ZeePedia

AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise

<< AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
AGGREGATE SUPPLY:The sticky-price model >>
img
Macroeconomics ECO 403
VU
LESSON 32
AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued...)
Why income might not rise
·
The central bank may try to prevent the depreciation by reducing the money supply
·
The depreciation might boost the price of imports enough to increase the price level (which
would reduce the real money supply)
·
Consumers might respond to the increased risk by holding more money.
Each of the above would shift LM* leftward.
The South East Asian Crisis
stock market %
nominal GDP% change
exchange rate% change
change from 7/97 to
1997-98
from 7/97 to 1/98
1/98
Indonesia
-59.4%
-32.6%
-16.2%
Japan
-12.0%
-18.2%
-4.3%
Malaysia
-36.4%
-43.8%
-6.8%
Singapore
-15.6%
-36.0%
-0.1%
S. Korea
-47.5%
-21.9%
-7.3%
Taiwan
-14.6%
-19.7%
n.a.
-1.2%
Thailand
-48.3%
-25.6%
(1996-97)
U.S.
n.a.
2.7%
2.3%
Floating vs. Fixed Exchange Rates
Argument for floating rates:
·
Allows monetary policy to be used to pursue other goals (stable growth, low inflation)
Arguments for fixed rates:
·
Avoids uncertainty and volatility, making international transactions easier
·
Disciplines monetary policy to prevent excessive money growth & hyperinflation
Mundell-Fleming and the AD curve
·
Previously, we examined the M-F model with a fixed price level. To derive the AD curve, we
now consider the impact of a change in P in the M-F model.
·
We now write the M-F equations as:
(IS* )
Y = C (Y - T ) + I (r *) + G + NX (ε )
151
img
Macroeconomics ECO 403
VU
(LM* )
M P = L (r *,Y )
(Earlier, we could write NX as a function of e because e and ε move in the same direction
when P is fixed.)
Deriving the AD curve
Why AD curve has negative slope:
↑P
⇒ ↓(M/P)
⇒ LM shifts left
⇒ ↑ε
⇒ ↓NX
⇒ ↓Y
LM*(P2)
ε
LM*(P1)
ε2
ε1
IS*
Y1
Y
Y2
P
P2
P1
AD
Y
Y2
Y1
From short run to the long run
If Y1 < Y then there is downward pressure on prices. Over time, P will move down, causing
(M/P)↑
ε↓
NX ↑
Y↑
152
img
Macroeconomics ECO 403
VU
LM*(P1)
ε
LM*(P2)
ε1
ε2
IS*
Y
Y1
Y
P
LRAS
P1
SRAS1
SRAS2
P2
AD
Y
Y1
Y
Large: between small and closed
·
Many countries - including the U.S. - are neither closed nor small open economies.
·
A large open economy is in between the polar cases of closed & small open.
·
Consider a monetary expansion:
·
Like in a closed economy,
ΔM > 0 ⇒ ↓r ⇒ ↑I (though not as much)
·
Like in a small open economy,
ΔM > 0 ⇒ ↓ε ⇒ ↑NX (though not as much)
153
img
Macroeconomics ECO 403
VU
THREE MODELS OF AGGREGATE SUPPLY
·  The sticky-wage model
·  The imperfect-information model
·  The sticky-price model
All three models imply:
Y = Y + α (P - P  e )
Where:
Y
Aggregate output
Y
Natural rate of output
α
a positive parameter
P
the actual price level
e
P
the expected price level
The sticky-wage model
·
Assumes that firms and workers negotiate contracts and fix the nominal wage before they
know what the price level will turn out to be.
·
The nominal wage, W, they set is the product of a target real wage, ω, and the expected
price level:
W = ω ×Pe
Pe
W
=ω×
⇒
P
P
If
Then
P = Pe
Unemployment and output are at their natural rates
P > Pe
Real wage is less than its target, so firms hire more workers and
output rises above its natural rate
P < Pe
Real wage exceeds its target, so firms hire fewer workers and
output falls below its natural rate
154
img
Macroeconomics ECO 403
VU
(a) Labor Demand
(b) Production Function
Real wage,
Income,
Y
output,
W/P
W/P1
Y = F (L )
Y
2
W/P2
Y
L = Ld (W/P )
1
... output,. .
4.
Labor,
Labor,
L
L
L
L
L
L
2. . . . Reduces
1
2
1
2
the real wage
3....hich raises
w
for a given
employment. .
,
nominal wage,.
.
(c) Aggregate Supply
Price level,
P
Y = Y + α (P
-P  e)
P
2
6. The aggregate
supply curve
P
1
summarizes
these changes.
1. An increase
in the price
Income, output,
Y
Y
Y
2
1
level. .
... and income.
5.
The sticky-wage model
·
Implies that the real wage should be counter-cyclical, it should move in the opposite
direction as output over the course of business cycles:
­  In booms, when P typically rises, the real wage should fall.
­  In recessions, when P typically falls, the real wage should rise.
·
This prediction does not come true in the real world:
155
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand