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Chapter 17: III part - Coggle Diagram
Chapter 17: III part
Policies to Maintain Full Employment
Figure: Maintaining Full Employment after a Temporary Fall in World Demand for Domestic Products
Policy Effects on Exchange Rates
Fiscal expansion restores equilibrium without changing the exchange rate
monetary expansion depreciates the currency to achieve full employment.
Production is at its potential or natural level when resources are effectively and sustainably used
When resources are over-employed, there is low unemployment, overtime work, overused equipment, and production above normal.
When resources are underemployed, there is high unemployment, idle equipment, and production is below normal.
Both Temporary Monetary and Fiscal Expansion can increase output and employment in the short run, helping to counteract recessions or over-employment caused by temporary disturbances.
Output and Employment: A rise in output (Y) leads to a rise in employment.
Figure: Policies to Maintain Full Employment After a Money Demand Increase
A temporary increase in money demand makes people want to hold more money → Higher interest rates (+R) → Currency appreciation (E ↓, the currency becomes stronger) → Lower output (Y ↓), moving the economy below full employment.
Two policy tools can be used to restore full employment:
Monetary Expansion (Increase Money Supply): Shifts the AA curve back to the right, from AA2 to AA1. Interest rates fall (R ↓) → Exchange rate increases (E ↑ → currency depreciates back to original E1) → Output returns to full employment (Y ↑). Full employment is restored without changing the exchange rate.
Fiscal Expansion (Increase Government Spending G): Shifts the DD curve to the right, from DD1 to DD2. Increases output (Y ↑) → BUT causes further appreciation of the currency (E ↓ to E3), because higher demand increases interest rates and capital inflows. Full employment is restored, but the exchange rate appreciates further.
Effects of Permanent Changes in Fiscal Policy
Expectation effect: People expect the currency to appreciate (Ee↓), reducing the attractiveness of foreign deposits → actual appreciation of the domestic currency (E↓).
Currency appreciation → ↓ Net Exports (because domestic goods become more expensive) → ↓ Aggregate Demand.
Immediate effect: ↑ government spending or ↓ taxes → ↑ Aggregate Demand (Y↑).
Figure: Effects of a Permanent Fiscal Expansion
Complete crowding out of net exports: the fiscal expansion is fully neutralized in terms of output due to exchange rate appreciation.
The increase in demand from fiscal policy is fully offset by the decrease in net exports due to the stronger currency.
Therefore, output remains unchanged in the long run at the natural/full-employment level.
Permanent Changes in Monetary Policy
A permanent increase in the supply of monetary assets (Ms ↑) lowers short-run interest rates (R ↓) and leads people to expect future depreciation of the domestic currency (expected exchange rate Ee ↑) → This raises the expected return on foreign currency deposits making them more attractive → The domestic currency depreciates (E ↑) more than it would if expectations remained constant, a phenomenon known as exchange rate overshooting → The AA curve shifts up (right) more strongly than in the case of fixed expectations, causing an increase in the current account (CA ↑) and output (Y ↑).
Figure: Short-run Effects of a Permanent Increase in the Money Supply
Effects of Permanent Changes in Monetary Policy in the Long Run
Figure: Long-Run Adjustments to a Permanent Increase in the Money Supply
Macroeconomic Policies and the Current Account
As income/output increases (Y↑) → imports increase (IM↑) → CA = EX - IM ↓.
To offset this drop in the current account, the domestic currency must depreciate (E↑) → makes exports cheaper and imports more expensive → CA↑.
The XX curve shows combinations of output (Y) and exchange rate (E) where the current account (CA) is at its desired level.
Figure: How Macroeconomic Policies Affect the Current Account
Permanent Changes in Monetary and Fiscal Policy
Impact both AA and DD through expectations shifts.
As a result, the effects of permanent policy changes differ significantly from those of temporary policy changes.
Affect expectations about future exchange rates over the long run. These changed expectations influence the exchange rate even in the short run.
Temporary Changes in Monetary Policy
Increase in money supply (Ms ↑) → Lowers interest rates (R ↓) → domestic currency depreciates (E rises) → AA curve shifts up/right; DD curve unchanged (Ms does not affect aggregate demand directly) → Cheaper domestic products increase aggregate demand and output → new short-run equilibrium with higher output and higher E.
Figure: Effects of a Temporary Increase in the Money Supply
Temporary Changes in Fiscal Policy
Figure: Effects of a Temporary Fiscal Expansion
Increase in government purchases (G ↑) or decrease in taxes (T ↓): Aggregate demand and output rise in the short run → DD curve shifts right (increased output for any exchange rate), AA curve remains unchanged (fiscal policy affects goods market first) → Higher output increases demand for real money balances → interest rates rise (R ↑) → Domestic currency appreciates (E falls) to keep interest parity.