Economics Chapter 18 Homework In the short run, however, incomplete price adjustment

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18 Balance of Payments II: Output, Exchange Rates, and

Macroeconomic Policies in the Short Run

Notes to Instructor

Chapter Summary

This chapter develops a standard short-run macroeconomic model for the open economy.

It begins with an overview of the components of demand and their determinants, then

derives a goods market equilibrium using the Keynesian cross. The next two sections

derive the IS and LM curves in the open economy. In Section 5, the foreign exchange

market is added to produce the standard IS–LM–FX model. The final section concludes

with an analysis of stabilization policy. The model presented here will be used in

applications in Chapter 19.

Comments

This chapter is very dense because it combines material that would easily take several

weeks to cover in an intermediate macroeconomics course. For those classes in which

intermediate macroeconomic theory is a prerequisite, this material can be taught

relatively quickly, emphasizing the richer role of the trade balance in equilibrium

outcomes. For these students, Sections 1 through 4 probably can be condensed, treating

everything except for the trade balance function as review. For those who have not yet

taken an intermediate macroeconomic theory course, this chapter may require more time

than previous chapters in the text.

It is worth emphasizing that this is a general equilibrium model of the economy.

1. Demand in the Open Economy

a. Preliminaries and Assumptions

b. Consumption

i. Marginal Effects

c. Investment

d. The Government

e. The Trade Balance

i. The Role of the Real Exchange Rate

ii. The Role of Income Levels

iii. Headlines: Oh! What a Lovely Currency War

iv. Headlines: The Curry Trade

v. Application: The Trade Balance and the Real Exchange Rate

f. Exogenous Changes in Demand

i. Side Bar: Barriers to Expenditure Switching: Pass-Through and the J

Curve

2. Goods Market Equilibrium: The Keynesian Cross

a. Supply and Demand

b. Determinants of Demand

c. Factors That Shift the Demand Curve

d. Summary

3. Goods and Forex Market Equilibria: Deriving the IS Curve

a. Equilibrium in Two Markets

4. Money Market Equilibrium: Deriving the LM Curve

a. Money Market Recap

b. Deriving the LM Curve

c. Factors That Shift the LM Curve

d. Summing Up the LM Curve

5. The Short-Run IS‒LM‒FX Model of an Open Economy

a. Macroeconomic Policies in the Short Run

i. Temporary Policies, Unchanged Expectations

b. Monetary Policy Under Floating Exchange Rates

c. Monetary Policy Under Fixed Exchange Rates

d. Fiscal Policy Under Floating Exchange Rates

6. Stabilization Policy

a. Application: The Right Time for Austerity

b. Problems in Policy Design and Implementation

i. Policy Constraints

ii. Incomplete Information and the Inside Lag

iii. Policy Response and the Outside Lag

iv. Long-Horizon Plans

v. Weak Links from the Nominal Exchange Rate to the Real Exchange Rate

vi. Pegged Currency Blocs

vii. Weak Links from the Real Exchange Rate to the Trade Balance

c. Application: Macroeconomic Policies in the Liquidity Trap

7. Conclusions

8. Appendix 1: The Marshall‒Lerner Condition

Lecture Notes

This chapter connects exchange rate movements to the national economy using the IS‒

LM model. By combining the theories of exchange rate determination with the balance of

payments accounting, we can better understand how exchange rate movements affect key

variables, such as net exports, capital flows, interest rates, and output.

1 Demand in the Open Economy

In previous chapters, we took the level of output as a given, allowing us to abstract from

fluctuations in the goods market. This assumption is acceptable for long-run economic

Preliminaries and Assumptions

■ Home and foreign price levels, and , are constant so expected inflation is

zero ( = 0).

■ Government spending and taxes are fixed: and .

Consumption

Consumption, C, is a function of disposable income, Yd = Y − :

C = C(Y − )

The assumption is that as disposable income rises, consumption increases. This is known

as the Keynesian consumption function. Note that this differs significantly from the

Marginal Effects The slope of the consumption function is the marginal propensity to

consume (MPC) and is assumed to be between zero and one. This is the fraction of each

additional dollar in disposable income that is spent on consumption.

Investment

Firms engage in capital investment projects only when the real return on the project

exceeds the cost of borrowing. The firm’s borrowing cost is the expected real interest

The Government

The government collects taxes, T, from households and spends government

consumption, G, on goods and services. Government consumption does not include

spending on government transfer programs, which are designed to redistribute income

between households.

The government’s tax revenue may not exactly equal its government consumption

spending.

■ G > T: Budget deficit

■ G < T: Budget surplus

■ G = T: Balanced budget

Fiscal policy refers to decisions about taxes and government consumption. Based on our

assumptions, these values are taken as given:

The Trade Balance

The quantities of exports and imports, and therefore the trade balance, are all directly

affected by exchange rates. We need to study the variables that influence the trade

The Role of the Real Exchange Rate The change in spending patterns in response to

exchange rate fluctuations is known as expenditure switching (between foreign and

home purchases).

Recall that the real exchange rate is defined as

We can use this expression to understand how expenditure switching works:

■ ↑ q → real depreciation of the home currency ‒ foreign goods are relatively more

The Role of Income Levels When income rises, people generally buy more of

everything, including imports. But we need to realize that our exports are other countries’

imports. And, of course, our imports are their exports. That means an increase in home

income increases home imports and foreign exports. Similarly, an increase in foreign

income increases foreign imports and home exports.

The home country’s income also affects the trade balance:

■ ↑ Y → home country increases spending on all goods → home country imports

rise → ↓ TB

■ ↓ Y → home country decreases spending on all goods → home country imports

fall → ↑ TB

Finally, the foreign country’s income affects the trade balance:

■ ↑ Y* → foreign country increases spending on all goods → home country exports

rise → ↑ TB

The trade balance is illustrated as a function of the real exchange rate shown in Figure

18-3. The trade balance is a positive function of the real exchange rate, in which an

H E A D L I N E S

The Curry Trade

In 2009, the British pound weakened dramatically vis-à-vis the euro. That led to some

interesting changes in trade across the English Channel.

A number of British citizens live in France. With the strong euro, they found it

costless to import food from the U.K. than to buy those items—even many French

specialty items—in local (French) stores. Croissants, baguettes, and even French wine

ended up in the shopping baskets of customers of Sterling Shopping, a British delivery

firm. That company ran five delivery vans full of food every week to France.

Discussion Questions:

■ Shipping French food products to the United Kingdom, then shipping them back

to France is costly. Given these high transportation costs, explain how it is

Here’s a graph of the pound‒euro exchange rate from 1999 through November 2010.

The effect of a change in output on the trade balance can be thought of in terms of the

marginal propensity to consume. Let MPCF denote the marginal propensity to consume

foreign imports and MPCH denote the marginal propensity to consume home goods and

services:

APPLICATION

The Trade Balance and the Real Exchange Rate

Figure 18-4 reports the real effective exchange rate relative to the trade balance in the

United States, 1975 to 2006. The real effective exchange rate measures real depreciation

and appreciation in the United States relative to a basket of other countries (weighted by

how much the United States trades with each country). This provides a comprehensive

measure of how real exchange rate fluctuations affect the trade balance.

From the data, we observe that the real effective exchange rate has a positive

relationship with the trade balance, as predicted by the model. This correlation is not

perfect because there appears to be a lag between when a real depreciation (appreciation)

occurs and when the trade balance increases (decreases). This lag is attributed to the

exchange rate pass-through and the J curve effect (discussed in detail in Side Bar:

Barriers to Expenditure Switching: Pass–Through and the J Curve).

Exogenous Changes in Demand

This section considers the sources of exogenous shocks to demand:

■ An exogenous change in consumption shifts the consumption function. Panel (a)

of Figure 18-6 shows an exogenous increase in consumption. When there is an

exogenous increase in consumption, the consumption function shifts up. For any

given level of disposable income, consumption increases, shifting the

■ An exogenous change in investment shifts the investment function. Figure 18-6,

panel (b), shows an exogenous increase in investment. An exogenous increase in

■ An exogenous change in the trade balance shifts the trade balance function. Panel

exogenous increase in the trade balance shifts the trade balance function up. For

S I D E B A R

Barriers to Expenditure Switching: Pass–Through and the J Curve

There are two key mechanisms at work when the real exchange rate changes.

■ A nominal depreciation is associated with a real depreciation (because prices are

fixed).

Trade Dollarization, Distribution, and Pass–Through

We assumed that all prices are set in local currency and that these prices are fixed in the

short run. In reality, some home goods may be priced in foreign currency. To understand

how this affects trade, define these two pricing schemes (treating the United States as the

foreign country):

■ = sticky U.S. dollar price–share d of all goods in the home country basket

This shows how a change in the nominal exchange rate may not fully pass through to

the real exchange rate. A 1% increase in E leads to a (1 − d)% increase in q. This is

known as exchange rate pass-through—the degree to which changes in nominal

exchange rates are passed through to real exchange rates. In the model given in the text,

we assume d = 0.

Table 18-1 reports the shares of exports and imports denominated in U.S. dollars and

The J Curve

A real depreciation improves a country’s trade balance through boosting exports and

reducing imports. In reality, this process takes time because orders for exports and

imports are placed in advance and the payment occurs much later, at the time of delivery.

It may take time for firms and intermediaries to fully adjust their orders.

Although exports continue to sell, for a time, in the same quantity at the same

2 Goods Market Equilibrium: The Keynesian Cross

This section uses the traditional Keynesian cross approach to goods market equilibrium.

Supply and Demand

The total aggregate supply of final goods and services is equal to total output, GDP − Y:

We know that the national income accounting identity says the supply of output is equal

to the demand for final goods and services. The demand for goods and services is given

by the previous components:

condition:

Determinants of Demand

The factors that can affect demand include

■ Home and foreign output (Y and Y*)

We begin by analyzing the impact of a change in home output. Suppose Y rises by $1.

Consumption spending will rise by +$MPC. And imports will rise by +$MPCF. The trade

balance will change by −$MPCF. The net change in aggregate demand will be $(MPC −

$MPCF) = $MPCH. In other words, a $1 increase in output will be divided three ways:

higher spending on domestically produced goods ($MPCH), higher spending on foreign-

So far our graph includes only aggregate demand:

When demand is graphed against output (income, Y), the slope of the line will be less

than 1.0. This graph shows how demand changes as Y changes. What is the one point at

which spending equals output?

To answer that question, we need another line in our graph, the line showing all

To see why the goods market adjusts to equilibrium, consider the following cases. Let

Y1 denote the equilibrium (point 1 in Figure 18-7).

Factors That Shift the Demand Curve

In the following examples, the first example is illustrated in panel (b) of Figure 18-6 (as

an increase in demand).

■ Government purchases:

■ Taxes (or other exogenous factors affecting consumption):

■ Interest rate: i

■ Nominal exchange rate: E

■ Home or foreign price levels: ,

↑ ⇒ ↓ q = ( /) ⇒ ↓ TB ⇒ D shifts downward ⇒ ↓ Y

Summary

The Keynesian cross is derived from the relationship between the demand for goods and

services, which depends on income, and their supply, or output, Y. Changes in demand

not associated with changes in output (Y) lead to a shift in the demand curve for goods

and services.

3 Goods and Forex Market Equilibria: Deriving the IS Curve

To derive the economy’s general equilibrium, we must consider the equilibrium in three

markets: the goods market, the money market, and the forex market. Students probably

will be familiar with the concept of general equilibrium (even if this term was not

explicitly used in earlier coursework). More advanced students will already be familiar

with the IS‒LM equilibrium used in this chapter and subsequent chapters.

Equilibrium in Two Markets

In the IS‒LM diagram, we study equilibrium in three markets: the goods market, the

forex market (IS), and the money market (LM). This section focuses on the IS curve.

The IS curve shows combinations of output Y and interest rate i in which the goods

and the forex markets are in equilibrium.

Forex Market Recap

The forex market equilibrium is given by the uncovered interest parity (UIP) condition:

Deriving the IS Curve

This section derives the shape of the IS curve through examining changes in the interest

rate.

Initial Equilibrium Using the diagrams, the equilibrium output and interest rate are

given from the goods market and forex market:

■ Goods market: The level of output from the goods market equilibrium must be a

A Fall in the Interest Rate To derive the IS curve, consider how a change in the interest

rate affects the demand for goods and the forex market. Figure 18-8 illustrates how a

decrease in the interest affects the two markets: