INTERNATIONAL FINANCE LESSON 7

Equilibrium Output in the Short-Run Antu Panini Murshid Today’s Agenda     The components and determinants of aggregate demand in an open economy Goods market equilibrium Asset market equilibrium Short run equilibrium in an open economy Components of Aggregate Demand  It is useful to decompose aggregate demand into four components:     Consumption spending Planned investment Government spending Net exports Determinants of Consumption  Disposable income     Income minus taxes (Y-T) Permanent income Real wealth Real interest rate Typically we will assume that taxes are lump sum Consumption Function   Since consumption is a function of disposable income we can write C = C(Yd,a), where Yd≡ Y-T, and a denotes all other arguments A linear consumption function would take the following form: C = a + bYd Autonomous consumption Marginal propensity to consume Autonomous Consumption  Autonomous consumption is that part of consumption which is not effected by disposable income   These are expenditures that would occur even if household disposable income was zero What determines autonomous consumption?  Other determinants of consumption, e.g wealth, real interest rates, etc Marginal Propensity to Consume   The proportion of each additional dollar of income that is used for consumption expenditures The marginal propensity to consume is just the slope of the consumption function Marginal Propensity to Consume   Normally we assume that the MPC is less than one Why is this a reasonable assumption?  Because some proportion of each additional dollar of income is devoted to savings A Linear Consumption Function Against Yd  Autonomous consumption is just the intercept  Note the slope of the consumption function is less than one consumption 450 autonomous consumption a slope = marginal propensity to Consume (b) c = a + b(Y-T)  Note also that the consumption function is drawn against disposable income  What would the consumption function look like, if we drew it against income? disposable income (Y-T) A Linear Consumption Function Against Y  If we draw consumption against income, the intercept becomes (abT1) consumption 450 c = a + b(Y-T1) c = a + b(Y-T2)  What happens to the consumption function if we increase taxes? The consumption function shifts downward a-bT1 a-bT2 income (Y) Exchange Rate and the Interest Rate Interest rate i1=10% Money supply M1s/P  Equilibrium interest rate   We have already discussed the relationship between the exchange rate and the interest rate, but lets take another look First draw the money market graph The equilibrium interest rate is 10% Money demand L(i,y) real money balances Exchange Rate and the Interest Rate Interest rate i1=10% Money supply M1s/P Equilibrium interest rate  Now lets make everything disappear… Money demand L(i,y) real money balances Exchange Rate and the Interest Rate  i1=10% …and reappear but rotated clockwise by 90 degrees Interest rate Money supply M1s/P real money balances Equilibrium interest rate Money demand L(i,y) Exchange Rate and the Interest Rate return on $ assets  $/€ Expected return on € assets e1=1.00 i1=10% Now lets add the foreign exchange market graph Interest rate Money supply M1s/P real money balances Equilibrium interest rate Money demand L(i,y) Implications of an Increase in Income for Asset Markets    What are the implications of an increase in income for the interest rate and exchange rate ↑Y ⇒ ↑Md ⇒ ↑i ⇒ ↓e Hence an increase in income will cause the currency to appreciate by causing the interest rate to rise Graphical Illustration equilibrium exchange rate $/€ e1 e2 i1 i2 and a new equilibrium exchange rate Interest rate M1/P real money balances equilibrium interest rate L(i,y1) L(i,y2) demand for money rises and we have a new equilibrium interest rate The AA-Schedule   The AA-schedule illustrates the relationship between the nominal exchange rate and level of income or output such that asset markets are in equilibrium The AA-schedule must be negatively sloped since an increase in income will cause the interest rate to rise, which will in turn cause the currency to appreciate in value Graphical Illustration $/€ $/€ e1 i1 i y1 Ms/P   real money balances  L(i,y1) L(i,y2) income Suppose equilibrium income is Y1 Corresponding money demand function is L(I,y1) The corresponding interest rate and exchange rate is i1, e1 respectively Graphical Illustration $/€ $/€ e1 e2 i2 i1 i y1 Ms/P  real money balances  L(i,y1) L(i,y2) y2 income This gives us the first point on the AA-schedule (e1,y1) Now suppose income ↑ to y2 ⇒ money demand ↑ as does the interest rate and the exchange rate falls Graphical Illustration $/€ $/€ e1 e2 i2 i1 AA i y1 Ms/P real money balances   L(i,y1) L(i,y2) y2 income Hence the new exchange rate-income combination is e2,y2 The locus of all such points traces out the AA-curve Shifts in the AA-Schedule    What would shift the AA-schedule? Any change other than a change in income, which affects the exchange rate Examples     A change in the nominal money supply A change in the price level A change in future expectations regarding the exchange rate A change in the foreign interest rate Quick Quiz  Which way will the AA-curve shift if:    real money supply increases expected future exchange rate falls the foreign interest rate falls Asset Markets ↔ Goods Markets    It should be clear that the level of income in an economy is determined by developments in both asset markets and goods markets? Asset markets determine important variables—interest rate and exchange rate —that impact on the goods market At the same time developments in the goods market can affect asset markets Equilibrium     An economy is only in equilibrium if it is on both the AA- and DD-curves If for instance an increase in e forced the economy off the DD-curve then income would have to rise to bring the goods market back to equilibrium as net exports increased If on the other hand the economy were forced off the AA-curve by an increase in output then the exchange rate would necessarily have to fall as interest rates rose It is to be expected that asset markets would clear more quickly than goods markets Equilibrium: Graphical Illustration  At point the exchange rate is exchange rate e1 DD 3—equilibrium AA Y1 Y* income (Y) too high and UCIP does not hold, hence the exchange rate appreciates immediately to return the foreign exchange market to equilibrium at point  At point 2, the goods market is not in equilibrium, so output increases  As output increases the interest rate rises and the exchange rate falls and we move along the AA schedule to point