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Chapter 11.2 11.4 Heiko Lampe Aggregate demand and output 11.

1.1 Overview This chapter will take the Keynesian assumption that prices are constant as a starting point. In this chapter the exchange rates will enter the game and we will observe, what the Keynesian model is. The broad overview can be deducted from the figure below.

11.2 Short-run fluctuations output, employment and unemployment In the short run capital is fixed. Firms can alter their production by labor usage, extra hours and so on. Thus they deviate from their original output trend, which is described as an output gap. The relation between output growth and unemployment is known as Okuns Law. A certain amount of output is linked to a certain amount of unemployment, holding the number of workers fixed and the hours worked per worker. This can be represented in a graph like: Ubar

U-Ubar = -g(Y-Ybar) U= real unemployment rate Ubar= medium run / trend /Blanchard g = constant factor Y = real GDP growth Ybar = growth trend GDP Ybar

An increase of output in this model is possible when decreasing unemployment.

11.3 The IS-LM Model in the open economy Exogenous variables are given and do not have to be explained. Endogenous variables have to be explained in the model. Some variables are exogenous or endogenous depending on the exchange rate regime. When the nominal exchange rate is fixed, the real exchange rate is exogenous if we assume the foreign and domestic prices to be constant. As discussed earlier, the total output is dependent of consumption, Investments and government spending. Now we add to all this PCA, the primary current account. Thus the exports and import enter the scene. PCA = X-Z = ExportsImports. Import function: Z = Z(A, ) with A= domestic Absorption(C+I+G) and = real exchange rate + + Export function: X = X(A*, ) with A*= total foreign Absorption + If the domestic Absorption increases, the imports will increase, an increase in the exchange rate will make it cheaper to buy outside and will increase imports as well. Of course the latter effect is reversed for the export function. If the Absorption in the foreign country increases however, the exports will increase as well. For PCA = X Z follows: PCA = PCA (A, A*, ) - + The current account function can now be written as PCA = PCA (Y, Y*, ) since the dependence on A is fundamentally a dependence on A - + Coming back to the 45 degree diagram with an open economy will give the same picture as before. The DD-Equation is now a little longer and looks like: DD = C (, Y T) + I(i, q) + G + PCA (Y, Y*, ) Here the q in the Investment function is Tobins q. The graph looks the same, but the DD line is flatter to account for the fact, that the PCA declines as income increases, because more is imported from abroad, reducing the net effect of an income increase. The next graph will show how output adjusts to desired demand. If the DD line shifts upward (due to an increase in government spending for example), the demand goes up to point B, motivating the producers to increase production. The higher production leads to higher income and thus new demand, resulting in the producers to increase their production again. Thus we will end up in the new equilibrium point. What is important is that the GDP or output will increase more than the initial increase in government spending and there is a multiplier effect, the demand multiplier. This is mathematically easily explained with the flatter DD line. However, the graph is on the next page and it should not give any problems to follow the steps.

The multiplier and the slope of the IS curve are interlinked. The larger the multiplier, the flatter is the curve. This is due to the larger output increase resulting from a shift of the DD curve. Graphically:

If the DD becomes flatter due to a including of PCA (some effects are taken out of the country via imports), the IS curve gets steeper. The shift has the same extent, but the equilibrium output will be lower. Consequently, the IS gets steeper. If marginal propensity to consume goes up, DD gets steeper. If marginal propensity to import goes up, DD gets flatter. If the PCA goes up, the DD gets steeper as well

The multiplier is finite, because of leakages. An increase in GDP is not fully translated into new domestic demand via higher income. There are three leakages: Taxes, savings and imports. The higher income may be saved, go to the government or be used to import. Thus the multiplier is dependent of the marginal propensity to save and import. It is important to distinguish between shifts of and movements along the IS curve. Every change of an exogenous variable shifts the curve. A change of an endogenous variable causes a movement along the curve. The small country assumption says that the domestic situation does not influence the foreign. The foreign rate of return i* is exogenous. So if you can get money in the domestic market and invest it in the foreign market at a better price, this is called arbitrage, you will make the interest rate in the domestic market change and adjust. Overall, with the expected exchange rate development the interest you can earn domestically and in the foreign market are after changing your money back the same. This phenomenon is called interest parity. i=i* the domestic return is equal to the foreign return. Since in this course the exchange rates are fixed that means that the interest rates in both countries are the same and the small country adjusts to changes in the big one (like Germany and The Netherlands years ago). The LM curve is not directly affected by the interest parity condition. It just describe the equilibrium in the domestic money market. Due to the small country assumption however, the adjustment of the interest has to come over the money market. In addition to that the money supply has to be regulated to hold the exchange rate fixed.

Of course it is important to distinguish again between movements along the LM and shifts of the LM. Here real money supply and the transaction costs are exogenous. In the Figure on this page the exogenous change of nominal money supply shifts the curve.

In this chapter we assume the wages and prices to be fixed. We can ignore the labor market, because it will adjust passively. Supply adjusts on all markets to the demand. This is the key issue of the Keynesian approach to macroeconomic. In addition to that

this chapter allows us to connect with the rest of the world by opening the economy. This opening is to search in the IS curve. The LM curve stays unaffected. The international financial market replaces the labor market and we have three markets again to bring them into one general equilibrium. The international financial market is just the fact that you should get the same return everywhere. This is not dependent of GDP. The financial integration line captures this:

interest rate


financial integration line

GDP i* is the foreign interest rate Bringing this together with the usual IS-LM-Model gives us the Mundell-Fleming model and looks like the graph below IS LM

interest rate


financial integration line

GDP Here we can observe the equilibrium of all three markets in point E. The rest of this chapter will explain how GDP and interest rate respond on various exogeneous disturbances. The approach is always the same: Find out which of the three curves will shift What has to happen to make them go through one point again? How does the economy move from one to the other equilibrium? This has to be, because none of the markets can be in disequilibrium for a long time. The financial integration line has to come to an equilibrium, because arbitrage does not last long. The goods market will adjust with inventory and output movements. The money market will clear very fast as well.

11.4 output and interest rate determination under fixed exchange rates An increase of the money supply will lead to a right shift of the LM-curve. Now there are three possibilities: either the IS curve restores the equilibrium, or the financial integration line, or the LM curve shifts back! Since the exchange rate is fixed, a decrease of the interest rate would bring a lot of domestic investors out of the country. This would give pressure on the exchange rate, forcing the authorities to buy back the own currency by using foreign assets. Finally that will decrease the money supply and the LM curve will shift back again.
An increase in the money supply implies a rightward shift of the LM. At point B (with a lower interest rate) capital outflows force the central bank to intervene and the money supply contracts, until the economy returns to point A. Monetary policy is ineffective.

This result leads us to the experience that the LM curve is endogenous and will adjust always. So monetary policy is ineffective under fixed exchange rates. This problem resulted in the invention of capital controls. In some countries it is not possible to bring capital freely out of the country. So the domestic interest rate is a bit independent of the world market, allowing for adjustments, which would be impossible without the restrictions. If any exogenous factor changes and the demand is increased, the results can be observed in figure 11.14. The new IS-LM intersects comes along with a higher interest rate and will thereby affect investments negatively which is called crowding out. The LM will shift out, because of the capital inflow.