A Short-Run Model of an Open Economy.PPT

A Short-Run Model of an Open Economy BA 282 Macroeconomics Class Notes - Part 4 Aggregate Demand Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world Recall GDP = C + I + G + EX - IM = D Each of these components has various sources that determine demand for that factor We will concentrate here on consumption and CA Specifically, let’s assume C = C(YD) and CA = CA(E, YD) Aggregate Demand and CA To see how a change in E effects CA we look at EX and IM Separately. Assume an increase in E This results in an increase in EX since domestic goods look cheaper to foreigners This can result in an increase or decrease in IM. Why? (for now assume an increase in E results in a decrease of IM) An increase in YD will decrease CA. Why? Aggregate Demand We can now write a more general function for D D = C(Y-T) + I + G + CA(E , Y-T) where Consumption demand (C) is a function of YD YD = Y - T (T = aggregate taxes) or more generally D = D(E , Y-T, I, G) Aggregate demand Let’s review D = D(E , Y-T, I, G) Increasing the real exchange rate increases D through the current account Increasing income will increase D through increases in consumption demand decrease D through increasing import demand The consumption demand effect will be greater then the import demand effect so an increase in income will increase aggregate demand Increasing investment demand I increases D Increasing government demand G increases D Aggregate Demand and Output Equilibrium in the Output Market Equilibrium in the domestic output market will occur when aggregate demand equals output (real income) In the short-run we consider prices fixed In the long-run prices will adjust Equilibrium in the Output Market The DD Schedule Now we need to derive the relationship between the exchange rate and output (the DD schedule) when the output market is in equilibrium To do this consider an increase in the nominal excha