Chapter 17 (6)
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 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
98 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
Macroeconomic Policies and the Current Account
Gradual Trade Flow Adjustment and Current Account Dynamics
The J-Curve
Exchange Rate Pass-Through and Inflation
◼ 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
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
Chapter 17 (6) Output and the Exchange Rate in the Short Run 99
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-
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
100 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ Answers to Textbook Problems
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 (below) as a rightward shift in the output market schedule from DD to DD. If the tariff is
3. A temporary fiscal policy shift affects employment and output, even if the government maintains a
balanced budget. An intuitive explanation for this relies upon the different propensities to consume
of the government and of taxpayers. If the government spends $1 more and finances this spending
4. A permanent fall in private aggregate demand causes the DD curve to shift inward and to the left and,
because the expected future exchange rate depreciates, the AA curve shifts outward and to the right.
Chapter 17 (6) Output and the Exchange Rate in the Short Run 101
5. Figure 17(6)-2 (below) can be used to show that any permanent fiscal expansion worsens the current
account. In this diagram, the schedule XX represents combinations of the exchange rate and income
for which the current account is in balance. Points above and to the left of XX represent current
account surplus, and points below and to the right represent current account deficit. A permanent fiscal
6. A temporary tax cut shifts the DD curve to the right and, in the absence of monetization, has no effect
on the AA curve. In Figure 17(6)-3, this is depicted as a shift in the DD curve to DD, with the
equilibrium moving from points 0 to 1. If the deficit is financed by future monetization, the resulting
expected long-run nominal depreciation of the currency causes the AA curve to shift to the right to
102 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
7. A currency depreciation accompanied by a deterioration in the current account balance could be
caused by factors other than a J-curve. For example, a fall in foreign demand for domestic products
8. The expansionary money supply announcement causes a depreciation in the expected long-run
exchange rate and shifts the AA curve to the right. This leads to an immediate increase in output
and a 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(6)-5. The effects of
a temporary fiscal expansion, depicted as a shift in the output market curve to DD, would not be
Chapter 17 (6) Output and the Exchange Rate in the Short Run 103
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
zero. Instead, we define the variable z = (q EX*)/EX. This variable is the ratio of imports to exports,
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.
As shown in Figure 17(6)-6, the permanent fiscal expansion will shift the output market curve from
DD to DD and is matched by an inward shift of the asset market equilibrium curve. If import prices
are not in the CPI and the currency appreciation does not affect the price level, the asset market curve
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
because it causes the expected future exchange rate to appreciate. A permanent rise in government
104 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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
because of its effect on the long-run exchange rate and shifts the DD curve because of its effect on
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
level following a permanent fiscal expansion. A permanent fiscal expansion cannot have an effect on
the long-run price level because there is no effect on the money supply or the long-run values of the
Chapter 17 (6) Output and the Exchange Rate in the Short Run 105
16. It is difficult to see how government spending can rise permanently without increasing taxes or how
taxes can be cut permanently without cutting spending. Thus, a truly permanent fiscal expansion is
17. High inflation economies should have higher pass-through as price setters are used to making adjustments
faster (menu costs fall over time as people learn how to change prices faster). Thus, a depreciation in
18. A “buy American” provision would have resulted in a larger rightward shift in the DD curve than an
unconstrained increase in government spending because there will be a greater demand for U.S.
output than if some imported goods could have been purchased with the stimulus funds. However, if this
19. Many answers are possible.