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Prepared by:
Fernando Quijano
18
1
Goods Market
Equilibrium: The
Keynesian Cross
Money Market
Equilibrium: Deriving
the LM Curve
Stabilization Policy
Conclusions
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Introduction
To gain a more complete understanding of how an open
economy works, we now extend our theory and explore
what happens when exchange rates and output fluctuate
in the short run.
We examine how macroeconomic aggregates (including
output, income, consumption, investment, and the trade
balance) in response to shocks in an open economy.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
that home and foreign price levels, P and P*, are fixed
due to price stickiness. As a result of price stickiness,
e = 0. If prices are
expected inflation is fixed at zero,
fixed, all quantities can be viewed as both real and
nominal quantities in the short run because there is no
inflation.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Consumption
The simplest model of aggregate private consumption
relates household consumption C to disposable
income Yd.
This equation is known as the Keynesian consumption
function.
Marginal Effects The slope of the consumption function is
called the marginal propensity to consume (MPC). We
can also define the marginal propensity to save (MPS) as
1 MPC.
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Consumption
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
FIGURE 18-1
income, Y T.
The slope of the function is the marginal propensity to consume, MPC.
Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Investment
The firms borrowing cost is the expected real interest
rate re, which equals the nominal interest rate i minus
the expected rate of inflation e: re = i e.
Since expected inflation is zero, the expected real
interest rate equals the nominal interest rate, re = i.
Investment I is a decreasing function of the real interest
rate; that is, investment falls as the real interest rate
rises.
Remember that this is true only because when expected
inflation is zero, the real interest rate equals the nominal
interest rate.
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Investment
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
FIGURE 18-2
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
The Government
We will assume that the governments role is simple. It
collects an amount T of taxes from private households
and spends an amount G on government consumption
of goods and services.
Excluded from this concept are large sums involved in
government transfer programs, such as social security,
medical care, or unemployment benefit systems.
In the unlikely event that G = T exactly, we say that the
government has a balanced budget. If T > G, the
government is said to be running a budget surplus (of
size T G); if G > T, a budget deficit (of size G T or,
equivalently, a negative surplus of T G).
Government purchases = G = G
Taxes = T = T.
Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
T
,
Y
T
)
Increasing
function
Decreasing
function
Increasing
function
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FIGURE 18-3 (1 of 2)
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FIGURE 18-3 (2 of 2)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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APPLICATION
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APPLICATION
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-6 (1 of 3)
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FIGURE 18-6 (2 of 3)
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FIGURE 18-6 (3 of 3)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Substituting we have
D C(Y T ) I(i) G TBEP * / P ,Y T ,Y * T *
market equilibrium condition is
The goods
Y C (Y T ) I (i) G TB EP * / P , Y T , Y * T *
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Determinants of Demand
FIGURE 18-7 (a) (1 of 2)
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Determinants of Demand
FIGURE 18-7 (a) (2 of 2)
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Determinants of Demand
FIGURE 18-7 (b)
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Fall in taxes T
Rise in government spending G
Fall in the home interest rate i
Rise in the nominal exchange rate E
Rise in foreign prices P *
Fall in home prices P
Any shift up in the consumption function C
Any shift up in the investment function I
Any shift up in the trade balance function TB
Demand curve D
up
shifts
Increase in demand D
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
i
Domestic interest rate
Domestic return
i*
Foreign interest rate
Ee
1
E
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Chapter 15: Exchange Rates II: The Asset Approach in the Short Run
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Chapter 15: Exchange Rates II: The Asset Approach in the Short Run
FX Market Equilibrium: A
Numerical Example
The returns calculated in
Table 15-1 are plotted in
this figure.
The dollar interest rate is
5%, the euro interest rate
is 3%, and the expected
future exchange rate is
1.224 $/.
The foreign exchange
market is in equilibrium at
point 1, where the
domestic returns DR and
expected foreign returns
FR are equal at 5% and
the spot exchange rate is
1.20 $/.
Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.
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FIGURE 18-8 (1 of 3)
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FIGURE 18-8 (2 of 3)
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FIGURE 18-8 (3 of 3)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-9 (1 of 2)
Exogenous Shifts in
Demand Cause the IS
Curve to Shift
In the Keynesian cross in
panel (a), when the
interest rate is held
constant at i1 , an
exogenous increase in
demand (due to other
factors) causes the
demand curve to shift up
from D1 to D2 as shown,
all else equal. This
moves the equilibrium
from 1 to 2, raising
output from Y1 to Y2.
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FIGURE 18-9 (2 of 2)
Exogenous Shifts in
Demand Cause the IS
Curve to Shift
(continued)
In the IS diagram in panel
(b), output has risen, with
no change in the interest
rate.
The IS curve has
therefore shifted right
from IS1 to IS2.
The nominal interest rate
and hence the exchange
rate are unchanged in
this example, as seen in
panel (c).
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IS IS(G,T,i* , E e , P*, P)
Factors That Shift the IS Curve
Fall in taxes T
Demand curve D
IS curve
shifts
up
shifts right
Increase
in
demand
D
Increase in
and at a given
at a given
home
interest
rate
i
home
interest rate i
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Real
Real
money
supply
(18-2)
money
demand
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FIGURE 18-10 (1 of 2)
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FIGURE 18-10 (2 of 2)
FIGURE 18-11 (1 of 2)
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FIGURE 18-11 (2 of 2)
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LM LM(M / P )
Factors That Shift the LM Curve
LM curve
down or right
shifts
Decrease in
equilibrium home interest rate i
at given level of outputY
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
FIGURE 18-12 (1 of 2)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
FIGURE 18-13 (2 of 2)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-13 (1 of 2)
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FIGURE 18-13 (2 of 2)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-14 (1 of 2)
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FIGURE 18-14 (2 of 2)
depreciate, rising from E1 to E2. This depreciation is inconsistent with the pegged
exchange rate, so the policy makers cannot move LM in this way.
They must leave the money supply equal to M1. Implication: under a fixed
exchange rate, autonomous monetary policy is not an option.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-15 (1 of 3)
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FIGURE 18-15 (2 of 3)
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FIGURE 18-15 (3 of 3)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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FIGURE 18-16 (1 of 3)
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FIGURE 18-16 (2 of 3)
to G2 and would shift the IS curve to the right in panel (a) from IS1 to IS2, causing
the interest rate to rise from i1 to i2.
The domestic return would then rise from DR1 to DR2.
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FIGURE 18-16 (3 of 3)
appreciate, falling from E to E2. To maintain the peg, the monetary authority must
now intervene, shifting the LM curve down, from LM1 to LM2. The fiscal expansion
thus prompts a monetary expansion.
In the end, the interest rate and exchange rate are left unchanged, and output
expands dramatically from Y1 to Y2. The new equilibrium is at to points 2 and 2.
Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
Summary
To sum up: a temporary expansion of fiscal policy under
fixed exchange rates raises output at home by a
considerable amount. (The case of a temporary
contraction of fiscal policy would have similar but opposite
effects.)
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Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
6 Stabilization Policy
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6 Stabilization Policy
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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6 Stabilization Policy
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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6 Stabilization Policy
Chapter 18: Output, Exchange Rates, and Macroeconomic Policies in the Short Run
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