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Chapter 17: Output and the Exchange Rate in the Short Run - Coggle Diagram
Chapter 17: Output and the Exchange Rate in the Short Run
Aggregate demand is the total demand for goods and services in an economy by individuals and institutions. Determinants of Aggregate Demand
Investment expenditure and government purchases – assumed exogenous (given)
Net foreign expenditure – measured by the current account, which depends on the real exchange rate. Determinants of the Current Account
Disposable income: Higher income → more imports, thus affecting the current account negatively
Real exchange rate: If foreign goods become more expensive (relative to domestic), → people spend more on domestic goods and less on imports
Consumption expenditure – depends on disposable income (Y-T). Determinants of Consumption Expenditure
Real interest rates can affect saving/consumption, but assumed unimportant here
Wealth might influence consumption, but also considered unimportant here
Disposable income (Y - T): Higher disposable income → more consumption, but less than proportionally
Marshall-Lerner Condition
A real depreciation of a country’s currency (i.e., domestic goods become cheaper relative to foreign goods) will improve the current account, all else equal.
Effects of Changes in the Real Exchange Rate
Real exchange rate falls → Real appreciation of domestic currency
→ Domestic goods become more expensive
→ Foreign goods become cheaper
→ Current account deteriorates
Real exchange rate rises → Real depreciation of domestic currency
→ Foreign goods become more expensive
→ Domestic goods become more attractive
→ Current account (CA) improves
→ Aggregate demand for domestic goods increases
Effect of Disposable Income on the Current Account
Increase in disposable income
→ More spending on imports
→ Current account worsens
Decrease in disposable income
→Less spending on imports
→ Current account improves
How Real Exchange Rate Changes Affect the Current Account
CA = Exports (EX) – Imports (IM)
Measures the net value of goods/services exchanged with the rest of the world.
Volume Effect vs. Value Effect
Volume effect: change in quantity of exports/imports.
Value effect: change in the price of imports/exports.
If volumes don’t change much (e.g., due to fixed contracts), the value effect may dominate. But in most countries, volume effect dominates after about 1 year or less. Example: We assume
real depreciation → CA improves → Because the volume effect > value effect
Figure: Aggregate Demand as a Function of Output
Short-Run Equilibrium for Aggregate Demand and Output
Equilibrium condition: Output (Y) = Aggregate demand (D)
Short-Run Relationship Between Output (Y) and Exchange Rate (E)
AA Schedule
The AA curve shows the inverse relationship between output (Y) and exchange rate (E) needed to keep both 1. The foreign exchange market (interest parity) and 2. The money market (real money supply = real money demand)
in equilibrium simultaneously.
Reflects interest parity and money market equilibrium
DD Schedule
The DD schedule shows all combinations of exchange rates (E) and output (Y) for which the output market is in short-run equilibrium. It describes how the exchange rate affects equilibrium output.
Based on the condition: Y = D(E, Y, I, G, etc.)
Figure: The Determination of Output in the Short Run
DD schedule
Effect of Exchange Rate on Aggregate Demand and Output
Assume fixed domestic (P) and foreign (P*) price levels.
A rise in the nominal exchange rate (E) means domestic currency depreciation. → This makes foreign goods more expensive relative to domestic goods. → This raises the relative price of foreign goods. → As a result, aggregate demand for domestic products increases. → In equilibrium, output (Y) rises to meet higher aggregate demand.
Key takeaway: If E (exchange rate) increases (currency depreciates), then Y (output) increases.
Figure: Output Effect of a Currency Depreciation with Fixed Output Prices
Any change in the E will move along the DD schedule
Factors That Shift the DD Curve
Investment (I)
Effect on Aggregate Demand and Output: Higher I → Higher aggregate demand and output for every E. DD curve: Right
Domestic Prices (P)
Effect on Aggregate Demand and Output: Higher P → Domestic goods more expensive → Lower net exports → Lower aggregate demand and output. DD curve: left
Taxes (T)
Effect on Aggregate Demand and Output: Lower T → Higher consumption → Higher aggregate demand and output for every E. DD curve: Right
Foreign Prices (P*)
Effect on Aggregate Demand and Output: Higher P* → Domestic goods cheaper relative to foreign → Higher net exports → Higher aggregate demand and output. DD curve: Right
Government purchases
Effect on Aggregate Demand and Output: More G → Higher aggregate demand and output for every E. DD curve: Right
Consumption (C)
Effect on Aggregate Demand and Output: More willingness to consume and save less → Higher aggregate demand and output. DD curve: Right
Preference for Domestic Goods
Effect on Aggregate Demand and Output: More preference for domestic goods over foreign goods → Higher aggregate demand and output. DD curve: Right