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# AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL

By Edwin Ross,2014-11-22 17:12
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AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL

THE COMPLETE SHORT-RUN OPEN ECONOMY

MACROECONOMIC MODEL

1. THE AGGREGATE GOODS MARKET The simple Keynesian Model.

EQUILIBRIUM: Y = C + I(i) + G (X M) dGSGS

NOTE:

1. Aggregate demand increases when C, I, G, or X increases or M d

decreases.

2. C is positively related to income (Y).

3. I is inversely related to the interest rate (i). d

4. X are positively related to foreign real income (Y) and positively GSf

related to the real exchange rate ( P x r/P) f\$ per SF1

5. M are positively related to Y and inversely related to the real GS

exchange rate.

A AD = C + I(i) + G (X M) dGSGS

o 45

Y Y 1

The aggregate goods market can be summarized with the IS curve, which shows all the combinations of the interest rate (i) and real output/income (Y) for

which the goods market is in equilibrium.

The IS curve shifts when:

1. Factors other than ?Y change consumption (C) i

2. Factors other than ?i change domestic investment (I) d 3. ?G (Fiscal Policy) 4. ?X GS 5. Factors other than ?Y change imports of goods

and services (M) GS

The IS curve DOES NOT shift when i or Y changes.

IS (Equil.:Y = C+I+G+X-M) dGSGS

Y

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2. THE AGGREGATE MONEY MARKET The money market is in

EQUILIBRIUM at the interest rate where the quantity of money demanded = the dsquantity of money supplied; M = M. This is demonstrated in the following

diagram.

s i M Quantity of Money Supplied

A di M Quantity of Money 1

Demanded

ds M, M

NOTE:

1. The quantity of money demanded is the amount of money people are willing to hold. It is positively related to income (Y) and inversely related to the interest rate (i).

2. The quantity of money supplied refers to certain financial assets “in circulation to the general public” (i.e. owned by or held by people and institutions other than banks and the government).

The money supply is assumed to be the sum of domestic currency held by the public and checFABle deposits at commercial banks. The size of the smoney supply (M) is determined by the Central Bank’s monetary policy. The Central Bank can change the money supply by buying and selling domestic government bonds (GB) or foreign exchange reserves (FXR). The equation below summarizes this:

CB CB

holdings of holdings of s ? M = ? GB + OFF FXR

Central Bank’s Central Bank’s

holdings of holdings of

domestic official foreign

government exchange reserves

bonds

The equation says that when the Central Bank buys government bonds or foreign

exchange reserves, the domestic money supply increases by a multiple of the amount of bonds or foreign exchange reserves purchased. When the Central Bank sells government bonds or foreign exchange reserves, the domestic money supply falls.

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The money market can be summarized by the LM curve, which shows all the combinations of the interest rate (i) and real output/income (Y) for which the

money market is in equilibrium.

i

ds LM (Equil: M = M)

Y

The LM curve shifts when:

d1. Factors other than ?Y or ?i change M. s2. The money supply (M) changes

(Monetary Policy).

The LM curve DOES NOT shift when i or Y

changes.

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3. THE FOREIGN EXCHANGE MARKET, which is linked to THE

BALANCE OF PAYMENTS ACCOUNT.

The foreign exchange market is linked to the balance of payments account because of its relationship to the OVERALL BALANCE (B), the sum of the current account and financial account.

B = CAB + FAB

= (pvt. X pvt. M) + (pvt. X pvt. M) GSGSAA

If THE OVERALL US BALANCE = 0, the current foreign exchange rate between the US dollar and foreign currencies (say, the Swiss franc) is at the equilibrium level (e or \$.80 per SF in the diagram below). 1

e (\$ per SF1) S SF

US B > 0 EXCESS SUPPLY OF SF

e 2

OVERALL US BALANCE = CAB + FAB = 0

e=\$.80 per SF1 1

e D 3SF US B < 0 EXCESS DEMAND FOR SF

# SF

The OVERALL BALANCE changes when there is a change in either the CAB or the FAB, ceteris paribus.

In turn, the CAB will change when exports or imports of goods and services change. According to the open-economy Keynesian Model, these will change when domestic income (Y), foreign income (Y), or the real exchange rate f

(RER) changes, where:

RER = Average Price of Foreign Goods and Services = P x e f\$ per SF

Average Price of Domestic Goods and Services P

Specifically, an increase in Y increases X. An increase in RER due to an fGS

increase in Por a decrease in P makes foreign products relatively expensive and f therefore also increases X. In turn, the increase in exports will require that GS

people sell more foreign currency (SF) for domestic currency (\$), Thus, the

supply of SF increases (and the supply curve shifts right) when there is an increase in X due to an increase in Y, an increase in P, or a decrease in P. GSff

An increase in Y increases M. A decrease in RER due to a decrease in P or GSf

an increase in P makes foreign goods relatively cheaper and therefore also

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increases M. Further, any increase in imports will necessitate an increase in GS

the demand for foreign currency (SF). Thus, an increase in M due to an GS

increase in Y, decrease in P, or increase in P will shift the demand curve for SF f

to the right.

The FAB will change when there is a change in international investors’ desire for domestic assets relative to foreign assets. In turn, this will happen in the short-run if domestic interest rates (i), foreign interest rates (i), or the fexexpected nominal exchange rate change (e), as suggested by the process of

uncovered interest arbitrage. For example, an increase in domestic interest rates (i) will make domestic assets relatively attractive, increasing the nation’s exports of assets (pvt. X) and reducing its imports of assets (pvt. M). In turn, this will AA

change the demand for and supply of foreign currency (SF), shifting both curves.

If the OVERALL US BALANCE is not “balanced” (i.e. the OVERALL BALANCE 0) and therefore there is either excess demand for or supply of foreign currency (see diagram on previous page), either the nominal exchange

rate will move or the government must intervene to keep the exchange rate at the current level.

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THE EFFECT OF GOVERNMENT STABILIZATION POLICIES (FISCAL AND

MONETARY POLICIES) ON THE MACROECONOMY IN THE SHORT-RUN

SHORT-RUN POLICY GOALS IN THE OPEN ECONOMY:

1. INTERNAL BALANCE: Goals related to the performance of the domestic

economy in the short-run, i.e. full-employment and stable prices. In the IS-LM model this means increasing (rather than decreasing) production. 2. EXTERNAL BALANCE: Goals related to the nation’s economic

interaction with the rest of the world, i.e. the nation desires a “sustainable” balance of payments. This is usually defined as achieving a zero balance in the overall balance or, equivalently, equilibrium in the foreign exchange market.

s Fiscal policy (;G, ;T) and monetary policy (;M which changes interest

rates) can achieve either of these goals. However, politicians tend to prefer fiscal and monetary policies that achieve internal balance, i.e. increase national production and employment. Thus, they have a fondness for expansionary fiscal and monetary policies: tax cuts, increases in government programs and spending, and “loose” monetary policy that keeps interest rates low. However, in the open

economy, the requirements for achieving external balance can prevent

expansionary fiscal and monetary policies from increasing production. Whether

expansionary fiscal and monetary policies increase production or not depends on (a) the degree of international capital mobility and on (b) the type of exchange

rate regime the nation has.

a. Degree of Mobility of Financial Capital Across Borders

We will assume that financial capital is perfectly mobile across national

borders, i.e. that each nation does not restrict the extent to which financial capital can move into and out of the country. In this type of environment, even miniscule changes in domestic interest rates relative to foreign interest rates can produce large and almost immediate changes in financial flows between countries. As a result, domestic and foreign interest rates will tend to equalize (when adjusted for risk).

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b. Type of Exchange Rate Regime

If the exchange rate is floating, maintaining external balance requires that the nominal exchange rate automatically move in response to imbalances.

SF S

e (\$ per SF1)

US B > 0 EXCESS SUPPLY OF SF

e ; e DECREASES: SF DEPRECIATES/\$ APPRECIATES 2

SF dep/\$ app

SF app/\$ dep

e 3 US B < 0 EXCESS DEMAND FOR SF ; e INCREASES: SF APPRECIATES/\$ DEPRECIATES SF D

# SF

If overall balance > 0 (a surplus), the resulting excess supply of foreign currency will cause the domestic currency (\$) to appreciate. A deficit in the overall

balance will result in a depreciation of the domestic currency. Thus, if

expansionary fiscal or monetary policy alters the nominal exchange rate, exports and imports of goods and services and thus aggregate demand can change. The change in aggregate demand due to changes in the exchange rate may offset the effect on aggregate demand of the fiscal or monetary policy.

When the exchange rate is fixed, the Central Bank must respond to

imbalances in the overall balance and therefore excess demand for or excess supply of foreign currency by buying or selling foreign currency from its official foreign exchange reserves to maintain the currency’s value and thus external

balance. This in turn changes the domestic money supply:

CB CB

holdings of holdings of s ? M = ? GB + OFF FXR

Central Bank’s Central Bank’s

holdings of holdings of

domestic official foreign

government exchange reserves

bonds

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e (\$ per SF1)

US B > 0 EXCESS SUPPLY OF SF; CB BUYS OFF FXR (SF) s e ; INCREASE M (\$) 2

e 1

e 3 US B < 0 EXCESS DEMAND FOR SF ; CB SELLS FXR (SF) s ; DECREASE M(\$)

SF D

# SF

For example, if the exchange rate is fixed at e in the diagram above, a deficit in 3

the overall balance and corresponding excess demand for foreign currency, will require the Central Bank to sell some of its foreign exchange reserves (SF), reducing its holdings of reserves and thus reducing the domestic money supply (\$). Similarly, if the exchange rate is fixed at e, the Central Bank will have to buy 2

foreign currency (SF) which will increase the nominal domestic money supply (\$). Thus, if an expansionary fiscal or monetary policy produces an imbalance in the overall balance, the domestic money supply may have to change to restore external balance if the nation operates under a fixed exchange rate regime. The

resulting change in aggregate demand due to the money supply change may offset the impact of the fiscal or monetary policy on aggregate demand.

STEPS TO FOLLOW WHEN EVALUATING THE IMPACT OF FISCAL AND

MONETARY POLICIES IN THE SHORT RUN IN THE “OPEN ECONOMY”

1. Start with IS-LM diagram to see what impact the policy potentially has on

domestic output/income in the short-run.

2. Since the link between the domestic economy and the international economy is

the domestic interest rate relative to the foreign interest rate, note the change in

the domestic interest rate.

3. Determine the impact of the policy on external balance: explain what impact

the change in domestic interest rate relative to the foreign interest rate will have

on the FAB and therefore on the overall balance.

4. Determine whether the change in the overall balance produces an excess

demand for or supply of foreign currency, using the foreign exchange market

diagram.

5. To restore external balance, indicate the required change in the money supply

(fixed exchange rate regime), or the required change in the nominal exchange

rate (flexible exchange rate regime).

6. Analyze the impact of the restoration of external balance (step 5) on domestic

output/income using the IS-LM diagram.

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