Sawye
Sprinkle Chapter 17
Output and the Exchange Rate in the Short Run
C h a p t e r XXXXXXXXXX
To accompany
International Economics, 3e by Sawye
Sprinkle
PowerPoint slides created by Jeff Heyl
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Publishing as Prentice Hall
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CHAPTER ORGANIZATION
Introduction
Aggregate Demand and Aggregate Supply: A Review
Determinants of the Cu
ent Account
Exchange Rate Changes and Equili
ium Output in an Open Economy
Summary
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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
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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 deflato
The aggregate demand curve slopes downward to the right
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
Figure 17.1 The Aggregate Demand Curve
Price Level (P)
P1
P0
Y1
Y0
Real GDP (Y)
Aggregate Demand (AD)
B
A
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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
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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)
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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 equili
ium 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
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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
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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)
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
Figure 17.2 Changes in Aggregate Demand
Price Level (P)
Real GDP (Y)
AD
AD”
AD’
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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
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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 cu
ent 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
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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 bo
owing must be paid off and consumers may need to reduce cu
ent consumption
As consumer spending falls, the AD curve shifts left
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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
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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)
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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
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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
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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
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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 cu
ency 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
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
Table 17.1 Determinants 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
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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
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
Figure 17.3 The Aggregate Supply Curve
Price Level (P)
P1
P0
Y1
Y0
Real GDP (Y)
Aggregate Supply (AS)
B
A
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
The aggregate supply represents the entire economy’s total production in the short-run
Higher price levels
ing 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
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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
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AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
Figure 17.4 Changes in Aggregate Supply