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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
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 )
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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 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)
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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
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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 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:
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