Determinants of Aggregate Demand in Small Economy with Flexible Exchange Rates, Slides of Economics

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Output and the Exchange Rate in

the Short Run

Long Run and Short Run

• Long run theories are useful when all prices of inputs

and outputs have enough time to adjust fully to

changes in supply and demand.

• 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

market demand.

• This chapter discusses a theory of the short run

behavior of a “ small ” economy with flexible exchange

rates under perfect capital mobility

Determinants of Aggregate Demand

• Aggregate demand ( D ) is the aggregate amount of

goods and services that people are willing to buy. It

consists of the following types of expenditure:

1. consumption expenditure ( C )

2. investment expenditure ( I )

3. government purchases ( G )

4. net expenditure by foreigners: the current account ( CA )

Determinants of Aggregate Demand

• Assumption : Consumption expenditure ( C ) increases when

d isposable income ( Y − T )—which is income ( Y ) minus taxes

( T )—increases

• … but by less than the increase in disposable income
• Real interest rates may influence the amount of saving and

consumption, but we assume that they are relatively

unimportant here.

• Wealth may also influence consumption, but we assume that it

is relatively unimportant here.

Determinants of Aggregate Demand

• Determinants of the current account include:
  • Real exchange rate : an increase in the real exchange rate

increases the current account.

• Disposable income : an increase in the disposable income

decreases the current account.

Determinants of Aggregate Demand (cont.)

• Assumption : exogenous political factors

determine government purchases ( G ) and the

level of taxes ( T ).

• Assumption : investment expenditure ( I ) is

determined exogenously by business

sentiment.

• A more complex model might assume that

investment depends on the cost of borrowing for

investment, the expected real interest rate.

Determinants of Aggregate Demand (cont.)

• Determinants of aggregate demand include:
  • Real exchange rate : an increase in the real exchange rate increases the

current account, and therefore increases aggregate demand for

domestic products.

• Disposable income : an increase in the disposable income increases

consumption, but decreases the current account.

• Since total consumption expenditure is usually greater than expenditure on foreign products, the first effect dominates the second effect. Therefore,
• When disposable income increases, aggregate demand increases, but by

less than the increase in disposable income.

• Therefore, when income increases or taxes decrease (or both), aggregate demand increases.

Determinants of Aggregate Demand (cont.)

• Determinants of aggregate demand include:
  • Government Spending : an increase in

government spending ( G ) increases aggregate

demand for domestic products ( D ).

• Business Investment : an increase in business

investment ( I ) increases aggregate demand ( D ).

Goods Market Equilibrium

Goods Market Equilibrium

Goods Market Equilibrium: Shifts of

the DD Curve

3

DD 2

Suppose the economy is initially at Point 1. Suppose there is a tax hike ( T ↑), but output is still at Y^1. Then, C will decrease. Let’s say C decreases by $100. This will require CA to increase by $100. But T ↑, by itself, will increase CA by less than $100.

Why? When C falls by $100, the consumption of imported goods would fall by less: say, by $55. So, the tax cut, by itself, would increase CA by only $55.

Therefore, to make CA increase by another $45, E must increase. So, the tax hike takes the economy from Point 1 to Point 3.

In other words, the tax hike shifts the DD curve upward and to the left. docsity.com

Goods Market Equilibrium: Shifts of

the DD Curve

3

DD 2

Suppose the economy is initially at Point 2. Suppose I or G increases ( I + G ↑), but output is still at Y^2. Then, CA must decrease. With unchanged Y , this requires a decrease in E. Therefore, if I or G increases and Y is unchanged, then the economy must move from Point 2 to Point 3. In other words, if I or G increases, the DD curve must shift downward or to the right.

Fig. 17-2: The Determination of Output

in the Short Run

Aggregate demand is greater than production: firms increase output

Output is greater than aggregate demand: firms decrease output

Short Run Equilibrium and the Exchange Rate:

DD Schedule

• How does the value of the foreign currency ( E ) affect the short

run equilibrium of aggregate demand and output?

• Domestic and foreign price levels ( P and P* ) are assumed fixed

in the short run.

• Therefore, a rise in the nominal exchange rate ( E ) makes

foreign goods more expensive relative to domestic goods. That

is, q = E × P* / P increases when E increases.

• As a result, CA increases and, therefore, D increases. That is, D

increases when E increases. See Fig 17-3.

• In equilibrium, Y = D. Therefore, Y increases when E increases.
• This gives the DD curve. See Fig 17-4. Y^ =^ D ( E×P */ P ,^ Y^ –^ T ,^ I ,^ G )