978-0132146654 Chapter 17 Lecture Notes

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88 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

Chapter 17

Output and the Exchange Rate

in the Short Run

.1  Chapter Organization

Determinants of Aggregate Demand in an Open Economy

Determinants of Consumption Demand

Determinants of the Current Account

How Real Exchange Rate Changes Affect the Current Account

How Disposable Income Changes Affect the Current Account

The Equation of Aggregate Demand

The Real Exchange Rate and Aggregate Demand

Real Income and Aggregate Demand

How Output Is Determined in the Short Run

Output Market Equilibrium in the Short Run: The DD Schedule

Output, the Exchange Rate, and Output Market Equilibrium

Deriving the DD Schedule

Factors That Shift the DD Schedule

Asset Market Equilibrium in the Short Run: The AA Schedule

Output, the Exchange Rate, and Asset Market Equilibrium

Deriving the AA Schedule

Factors That Shift the AA Schedule

Short-Run Equilibrium for the Economy: Putting the DD and AA Schedules Together

Temporary Changes in Monetary and Fiscal Policy

Monetary Policy

Fiscal Policy

Policies to Maintain Full Employment

Inflation Bias and Other Problems of Policy Formulation

89 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

Permanent Shifts in Monetary and Fiscal Policy

A Permanent Increase in the Money Supply

Adjustment to a Permanent Increase in the Money Supply

A Permanent Fiscal ExpansionMacroeconomic Policies and the Current Account

Gradual Trade Adjustment and Current Account Dynamics

The J-Curve

Exchange Rate Pass-Through and Inflation

Box: Exchange Rates and the Current Account

The Liquidity Trap

Summary

APPENDIX 1 TO CHAPTER 17: Intertemporal Trade and Consumption Demand

APPENDIX 2 TO CHAPTER 17: The Marshall-Lerner Condition and Empirical Estimates

of Trade Elasticities

Online Appendix: The IS-LM and the DD–AA Model

.2  Chapter Overview

This chapter integrates the previous analysis of exchange rate determination with a model of short-run

output determination in an open economy. The model presented is similar in spirit to the classic

Mundell-Fleming model, but the discussion goes beyond the standard presentation in its contrast of the

effects of temporary versus permanent policies. The distinction between temporary and permanent policies

allows for an analysis of dynamic paths of adjustment rather than just comparative statics. This dynamic

analysis brings in the possibility of a J-curve response of the current account to currency depreciation. The

chapter concludes with a discussion of exchange rate pass-through, that is, the response of import prices to

exchange rate movements.

The chapter begins with the development of an open-economy fixed-price model. An aggregate demand

function is derived using a Keynesian cross diagram in which the real exchange rate serves as a shift

parameter. A nominal currency depreciation increases output by stimulating exports and reducing imports,

given foreign and domestic prices, fiscal policy, and investment levels. This yields a positively sloped

output-market equilibrium (DD) schedule in exchange rate output space. A negatively sloped asset-market

equilibrium (AA) schedule completes the model. The derivation of this schedule follows from the analysis

of previous chapters. For students who have already taken intermediate macroeconomics, you may want to

point out that the intuition behind the slope of the AA curve is identical to that of the LM curve, with the

additional relationship of interest parity providing the link between the closed-economy LM curve and the

open-economy AA curve. As with the LM curve, higher income increases money demand and raises the

home-currency interest rate (given real balances). In an open economy, higher interest rates require currency

appreciation to satisfy interest parity (for a given future expected exchange rate).

The effects of temporary policies as well as the short-run and long-run effects of permanent policies can be

studied in the context of the DD–AA model if we identify the expected future exchange rate with the

long-run exchange rate examined in Chapters 15 and 16. In line with this interpretation, temporary policies

are defined to be those which leave the expected exchange rate unchanged, while permanent policies are

those which move the expected exchange rate to its new long-run level. As in the analysis in earlier

chapters, in the long run, prices change to clear markets (if necessary). While the assumptions concerning the

expectational effects of temporary and permanent policies are unrealistic as an exact description of an

economy, they are pedagogically useful because they allow students to grasp how differing market

Chapter 17 Output and the Exchange Rate in the Short Run 90

expectations about the duration of policies can alter their qualitative effects. Students may find the

distinction between temporary and permanent, on the one hand, and between short run and long run, on the

other, a bit confusing at first. It is probably worthwhile to spend a few minutes discussing this topic.

Both temporary and permanent increases in money supply expand output in the short run through exchange

rate depreciation. The long-run analysis of a permanent monetary change once again shows how the

well-known Dornbusch overshooting result can occur. Temporary expansionary fiscal policy raises output

in the short run and causes the exchange rate to appreciate. Permanent fiscal expansion, however, has no

effect on output even in the short run. The reason for this is that, given the assumptions of the model, the

currency appreciation in response to permanent fiscal expansion completely “crowds out” exports. This is

a consequence of the effect of a permanent fiscal expansion on the expected long-run exchange rate which

shifts inward the asset-market equilibrium curve. This model can be used to explain the consequences of

U.S. fiscal and monetary policies between 1979 and 1984. The model explains the recession of 1982 and

the appreciation of the dollar as a result of tight monetary and loose fiscal policy.

The chapter concludes with some discussion of real-world modifications of the basic model. Recent

experience casts doubt on a tight, unvarying relationship between movements in the nominal exchange rate

and shifts in competitiveness and thus between nominal exchange rate movements and movements in the

trade balance as depicted in the DD–AA model. Exchange rate pass-through is less than complete and thus

nominal exchange rate movements are not translated one-for-one into changes in the real exchange rate.

Also, the current account may worsen immediately after currency depreciation. This J-curve effect occurs

because of time lags in deliveries and because of low elasticities of demand in the short run as compared to

the long run. The chapter contains a discussion of the way in which the analysis of the model would be

affected by the inclusion of incomplete exchange rate pass-through and time-varying elasticities. Appendix 2

provides further information on trade elasticities with a presentation of the Marshall-Lerner conditions and

a reporting of estimates of the impact of short-run and long-run elasticities of demand for international

trade in manufactured goods for a number of countries.

A discussion of how the current account balance can affect the exchange rate is also illuminating: a country

running a persistent current account deficit will experience a loss in net foreign wealth, which in turn may

depreciate the currency given home biases in consumption. This observation is matched with U.S. data to

illustrate that fiscal expansions in the United States that initially lead to currency appreciations and current

account deficits will, over time, lead to depreciations in the dollar. The chapter concludes with the efficacy

of monetary policy in a liquidity trap. When nominal interest rates are at zero (as they effectively were in

the United States in 2010), any attempt to stimulate the economy through monetary expansion will be

ineffective given that interest rates cannot fall below zero. A modification of the DD–AA model shows that

for a country in a liquidity trap, a section of the AA curve is perfectly elastic. In fact, monetary policy can

only affect output by changing the expected exchange rate. This may explain the unconventional monetary

policies recently taken by the Federal Reserve such as the purchase of long-term government bonds.