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Chapter 17
Output and the Exchange Rate
in the Short Run
◼ 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.
Permanent Shifts in Monetary and Fiscal Policy.
A Permanent Increase in the Money Supply.
Adjustment to a Permanent Increase in the Money Supply.
120 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
A Permanent Fiscal Expansion.
Macroeconomic Policies and the Current Account.
Gradual Trade Flow Adjustment and Current Account Dynamics.
The J-Curve.
Exchange Rate Pass-Through and Inflation.
Box: Understanding Pass-Through to Import and Export Prices.
The Current Account, Wealth, and Exchange Rate Dynamics.
The Liquidity Trap.
Case Study: How Big Is the Government Spending Multiplier?
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
◼ 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
Chapter 17 Output and the Exchange Rate in the Short Run 121
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 (4) and 16 (5). In line with this interpretation, temporary
policies are defined to be those that leave the expected exchange rate unchanged, while permanent policies
are those that 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). Although 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
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 the asset-market equilibrium curve inward. 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.
Furthermore, the degree of exchange rate pass through will depend on the currency that exports are
invoiced in as well as whether an exchange rate change was caused by a change in output demand (less
pass-through) or a change in asset demand (more pass-through). 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
122 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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.
◼ Answers to Textbook Problems
1. A decline in investment demand decreases the level of aggregate demand for any level of the
2. A tariff is a tax on the consumption of imports. The demand for domestic goods, and thus the level of
aggregate demand, will be higher for any level of the exchange rate. This is depicted in Figure 17(6)-1
Chapter 17 Output and the Exchange Rate in the Short Run 125
© 2018 Pearson Education, Inc.
currency depreciation. The effects of the anticipated policy action thus precede the policy’s actual
implementation.
9. The DD curve might be negatively sloped in the very short run if there is a J-curve, though the absolute
value of its slope would probably exceed that of AA. This is depicted in Figure 17-5. The effects of a
Figure 17-5
10. The derivation of the Marshall-Lerner condition uses the assumption of a balanced current account to
substitute EX for (q EX*). We cannot make this substitution when the current account is not initially
11. If imports constitute part of the CPI, then a fall in import prices due to an appreciation of the currency
will cause the overall price level to decline. The fall in the price level raises the real money supply.
126 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
not in the CPI and the currency appreciation does not affect the price level, the asset market curve
shifts to AA, and there is no effect on output, even in the short run. If, however, the overall price
level falls due to the appreciation, the shift in the asset market curve is smaller, to AA, and the initial
equilibrium point, point 1, has higher output than the original equilibrium at point 0. Over time, prices
rise when output exceeds its long-run level, causing a shift in the asset market equilibrium curve from
AA to AA, which returns output to its long-run level.
Figure 17-6
12. An increase in the risk premium shifts the asset market curve out and to the right, all else being equal.
A permanent increase in government spending shifts the asset market curve in and to the right
13. Suppose output is initially at full employment. A permanent change in fiscal policy will cause both
the AA and DD curves to shift such that there is no effect on output. Now consider the case where the
economy is not initially at full employment. A permanent change in fiscal policy shifts the AA curve
Chapter 17 Output and the Exchange Rate in the Short Run 127
© 2018 Pearson Education, Inc.
price level (because M is constant). This fall in P in the long run would move AA and DD both out.
We could also consider the fact that in the case where we begin at full employment and there is no
impact on Y, AA was shifting back due to the real appreciation necessitated by the increase in demand
for home products (as a result of the increase in G). If there is a permanent increase in Y, there has
also been a relative supply increase that can offset the relative demand increase and weaken the need
for a real appreciation. Because of this, AA would shift back by less. We do not know the exact effect
without knowing how far the lines originally move (the size of the shock), but we do know that
without the restriction that Y is unchanged in the long run, the argument in the text collapses, and we
can have both short-run and long-run effects on Y.
14. We are given that the central bank in the economy can keep both interest rates and exchange rates
fixed. Thus, we need to only consider the goods side of the economy. The goods market equilibrium
is Y = (1 − s)Y + I + G + aE − mY. Collecting terms and solving for Y yields:
15. The text shows output cannot rise following a permanent fiscal expansion if output is initially at its
long-run level. Using a similar argument, we can show that output cannot fall from its initial long-run
Chapter 17 Output and the Exchange Rate in the Short Run 129
© 2018 Pearson Education, Inc.
domestic interest rate R were to increase, then it must be the case that the domestic currency is
expected to depreciate. However, this cannot be. When output rises above full employment, there is
excess demand. If the currency were to depreciate, then this would only exacerbate this excess
demand. As such, it is impossible for an increase in government spending to increase output above
full employment.
Rather, the increase in government spending will cause the expected exchange rate to fall (expected
appreciation of the domestic currency), which in turn must cause the current exchange rate to fall
since R=R*. Looking at the expression for output we derived as , any increase in G will
be offset by a proportionate decrease in aE, leaving output unchanged. The larger the parameter a, the
smaller the appreciation of the domestic currency to an increase in government spending.
20. Start with the money market condition and plug in the approximation for interest rate
This makes intuitive sense. An increase in government spending that causes the exchange rate to fall
(currency depreciation) will have a smaller effect on output when output is sensitive to exchange rate
changes (larger value for a). The parameter b represents the responsiveness of money demand to
