Chapter 16Output and the Exchange Rate in the Short Run.ppt

Chapter 16Output and the Exchange Rate in the Short Run Supplementary Notes Introduction This chapter builds on the short run and long models of exchange rates to explain how output and the exchange rate are determined in the short run. Develop the AA-DD model (similar to the IS-LM model with a different focus) Aggregate Demand Aggregate demand is the aggregate amount of goods and services that people are willing to buy: consumption expenditure (C) investment expenditure (I) government purchases (G) net expenditure by foreigners: the current account (CA) Aggregate Demand (cont.) Determinants of consumption expenditure include: Disposable income (Y-T): income from production (Y) minus taxes (T). The marginal propensity to consume (MPC) out of disposable income is positive but less than one. Other important determinants of consumption Real interest rates Wealth They are ignored for simplicity. Aggregate Demand (cont.) Determinants of the current account include: Disposable income: more disposable income means more expenditure on foreign products (imports) and a reduction in CA. Real exchange rate (EP*/P): the prices of foreign products relative to the prices of domestic products, both measured in domestic currency: The Real Exchange Rate and the Current Account The current account measures the value of exports less the value of imports: CA ≈ EX – IM. Current account in domestic currency = PQx – EP*Qm Current account in real terms = Qx – (EP*/P)Qm EX ? Qx, IM ? (EP*/P)Qm When the real exchange rate EP*/P rises, the prices of foreign products rise relative to the prices of domestic products. The volume of exports (Qx) rises. The volume of imports (Qm) falls. The value of imports in terms of domestic products (EP*/P) rises. The Real Exchange Rate and the Current Account (cont.) If the volumes of imports and exports do not change much, the value effect may dominate the volume effect when the real exchange rate changes. Evidence indicates that for most co