

Macroeconomics
ECO 403
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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
199798
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%
(199697)
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
MundellFleming
and the AD curve
·
Previously,
we examined the MF model
with a fixed price level. To
derive the AD curve,
we
now
consider the impact of a
change in P in the MF
model.
·
We
now write the MF equations
as:
(IS* )
Y
= C
(Y
 T
) +
I (r
*) +
G + NX
(ε
)
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Macroeconomics
ECO 403
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(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↑
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Macroeconomics
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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)
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Macroeconomics
ECO 403
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THREE
MODELS OF AGGREGATE
SUPPLY
·
The
stickywage model
·
The
imperfectinformation model
·
The
stickyprice 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
stickywage 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
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Macroeconomics
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(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
stickywage model
·
Implies
that the real wage
should be countercyclical, 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:
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