1. The U.S has unusually high income elasticity of demand for imports. If the U.S economy had an exceptionally strong year of economic growth, what effects would this have on output and the price level?
2. Suppose that real interest rates in a county fell. What effect would this have on the real exchange rate and the current account? How this would effects equilibrium output and the price level?
Sawyer/Sprinkle Chapter 17 Output and the Exchange Rate in the Short Run C h a p t e r 1 7 To accompany International Economics, 3e by Sawyer/Sprinkle PowerPoint slides created by Jeff Heyl Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› CHAPTER ORGANIZATION Introduction Aggregate Demand and Aggregate Supply: A Review Determinants of the Current Account Exchange Rate Changes and Equilibrium Output in an Open Economy Summary Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› 2 How can we analyze the short-run of an open economy? What are the impacts on a country’s imports and exports from changes in the real exchange rate? Present a general model of output and price determination in an open economy How much effect do changes in foreign trade have on growth rate of GDP? What is the importance of the real exchange rate in an open economy? Its effect on output and output composition? INTRODUCTION Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Aggregate Demand Aggregate demand is the relationship between total quantity demanded of goods and services in all sectors of the economy and the price level, holding all else constant The axis are total output of goods and services measured by real GDP and the price level measured by GDP price deflator The aggregate demand curve slopes downward to the right Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Figure 17.1The Aggregate Demand Curve Price Level (P) P1 P0 Y1 Y0 Real GDP (Y) Aggregate Demand (AD) B A Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The aggregate demand curve does not behave in the same manner as an ordinary demand curve If the price of a single product falls, the consumer’s real income rises increasing the amount consumed for a normal good (income effect) The lower price induces consumers to purchase more of the product because it’s cheaper (substitution effect) Neither the income or substitution effect are relevant to overall price level Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW If the aggregate price level falls, prices consumers pay are falling and prices people receive as wages, rents, etc. are falling Therefore, there is no income effect (no change in demand as the price level falls) The price level is a measure of prices in general, not a particular price As price levels fall there is no substitution effect (because prices in general are falling, not the price of a particular good) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW This means the aggregate demand curve is negatively sloped for different reasons: As the price level rises, interest rates increase, the interest rate effect This is because MD will increase, holding MS constant, so equilibrium interest rates in the money market will increase Higher interest rates curtail business investment and consumer spending on items such as housing and cars As the price level increases, aggregate quantity demanded falls, and vice versa Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW As the price level changes, it impacts a country’s total exports and imports, the international substitution effect As the price level increases, the price of domestically produced goods rises relative to foreign produced goods Foreign demand for domestically produced goods (exports) declines and domestic demand for imported goods (imports) increases As the price level increases, aggregate quantity demanded falls, and vice versa Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Changes in Aggregate Demand Changes in the determinants of the aggregate demand (previously held constant) will cause the curve to shift The new AD curve shows that at any given price level, society wants to buy more (or less) goods and services To analyze the shifts we can use the expenditure approach to calculating GDP (Ch12) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Figure 17.2Changes in Aggregate Demand Price Level (P) Real GDP (Y) AD AD” AD’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW There are four different sectors of an open economy that buy real goods and services; public consumption (C), business investment and public spending on housing (I), government spending (G), and exports and imports (X-M) Changes in any of these factors shifts the AD curve Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The largest component of aggregate demand is generally consumption (C) Public consumption can change for a number of reasons not related to the price level Changes in consumer expectations about the course of economic events can change current consumption The more confident consumers are about the future, the more likely they are to consume today This would shift the AD curve to the right Lower confidence levels would shift the curve to the left Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The degree of consumer indebtedness also effects consumption and aggregate demand High levels of indebtedness from past consumption financed by borrowing must be paid off and consumers may need to reduce current consumption As consumer spending falls, the AD curve shifts left Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The government can affect consumption and aggregate demand by adjusting the level of taxes Higher taxes (or lower transfer payments) reduce society’s after tax income The lower income leads to lower consumption spending and the AD curve shifts to the left Of course, lower taxes (or higher transfer payments) increase after tax income, thus consumption, and the AD curve shifts to the right Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Investment spending (I) is even more unstable than consumption spending Investment spending is sensitive to higher interest rates If interest rates change, holding price levels constant (as in Ch15), aggregate demand will change as investment responds to interest rate changes Higher interest rates tend to decrease business and housing investment (shift AD left) and lower interest rates tend to increase it (shift AD right) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW As economic conditions change, expectations of future economic conditions generally change in the same direction causing a change in investment spending The government can also change the level of business taxation Increases or decreases in the level of business taxes tend to raise or lower investment spending Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Government spending (G) can also influence the level of aggregate demand As government spending on goods and services increases, aggregate demand increases The opposite is also true Government spending at federal, state or local level in most countries is a sufficiently large component of total spending and has a noticeable impact on aggregate demand even when spending changes are small Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Aggregate demand may change because of changes in exports (X) and imports (I) These are caused primarily by changes in incomes and the exchange rate Exports are very sensitive to change in incomes in foreign countries As foreign incomes increase, exports from the U.S. tend to increase which increases aggregate demand As foreign incomes decline, exports fall and aggregate demand decreases Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The faster the economic growth in the rest of the world, the greater will be the change in U.S. aggregate demand Movements in the real exchange rate can also affect the level of exports and imports As the dollar depreciates, a unit of foreign currency will buy more U.S. goods and a dollar will buy fewer foreign goods This causes a change in aggregate demand As exports and imports are a relatively small part of the U.S. GDP, this is a trivial effect Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Table 17.1Determinants or Factors that Shift the Aggregate Demand Curve Change in Consumption Spending Change in Consumer Wealth Change in Consumer Expectations Change in Consumer Indebtedness Change in Taxes Change in Investment Spending Change in Interest Rate Change in Business Expectations Change in Business Taxes Change in Government Spending Change in Federal, State, and Local Government Spending Change in Exports and Imports Change in Foreign Incomes Change in Exchange Rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Aggregate Supply Aggregate supply is the relationship between the total quantity of goods and services an economy produces at various price levels, holding all other determinants of production unchanged The aggregate supply (AS) curve slopes upward to the right As price level rises, quantity of goods and services the economy produces increases Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Figure 17.3The Aggregate Supply Curve Price Level (P) P1 P0 Y1 Y0 Real GDP (Y) Aggregate Supply (AS) B A Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW The aggregate supply represents the entire economy’s total production in the short-run Higher price levels bring higher levels of total production in the economy We assume that in the short-run, labor force, capital stock, stock of natural resources, and level of technology are held constant If the price level increases, everything else constant, the aggregate quantity supplied increases Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Changes in Aggregate Supply A change in the aggregate supply means that the per-unit production costs are rising (or falling) for some reason unrelated to an increase in production/output An increase in aggregate supply will shift the curve to right At any given price level, firms are willing and able to produce more goods and services Or, Firms can produce the same level of output at lower unit costs Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 – ‹#› AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW Figure 17.4Changes in Aggregate Supply