary and Fiscal Policy“Permanent” policy changes are those that are assumed to modify peoples expectations about exchange rates in the long run.47Copyright 2009 Pearson Addison-Wesley.
61、All rights reserved.Permanent Changes in Monetary PolicyA permanent increase in the quantity of monetary assets suppliedlowers interest rates in the short run and makes people expect future depreciation of the domestic currency, increasing the expected rate of return on foreign currency deposits. Th
62、e domestic currency depreciates more than (E rises more than) the case when expectations are constant (Chapter 14 results). The AA curve shifts up (right) more than the case when expectations are held constant.48Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-14: Short-Run Effects
63、 of a Permanent Increase in the Money SupplyA permanent increase in the money supply decreases interest rates and causes people to expect a future depreciation, leading to a large actual depreciation49Copyright 2009 Pearson Addison-Wesley. All rights reserved.Effects of Permanent Changes in Monetary
64、 Policy in the Long RunWith employment and hours above their normal levels, there is a tendency for wages to rise over time.With strong demand of goods and services and with increasing wages, producers have an incentive to raise prices over time.Both higher wages and higher output prices are reflect
65、ed in a higher level of average prices. What are the effects of rising prices?50Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-15: Long-Run Adjustment to a Permanent Increase in the Money SupplyIn the long run, output returns to its normal level, and we also see overshooting: E1
66、E3 E2Higher prices make domestic products more expensive relative to foreign goods: reduction in aggregate demandHigher prices reducereal money supply,Increasing interest rates, leading to adomestic currency appreciation51Copyright 2009 Pearson Addison-Wesley. All rights reserved.Effects of Permanen
67、t Changes in Fiscal PolicyA permanent increase in government purchases or reduction in taxes increases aggregate demandmakes people expect the domestic currency to appreciate in the short run due to increased aggregate demand, thereby reducing the expected rate of return on foreign currency deposits
68、 and making the domestic currency appreciate.The first effect increases aggregate demand of domestic products, the second effect decreases aggregate demand of domestic products (by making them more expensive).52Copyright 2009 Pearson Addison-Wesley. All rights reserved.Effects of Permanent Changes i
69、n Fiscal Policy (cont.)If the change in fiscal policy is expected to be permanent, the first and second effects exactly offset each other, so that output remains at its potential or natural (or long run) level.We say that an increase in government purchases completely crowds out net exports, due to
70、the effect of the appreciated domestic currency.53Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-16: Effects of a Permanent Fiscal ExpansionAn increase ingovernment purchases raisesaggregate demandTemporary fiscalexpansion outcomeWhen the increase of government purchases is perma
71、nent, the domestic currency is expected to appreciate, and does appreciate.54Copyright 2009 Pearson Addison-Wesley. All rights reserved.Macroeconomic Policies and the Current AccountTo determine the effect of monetary and fiscal policies on the current account, derive the XX curve to represent the c
72、ombinations of output and exchange rates at which the current account is at its desired level. As income from production increases, imports increase and the current account decreases when other factors remain constant.To keep the current account at its desired level, the domestic currency must depre
73、ciate as income from production increases: the XX curve should slope upward.55Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-17: How Macroeconomic Policies Affect the Current Account56Copyright 2009 Pearson Addison-Wesley. All rights reserved.Macroeconomic Policies and the Curren
74、t Account (cont.)The XX curve slopes upward but is flatter than the DD curve.DD represents equilibrium values of aggregate demand and domestic output.As domestic income and production increase, domestic saving increases, which means that aggregate demand (willingness to spend) by domestic residents
75、does not rise as rapidly as income and production.57Copyright 2009 Pearson Addison-Wesley. All rights reserved.Macroeconomic Policies and the Current Account (cont.)As domestic income and production increase, the domestic currency must depreciate to entice foreigners to increase their demand of dome
76、stic products in order to keep the current account (only one component of aggregate demand) at its desired levelon the XX curve.As domestic income and production increase, the domestic currency must depreciate more rapidly to entice foreigners to increase their demand of domestic products in order t
77、o keep aggregate demand (by domestic residents and foreigners) equal to productionon the DD curve.58Copyright 2009 Pearson Addison-Wesley. All rights reserved.Macroeconomic Policies and the Current Account (cont.)Policies affect the current account through their influence on the value of the domesti
78、c currency.An increase in the quantity of monetary assets supplied depreciates the domestic currency and often increases the current account in the short run.An increase in government purchases or decrease in taxes appreciates the domestic currency and often decreases the current account in the shor
79、t run.59Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-17: How Macroeconomic Policies Affect the Current AccountAn increase in the money supply shifts up the AA curve and depreciates the domestic currency, increasing the current account above XX.A temporary fiscal expansion shift
80、s the DD and appreciates the domestic currency, decreasing the CA below XX.Because the AA curve also shifts, a permanent fiscal expansion decreases the CA more.60Copyright 2009 Pearson Addison-Wesley. All rights reserved.Value Effect, Volume Effect and the J-curveIf the volume of imports and exports
81、 is fixed in the short run, a depreciation of the domestic currency will not affect the volume of imports or exports, but will increase the value/price of imports in domestic currency and decrease the current account: CA EX IM.The value of exports in domestic currency does not change.The current acc
82、ount could immediately decrease after a currency depreciation, then increase gradually as the volume effect begins to dominate the value effect. 61Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-18: The J-CurveJ-curve: valueeffect dominatesvolume effectvolume effect dominatesvalue
83、 effectImmediateeffect of real depreciationon the CA62Copyright 2009 Pearson Addison-Wesley. All rights reserved.Value Effect, Volume Effect and the J-curve (cont.)Pass through from the exchange rate to import prices measures the percentage by which import prices change when the value of the domesti
84、c currency changes by 1%.In the DD-AA model, the pass through rate is 100%: import prices in domestic currency exactly match a depreciation of the domestic currency.In reality, pass through may be less than 100% due to price discrimination in different countries. firms that set prices may decide not
85、 to match changes in the exchange rate with changes in prices of foreign products denominated in domestic currency.63Copyright 2009 Pearson Addison-Wesley. All rights reserved.Value Effect, Volume Effect and the J-curve (cont.)If prices of foreign products in domestic currency do not change much bec
86、ause of a pass through rate less than 100%, then thevalue of imports will not rise much after a domestic currency depreciation, and the current account will not fall much, making the J-curve effect smaller.volume of imports and exports will not adjust much over time since domestic currency prices do
87、 not change much. Pass through of less than 100% dampens the effect of depreciation or appreciation on the current account.64Copyright 2009 Pearson Addison-Wesley. All rights reserved.IS-LM ModelIn the DD-AA model, we assumed that investment expenditure is determined by exogenous business decisions.
88、In reality, the amount of investment expenditure depends on the interest rate.Investment projects use saved or borrowed funds, and the relevant interest rate represents the (real) cost of spending or borrowing those funds.A higher interest rate means less investment expenditure.The IS-LM model predi
89、cts that investment expenditure is inversely related to the relevant interest rate.65Copyright 2009 Pearson Addison-Wesley. All rights reserved.IS-LM Model (cont.)The IS-LM model also allows for consumption expenditure and expenditure on imports to depend on the interest rate.A higher interest rate
90、makes saving more attractive and consumption expenditure (on domestic and foreign products) less attractive.However, the effect of the interest rate is much larger on investment expenditure than it is on consumption expenditure and imports.66Copyright 2009 Pearson Addison-Wesley. All rights reserved
91、.IS-LM Model (cont.)The IS-LM model expresses aggregate demand as:D = C(Y T, R-e ) + I(R-e)+ G + CA(EP*/P, Y T, R-e )Or more simply: D = D(EP*/P, Y T, R-e, G)Investment as a function of the real interest rateR-e Current account asa function of the realexchange rate, disposable income and the real in
92、terestrate R-e Consumptionas a functionof disposableincome and thereal interest rate R-e Government purchases areexogenous67Copyright 2009 Pearson Addison-Wesley. All rights reserved.IS-LM Model (cont.)Instead of relating exchange rates and output, the IS-LM relates interest rates and output.In equi
93、librium, aggregate output = aggregate demandY = D(EP*/P, Y T, R-e, G)In equilibrium, interest parity holdsR = R* + (Ee-E)/EE(1+R) = ER* + Ee E(1+RR*) = Ee E = Ee/(1+RR*) 68Copyright 2009 Pearson Addison-Wesley. All rights reserved.IS-LM Model (cont.)Y = D(EeP*/P(1+RR*) , Y T, R-e, G) This equation d
94、escribes the IS curve: combinations of interest rates and output such that aggregate demand equals aggregate output, given values of exogenous variables Ee,P*,P, R*,T, e, and G.Lower interest rates increase investment demand (and consumption and import demand), leading to higher aggregate demand and
95、 higher aggregate output in equilibrium.The IS curve slopes down.69Copyright 2009 Pearson Addison-Wesley. All rights reserved.IS-LM Model (cont.)In equilibrium, the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded: Ms/P = L(R,Y)This equation describes t
96、he LM curve: combinations of interest rates and output such that the money market is in equilibrium, given values of exogenous values P and Ms.Higher income is predicted to cause higher demand of real monetary assets and higher interest rates in the money market.The LM curve slopes up.70Copyright 20
97、09 Pearson Addison-Wesley. All rights reserved.IS-LM Model (cont.) Y1R11LMIS Output, Y Interest rate, ROutput marketsare in equilibriumMoney marketis in equilibriumBoth the output markets and money market are in equilibrium at R1 and Y171Copyright 2009 Pearson Addison-Wesley. All rights reserved.Eff
98、ects of Temporary Changes in the Money Supply (cont.) R2LM2Output, Y Interest rate, RLM1Y22Y11R12E21E1Exchange rate, E ( increasing)Expected return on foreign currency depositsIS1Temporary increasein moneysupply72Copyright 2009 Pearson Addison-Wesley. All rights reserved.Effects of Permanent Changes
99、 in the Money Supply in the Short Run R3R2LM2Output, Y Interest rate, RLM1Y22Y33Y11R12E21E1E33Exchange rate, E ( increasing)Expected return on foreign currency depositsIS1IS2Domestic currencyis expectedto depreciatePermanent increasein moneysupply73Copyright 2009 Pearson Addison-Wesley. All rights r
100、eserved.Effects of Temporary Changes in Fiscal Policy R2R1Output, Y Interest rate, RLMY11Y222E2Exchange rate, E ( increasing)Expected return on foreign currency depositsE11IS1IS2Temporaryfiscal expansion74Copyright 2009 Pearson Addison-Wesley. All rights reserved.Effects of Permanent Changes in Fisc
101、al Policy R2R1Output, Y Interest rate, RLMY11Y222E2Exchange rate, E ( increasing)Expected return on foreign currency depositsE11E33IS1IS2Permanentfiscal expansionDomestic currencyis expected to appreciate75Copyright 2009 Pearson Addison-Wesley. All rights reserved.Summary1.Aggregate demand is influe
102、nced by disposable income and the real exchange rate.2.The DD curve shows combinations of exchange rates and output where aggregate demand = aggregate output.3.The AA curve shows combinations of exchange rates and output where the foreign exchange markets and money market are in equilibrium.76Copyri
103、ght 2009 Pearson Addison-Wesley. All rights reserved.Summary (cont.)4.In the DD-AA model, we assume that a depreciation of the domestic currency leads to an increase in the current account and aggregate demand.5.But reality is more complicated, and the J-curve shows that the value effect at first do
104、minates the volume effect.77Copyright 2009 Pearson Addison-Wesley. All rights reserved.Summary (cont.)6.A temporary increase in the money supply is predicted to increase output and depreciate the domestic currency.7.A permanent increase does both to a larger degree in the short run, but in the long
105、run output returns to its normal level.8.A temporary increase in government purchases is predicted to increase output and appreciate the domestic currency.9.A permanent increase in government purchases is predicted to completely crowd out net exports, and therefore to have no effect on output. 78Cop
106、yright 2009 Pearson Addison-Wesley. All rights reserved.Summary (cont.)10.The IS-LM model compares interest rates with output.11.The IS curve shows combinations of interest rates and output where aggregate demand = aggregate output.12.The LM curve shows combinations of interest rates and output wher
107、e the money market is in equilibrium.13.The IS-LM model can be used with the model of the foreign exchange markets to compare output, interest rates and exchange rates.79Copyright 2009 Pearson Addison-Wesley. All rights reserved.Additional Chapter Art80Copyright 2009 Pearson Addison-Wesley. All righ
108、ts reserved.Table 16-1: Factors Determining the Current Account81Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16-1: Aggregate Demand as a Function of Output82Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 16A1-1: Change in Output and Saving 83Copyright 2009 Pearson Addison-Wesley. All rights reserved.Table 16A2-1: Estimated Price Elasticities for International Trade in Manufactured Goods84Copyright 2009 Pearson Addison-Wesley. All rights reserved.
