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Chapter Nineteen. Prices and Output in an Open Economy. Introduction Apples vs. GDP: Supply in Micro- and Macroeconomics Aggregate Demand under Fixed Exchange Rates Long-Run Aggregate Supply Medium-Run Aggregate Supply Combining Aggregate Demand and Aggregate Supply. - PowerPoint PPT Presentation
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Chapter Nineteen Prices and Output in an Open Economy © 2003 South-W estern/Thom son Learning
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Page 1: Chapter Nineteen

Chapter Nineteen

Prices and Output in an Open Economy

© 2003 South-Western/Thomson Learning

Page 2: Chapter Nineteen

2

Chapter Nineteen Outline

1. Introduction

2. Apples vs. GDP: Supply in Micro- and Macroeconomics

3. Aggregate Demand under Fixed Exchange Rates

4. Long-Run Aggregate Supply

5. Medium-Run Aggregate Supply

6. Combining Aggregate Demand and Aggregate Supply

Page 3: Chapter Nineteen

3

Chapter Nineteen Outline

7. Macroeconomic Policy under Fixed Exchange Rates

8. Aggregate Demand under Flexible Exchange Rates

9. Macroeconomic Policies under Flexible Exchange Rates

10.Supply Shocks

Page 4: Chapter Nineteen

4

Introduction

• We have examined the effects of macroeconomic policies in the short- and long-run. Now it is time to study those effects in the medium-run.

• Two definitions:1. A sustained rise of the overall price level defines

inflation.2. A sustained fall in the price level, rarely

observed, represents deflation.• Need to distinguish between the supply, or

production, side of the economy and the demand, or expenditure, side.

Page 5: Chapter Nineteen

5

Apples vs. GDP: Supply in Micro- and Macroeconomics

• The effects of changes of price and supply in the apple market is shown in Figure 19.1:– In panel (a), the supply curve for apples is

perfectly horizontal.• The price of apples is fixed, and demand determines

quantity.

– In panel (b), the supply curve for apples is upward sloping, reflecting the movement of resources into and out of apple production in response to relative price changes.

See

Figure 19.1

Page 6: Chapter Nineteen

6

Figure 19.1: Price and Supply in the Apple Market

Q0 0

P

apples QapplesQ0 Q1Q1Q0

D1

D0

D1

D0

S

S

= P1P0

P1

P0

applesPapples

(a) (b)

Page 7: Chapter Nineteen

7

Aggregate Demand under Fixed Exchange Rates

• An economy’s aggregate demand curve represents the relationship between the quantity demanded of domestic goods and the domestic price level.– The quantity examined represents the economy’s

total output of goods and services, or GDP.– The relevant price represents the overall domestic

price level, the GDP deflator.

Page 8: Chapter Nineteen

8

Aggregate Demand under Fixed Exchange Rates

• The slope of the aggregate demand curve.– Slopes downward like a microeconomic demand

curve, but for different reasons:1. A rise in the domestic price level raises the price of

domestic goods relative to that of foreign ones.

2. The quantity demanded of real money balances depends positively on real income and negatively on the interest rate.

Page 9: Chapter Nineteen

9

Aggregate Demand under Fixed Exchange Rates

• The effects of a rise in the price level in the money market is shown in Figure 19.2:– A rise in the price level from P0 to P1 reduces the

real money stock (M/P), assuming that the nominal money stock (M) is held constant.

• The equilibrium interest rate rises to reduce the quantity demanded of real money balances to equal the new, smaller stock.

See

Figure 19.2

Page 10: Chapter Nineteen

10

Figure 19.2: Effect of a Rise in the Price Level in the Money Market

Quantity of RealMoney Balances

i

(M 00 /P1) (M 0 /P0)

i0

i1

(P1 > P0)

(M 0/P1) (M 0 /P0)

L(Q0, i)

Page 11: Chapter Nineteen

11

Shifts in the Aggregate Demand Curve

• A change in nominal money stock, fiscal policy variables, the nominal exchange rate, or foreign price level alters the demand for domestic goods at each domestic price level, and therefore, shifts the aggregate demand curve.– Figure 19.3 illustrates the various shifts in the

aggregate demand curve (next slide).

Page 12: Chapter Nineteen

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Figure 19.3: Shifts in the Aggregate Demand Curve

Q

P

0

AD1

AD0

AD2

Rise in e (devaluation)Increase in MIncrease in G or decrease in taxesRise in P *

Fall in e (revaluation)Decrease in MDecrease in G or increase in taxesFall in P *

Page 13: Chapter Nineteen

13

Shifts in the Aggregate Demand Curve

• The demand for domestically produced goods is reduced at each domestic price level by revaluation of domestic currency, decline in domestic nominal money stock, decrease in government purchases, rise in taxes, or a fall in foreign price level.

Page 14: Chapter Nineteen

14

Shifts in the Aggregate Demand Curve

• Demand for domestically produced goods increases at each domestic price level due to devaluation of domestic currency, rise in domestic money stock, an increase in government purchases, reduction in taxes, or a rise in foreign price level.– Changes in the domestic price level itself, other

things being equal, cause movements along a single aggregate demand curve rather than shifts in it.

Page 15: Chapter Nineteen

15

Long-Run Aggregate Supply

• Aggregate supply refers to the relationship between an economy’s price level and the total quantity of goods and services produced.– Quantity of available resources and existing

technology constrain the total quantity of output an economy can produce.

• The short, medium, and long runs– Short run: period during which the price level

remains fixed in response to economic shocks or policy changes, so aggregate demand alone determines real output.

Page 16: Chapter Nineteen

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Long-Run Aggregate Supply

– Medium run: the period during which the price level begins to respond to shocks or policy changes, but individuals or firms may remain unaware of some price changes or may find it too costly due to contracts or other rigidities to adjust their behavior in response to those changes.

– Long run: denotes the time over which everyone in the economy knows the price level and has had time to adjust production decisions accordingly.

Page 17: Chapter Nineteen

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The Vertical Long-Run Aggregate Supply Curve

• The long-run aggregate supply (LRAS) curve is a simple vertical line at the economy’s full-employment output, implying that changes in the price level have no effect on the quantity of output supplied.– Figure 19.4: in the long-run, the quantity of output

does not depend on the price level.• The economy’s quantity of resources and technology

determine the horizontal placement of the LRAS curve.

See Figure 19.4

Page 18: Chapter Nineteen

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Figure 19.4: Long-Run Aggregate Supply

P2

P1

Q

P

0

LRAS

Page 19: Chapter Nineteen

19

Medium-Run Aggregate Supply

• Medium-run aggregate supply (MRAS) curve captures the behavior of individuals and firms when lack of information about the price level, stickiness of some prices, or inability to adjust quickly to a change in the price level causes behavior to differ from what it would be with full information and instantaneous adjustment.

Page 20: Chapter Nineteen

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Medium-Run Aggregate Supply

• The slope of MRAS curve is represented in Figure 19.5:– A rise in the price level causes an increase in the

quantity of output supplied.• This is captured by the upward-sloping portion of the

MRAS curve.

• At some point, the economy reaches the constraint of resources and technology, causing the medium-run aggregate supply curve to become vertical.

See Fig. 19.5

Page 21: Chapter Nineteen

21

Figure 19.5: Medium-Run Aggregate Supply

Q

PMRAS

0

P0

LRAS

Page 22: Chapter Nineteen

22

Shifts in the MRAS Curve

• Each MRAS curve is drawn for given values of input prices and of firms’ expectations about prices other than those of their own products.– If price level rises, but contractual rigidities keep

some input prices constant and firms do not immediately alter their expectations about other prices, firms will perceive relative prices of their outputs as having risen and will increase output.• This causes the economy to move up along a given

MRAS curve, as depicted in Figure 19.6.

See Figure 19.6

Page 23: Chapter Nineteen

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Figure 19.6: Vertical Shift in the Medium-Run Aggregate Supply Curve

Q

P

P1

0

P0

P2

1

23

LRASMRAS(W1, P1)

e

MRAS(W0, P0)e

(W1 > W0, P1 > P 0 )e e

Page 24: Chapter Nineteen

24

Combining Aggregate Demand and Aggregate Supply

• Assume perfectly mobile capital:– Portfolio owners, in deciding where to put their funds,

consider only interest rates, exchange rates, and expected changes in exchange rates.

• No government regulations restrict capital flows among countries.

– In the medium-run, as shown in figure 19.7, the economy must be at the intersection of AD curve and MRAS curve.

– In long-run, this intersection must occur also on the LRAS.

See Figure 19.7

Page 25: Chapter Nineteen

25

Figure 19.7: Medium-Run and Long-Run Equilibrium

Q

P

P1

0

MRAS

P0

Q0 Q1

AD1

AD0

Medium run: AD = MRAS

Long run: AD = MRAS = LRAS

LRAS

Page 26: Chapter Nineteen

26

Macroeconomic Policy under Fixed Exchange Rates

• Without fixed price levels, the economy contains automatic adjustment mechanisms for reaching long-run equilibrium.– Mechanisms that do not require active responses

from policy makers.– At this equilibrium, the following statements are

true:1. The quantity demanded of domestic goods equals the

quantity supplied at full employment; and

2. BOP equilibrium prevails.

Page 27: Chapter Nineteen

27

Macroeconomic Policy under Fixed Exchange Rates

• Primary shortcoming of automatic adjustment mechanisms is their lack of speed.

• In the medium-run, fiscal policy can alter income, but monetary policy cannot.– Neither policy can affect real output in the long-

run, although fiscal policy continues to affect the price level.

Page 28: Chapter Nineteen

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Macroeconomic Policy under Fixed Exchange Rates

• Fiscal policy, prices, and output– The effects of an expansionary fiscal policy with

flexible prices, fixed exchange rates, and perfectly mobile capital are shown in Figure 19.8:

• Beginning from a long-run equilibrium at point 1, output is raised temporarily.

– As firms and individuals adjust to the rise in the price level, the increase in output is offset, and the long-run effect is merely a rise in the price level and there is no effect on real output.

See Figure19.8

Page 29: Chapter Nineteen

29

Figure 19.8: Effects of Expansionary Fiscal Policy

Q

PMRAS2

0

P2

P1

3

21

LRAS

AD3

AD2

AD1

MRAS1

Page 30: Chapter Nineteen

30

Macroeconomic Policy under Fixed Exchange Rates

• Fiscal policy, prices, and output (cont.)– Two alternative paths to long-run equilibrium are

compared in Figure 19.9:• Expansionary fiscal policy vs. automatic adjustment:

– Beginning at point 1, expansionary fiscal policy brings the economy to a new long-run equilibrium at point 2b.

– Automatic adjustment leads to a long-run equilibrium at point 2a.

– In either case, the location of the LRAS curve determines output.

– The equilibrium price level is higher in the case of expansionary fiscal policy (P2) than in that of automatic adjustment (P0).

See

Figure

19.9

Page 31: Chapter Nineteen

31

Figure 19.9: Expansionary Fiscal Policy versus Automatic Adjustment

Q

P

P0

0

MRAS1

P1

P2

2a

2b

1

LRAS

MRAS0

AD2

AD1

Page 32: Chapter Nineteen

32

Macroeconomic Policy under Fixed Exchange Rates

• Monetary policy, prices, and output.– Monetary policy cannot affect income with a fixed

price level, a fixed exchange rate, and perfectly mobile capital.• Conclusion continues to hold when we introduce price

flexibility.– When the economy operates at less than full-

employment and as long as the price level is flexible, the price adjustment mechanism pushes output toward its long-run level.

– As for the BOP, the fixed exchange rate implies that the money stock adjusts – through changes in FX reserves – to equate the BOP.

Page 33: Chapter Nineteen

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Macroeconomic Policy under Fixed Exchange Rates

• Exchange rate policy, prices, and output.– Third type of possible macroeconomic policy involves

a permanent change in exchange rate, such as a devaluation (Figure 19.10).

• Beginning at point 1, the devaluation lowers the relative price of domestic goods and switched expenditure toward them.

– The AD curve shifts right from AD1 to AD2.– At point 2, the BOP is in surplus due to the

devaluation. Intervention in the FX market increase domestic money supply, and the AD curve shifts further right.

• MRAS curve moves upward.• Long-run equilibrium is restored at point 3.

See

Figure

19.10

Page 34: Chapter Nineteen

34

Figure 19.10: Effect of a Devaluation with Flexible Prices . . . Perfectly Mobile Capital

Q

P

P3

0

MRAS3

P2

P1 12

3

LRAS

MRAS1

AD1

AD2

AD3

Page 35: Chapter Nineteen

35

Aggregate Demand under Flexible Exchange Rates

• Just as it does under a fixed exchange rate regime, the AD curve under a flexible regime captures the negative relationship between the domestic price level and the quantity demanded of domestic goods and services.– Slope of AD curve: downward for same reasons as

under a fixed regime.1. Rise in price level raises the relative price of

domestic goods and shifts expenditure toward foreign goods.

2. Rise in domestic price level lowers real money stock, raises domestic interest rate, lowers investment, and causes capital inflows and currency appreciation.

Page 36: Chapter Nineteen

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Aggregate Demand under Flexible Exchange Rates

• Shifts in AD curve.– Situation 1: Permanent increase in money stock…

• Raises real money stock and lowers interest rate; causes capital outflow, which depreciates domestic currency and lowers relative price of domestic goods.

– Implies larger quantity of domestic goods at each price level – AD curve shifts right.

– Situation: Permanent rise in government purchases…

Page 37: Chapter Nineteen

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Aggregate Demand under Flexible Exchange Rates

• Shifts in AD curve.– Situation 2: Permanent rise in government

purchases…• This change has no effect on aggregate demand under a

flexible regime and perfect capital mobility.– Interest rate rises to make individuals content to hold only the

available stock of real balances.

– Capital flows in, domestic currency appreciates, and relative price of domestic goods rise.

– Net exports fall enough to offset initial increase in government purchases.

– Total demand remains unchanged.

Page 38: Chapter Nineteen

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Macroeconomic Policies under Flexible Exchange Rates

• Automatic adjustment mechanisms– When both the price level and the exchange rate

are flexible, the economy contains automatic adjustment mechanisms for bringing it into equilibrium on the long-run supply curve with balance payments.

• Price level adjusts to equate the quantity demanded of domestic goods with quantity supplied at full employment.

• Exchange rate adjusts to bring the BOP into equilibrium.

Page 39: Chapter Nineteen

39

Macroeconomic Policies under Flexible Exchange Rates

• Macroeconomic policy, prices, and output.– The effects of expansionary monetary policy with

flexible prices, flexible exchange rates and perfectly mobile capital are depicted in Fig. 19.11:

• Beginning from a point of long-run equilibrium at point 1, expansionary monetary policy can raise output, but only temporarily.

– As individuals and firms adjust to accompanying rise in price level, output falls back to original level.

– Policy’s long-run effect consists solely of a proportional rise in price level and proportional depreciation of domestic currency.

See

Figure

19.11

Page 40: Chapter Nineteen

40

Figure 19.11: Effect of Expansionary Monetary Policy . . . Perfectly Mobile Capital

Q

P

P1

0

MRAS2

P2

LRAS

MRAS1

3

2

1

AD2

AD1

Page 41: Chapter Nineteen

41

Macroeconomic Policies under Flexible Exchange Rates

• Exchange rate overshooting: occurs when a variable responds to a disturbance more in the medium-run than it does in the long-run.

• Tends to occur when some variables adjust more quickly than others.

• Figure 19.12 contrasts expansionary monetary policy with automatic adjustment:

• Beginning from point 1, expansionary monetary policy leads to a long-run equilibrium at point 2a with price level P1.

• Automatic adjustment leads to long-run equilibrium at 2b with price level P2. See Figure 19.12

Page 42: Chapter Nineteen

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Figure 19.12: Expansionary Monetary Policy versus Automatic Adjustment

Q

P

P1

0

MRAS1

P2 2b

2a

AD2

AD1

1

LRAS

MRAS2

Page 43: Chapter Nineteen

43

Supply Shocks

• Supply shocks: include any event that alters the economy’s long-run equilibrium productive capacity.– Examples include earthquakes, floods, wars, and

oil embargoes.

• Definition of stagflation: combination of rising prices and declining output.

Page 44: Chapter Nineteen

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Supply Shocks

• Effects of an adverse supply shock and potential policy responses are illustrated in Figure 19.13:

– Shock shifts MRAS and LRAS curves left.

– Policy makers have several options:1. Can leave AD unchanged at AD0; new long-run equilibrium at point

3a.

2. Expand AD to AD1 to speed the economy’s return to full employment at point 3b; prices rise.

3. Aggressively expand AD to AD2 and push output back to its pre-shock level; much higher prices at 4c.

4. Contract AD to AD3 and restore long-run equilibrium at point 4d; keeps prices down but may require higher unemployment.

– Regardless of choice, the new long-run, full-employment output is at the lower Q1.

See

Figure

19.13

Page 45: Chapter Nineteen

45

Figure 19.13: An Adverse Supply Shock and Potential Policy Responses

Q

P

P1

0

MRAS1

P2

AD0

AD1

LRAS

MRAS2

LRAS

MRAS0

AD2

AD3

Q1 Q0

Pc

Pb

Pa

Pd

4c

3c

3b2

3d 3a

1

4d

1 0

Page 46: Chapter Nineteen

46

Note for Case 1: Unemployment – Structural and Cyclical

• Figure 19.14: 1999 unemployment rates for 21 developed-country members of the OECD plus for the 11-member euro area.– Each country’s actual unemployment rate

(illustrated by the red line) can be decomposed into a structural component (the blue bars) and a cyclical component (difference between the height of the bar and that of the line).

See

Figure 19.14

Page 47: Chapter Nineteen

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Figure 19.14: Unemployment Rates’ Structure and Cyclical Components, 1999 (% Labor Force)

Page 48: Chapter Nineteen

48

Note for Case 2: Government Budgets – Structural and Cyclical

• Figure 19.15 illustrates the Japanese fiscal policy indicators for 1990-90.– The country’s fiscal policy stance turned

contractionary in 1997 when the government increased taxes.

• The Japanese economy already stood at the brink of a recession, and the fiscal contraction pushed further in that direction.

See Figure 19.15

Page 49: Chapter Nineteen

49

Figure 19.15: Japanese Fiscal Policy Indicators, 1990-1999 (Percent)

Page 50: Chapter Nineteen

50

Note on the Appendix: The Aggregate Demand Curve

• Figure 19A.1 represents the derivation of aggregate demand curve from IS-LM-BOP with perfectly mobile capital.– Real output and the price level are negatively-

related along an aggregate demand curve.

See

Figure

19A.1

See

Figure

19A.1

Page 51: Chapter Nineteen

51

Figure 19A.1a: Derivation of Aggregate Demand Curve

(a)

0

i

Q 2 Q 3 Q 1 Q 0 Q

IS 2

IS 3

IS 1

IS 0

BOP

LM 1 (M/P1 )

LM 0 (M/P0 )

Page 52: Chapter Nineteen

52

Figure 19A.1b: Derivation of Aggregate Demand Curve

(b)

AD (fixed rate, high elasticity)

0

P

Q 2 Q3 Q1 Q 0 Q

P 1

P 0

AD (flexible rate)AD (fixed rate, low elasticity)

Page 53: Chapter Nineteen

53

Summary

• The introduction of price flexibility in this chapter has three major implications:1. Economy now contains an automatic adjustment

mechanism for bringing output to its long-run equilibrium level at full employment.

2. Remaining effective tools of macroeconomic policy can permanently increase output only if the economy is operating temporarily to the left of the LRAS and only by raising the price level.

3. Expansionary macroeconomic policy can permanently affect only the price level and not the level of real output or employment.

Page 54: Chapter Nineteen

54

Key Terms in Chapter 19

• Inflation

• Deflation

• Aggregate demand curve

• Aggregate supply

• Short run

• Medium run

• Long run

• Long-run aggregate supply curve

Page 55: Chapter Nineteen

55

Key Terms in Chapter 19

• Medium-run aggregate supply curve

• Perfectly mobile capital

• Automatic adjustment mechanisms

• Price adjustment mechanism

• Overshooting

• Supply shocks

• Stagflation


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