INTERNATIONAL FINANCE LESSON 7

Determinants of Exports An increase in world income, increases the demand for exports  A depreciation in the real exchange rate makes domestically produced goods more competitive and s

Equilibrium Output in the Short-Run

Antu Panini Murshid

Today’s Agenda

aggregate demand in an open

economy

economy

Components of Aggregate

Demand

demand into four components:

 Consumption spending

 Planned investment

 Government spending

 Net exports

sum

Consumption Function

disposable income we can write C =

C(Yd,a), where Yd≡ Y-T, and a denotes

all other arguments

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

just the slope of the consumption

function

Marginal Propensity to

Consume

less than one

 Because some proportion of each

additional dollar of income is devoted to savings

A Linear Consumption Function Against Yd

disposable income (Y-T)

c = a + b(Y-T)

 Autonomous consumption is just the intercept

 Note the slope of the consumption function is less than one

 Note also that the consumption function is drawn against

disposable income

 What would the consumption function look like, if we drew it against income?

a

 The consumption function shifts downward

 If we draw consumption against income, the intercept becomes (a-

bT1)

a-bT1

c = a + b(Y-T 2 )

a-bT2

Determinants of Planned

Investment

 Real interest rate (cost of borrowing)

 Rate of return on capital (marginal

product of capital)

1,000 1,500

investments shifts the schedule to the right

investments has the same effect

Adding Up Consumption and Investment

 First draw the

Impact of an Increase in Investment

expectations, etc will raise

investment and shift C+I schedule up

Assumption: Planned

Investment is Exogenous

of planned investment, let us assume that it is exogenously given

 This will make life simpler and let us

focus on other important channels by which income is affected in an open economy

Assumption: Government

Savings

assume that government spending is exogenously given

 Again this is a simplification that lets

us focus on the important

open-economy channels that impact on

income

What About Net Exports?

 One component of expenditure that we

cannot simply treat as exogenous is net

exports

 Net exports have an important influence on

aggregate demand in open economies and one that distinguishes it from closed

economies

 Below we consider the determinants of

exports and imports separately

Determinants of Exports

 An increase in world income, increases

the demand for exports

 A depreciation in the real exchange rate

makes domestically produced goods more competitive and so increases the demand for our exports

Determinants of Imports

 An increase in domestic disposable

income will increase the demand for imports

 A depreciation in the real exchange rate

will have an ambiguous effect on imports

Real Exchange Rate and

Imports

exchange rate depreciation will have:

 Lower the volume of imports

 Increase the price of imports

 There are therefore opposing forces at

work since the total value of imports is just:

Value of imports = price * volume ?

The Marshall-Lerner Condition

 So what will be the overall effect of a real

exchange rate depreciation on net exports?

 The Marshall-Lerner condition says that a

real exchange rate depreciation will improve the trade balance if: ηx+ηM>1, where ηX is

the elasticity of demand for exports and ηM

is the elasticity of demand for imports

 Can you prove this (assume NX = 0)?

Intuition Behind the M-L

Condition: Elasticity of Imports

 If demand is inelastic a

reduction an exchange rate depreciation and a rise in the price of imports has little impact on quantity of imports demanded, hence value of imports rises:

 If demand is elastic the

same change in price has a much larger impact on

volumes and so imports fall

Q1

Q2

D 1

Intuition Behind the M-L

Condition: Elasticity of Exports

 When export-demand is

elastic an exchange rate depreciation which lowers the foreign price of exports, has a large impact on the quantity demanded

 This implies that the value

of exports necessarily rises significantly since the

domestic price received for exports has not changed

Q1 Q2

Does the Marshall-Lerner

Condition Hold? The J-Curve

 In our analysis, we will assume that the

Marshall-Lerner condition holds

 Is this a good assumption?

 Yes and no

 Often the initial effect of a depreciation is to

cause the trade deficit to increase, over time however the deficit improves This is known

as the J-curve effect

Reasons for the J-Curve

adjust after exchange rate changes

placed months in advance, hence the primary effect of a depreciation is to

raise the value of the pre-contracted level of imports

Summarizing the Determinants

of AD: Income

 Why? Why does the increase in import

demands not dominate the increase in consumption

Summarizing the Determinants of AD: World Income

Summarizing the Determinants of AD: Real Exchange Rate

 We will assume that the Marshall-Lerner

condition holds

 ↑ θ (real ex depreciation) ⇒

 Note ↑ θ (real ex depreciation) implies either

 ↑ e (nominal exchange rate)

 ↑ P f (foreign price level)

 ↓ P (domestic price level)

 ↑ exports + ↓ imports

 Net effect ↑ aggregate demand

All of these factors will increase θ

Summarizing the Determinants of

AD: Other Determinants

of AD

 real interest rate, productivity of capital,

future expectations, etc

focus on the impact of disposable

income and the real exchange rate on consumption and net exports, all other variables are treated as exogenous

Equation For Aggregate

Demand

Aggregate Demand Function

 Planned aggregate expenditures

 Note in this example net exports are negative

C + I +G + NX=aggregate expenditures

Government spending Net exports

Slope of Aggregate Demand

Function in Open Economy

 Note that the slope of the aggregate

demand function is less than the slope of

the domestic absorption function Why?

 Because imports increase with income

 The proportion of each additional dollar of

household income that is used for imports is called the marginal propensity to import

(MPM)

 The slope of the aggregate demand function

is equal to MPC-MPM

Illustrating Increases in Aggregate Demand

 The following factors

will increase aggregate demand:

 ↓ taxes, ↑ government

spending, ↑ planned investment, ↑ θ, ↑ world incomes, ↑

autonomous consumption a shift in preferences for

domestic goods over foreign goods

Quick Quiz

 Can you illustrate the impact of the

following on aggregate demand:

 An exchange rate depreciation

 A decline in the foreign price level

 A fall in world real income

 A rise in lump sum taxes

Goods Market Equilibrium

 What is the equilibrium level of income in an

economy?

 We would like to have some notion of

equilibrium where the demand for goods

and services is equal to the supply

Therefore we define an equilibrium in the

goods markets as follows:

Total Output Produced = Planned AE (AD)

Y = C + I + G + NX

Goods Market Equilibrium:

Impact of an Increase in Net Exports on Equilibrium Output

 Initially suppose

equilibrium income

is Y1

 Now suppose net

exports rise (for whatever reason), then AD rises and

so too does equilibrium income

Aggregate Demand, Output

and Exchange Rates

 Is aggregate demand and income related to

the exchange rate?

 Clearly yes What is this relationship?

 If the M-L condition holds we know that an

increase in θ increases AD

 Hence all else equal an increase in the

nominal exchange rate should imply an

increase in AD This will imply an increase

in equilibrium income/output

Recap on the Intuition

 When the nominal exchange rate rises

(depreciates), all else equal:

 Exports become more competitive and thus

exports increase

 If the M-L condition holds imports will

decline because imports are now more

expensive

 Hence AD increases

 This in turn implies an increase in income

The DD-Schedule

 The DD-schedule illustrates the relationship

between the nominal exchange rate and the level of income or output such that the

goods market is in equilibrium

 The DD-schedule must be positively sloped

since an increase in the nominal exchange rate implies an increase in equilibrium

output

Deriving the DD Schedule

 Equilibrium income is Y1

suppose the exchange rate

is e1

 Now suppose the

exchange rate rises to e2

 AD ↑ and Y ↑ to Y 2

 Hence the new exchange

rate-income combination is

e 2 ,Y 2

 The locus of such points

traces out the DD-curve

Shifts in the DD-Schedule

exchange rate, which affects the equilibrium level of income

 A change in fiscal policy

 A change in planned investment

 A change in the domestic or foreign price level

 A change in autonomous consumption

 A change in the preferences for domestic goods

over foreign goods

Quick Quiz

 Which way will the DD-curve shift if:

 planned investment rises

 domestic price level rises

 consumers express an increased

preference for foreign goods

Asset Markets

goods market Now we will introduce asset markets

markets

 Money market

 Foreign exchange market

Asset Markets Equilibrium

 The money market is in equilibrium if:

demand for money = supply of money

P*L(y,i) = M s

 The foreign-exchange market is in

equilibrium if:

domestic interest rate

= expected return on foreign assets

i = i f + E(%∆e)

What is Determined in Asset Markets?

market?

 Equilibrium interest rate

exchange market?

 Equilibrium exchange rate

Exchange Rate and the 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

real money balances Interest rate Money supply M 1 s /P

Exchange Rate and the Interest Rate

 Now lets make

everything disappear…

i1=10%

Money demand L(i,y)

Equilibrium interest rate

real money balances Interest rate Money supply M 1 s /P

Exchange Rate and the

 …and reappear but

rotated clockwise

by 90 degrees

Exchange Rate and the

 Now lets add the

foreign exchange market graph

$/€ return on$ assets

e1=1.00

Expected return

on € assets

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

cause the currency to appreciate by

causing the interest rate to rise

e 1

equilibrium exchange rate

e 2

demand for money rises and we have a new equilibrium interest rate

and a new equilibrium exchange rate

i 2

L(i,y 2 )

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

demand function is L(I,y1)

 The corresponding interest

rate and exchange rate is

i1, e1 respectively

y 1

 This gives us the first

point on the AA-schedule (e 1 ,y 1 )

 Now suppose income ↑ to

y2 ⇒ money demand ↑ as does the interest rate and the exchange rate falls

y 1 y 2

 The locus of all such

points traces out the AA-curve

y 1 y 2

AA

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

 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 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 3