ECON332 Chapter Notes - Chapter 6: Money Market, Fiscal Policy, Monetary Policy

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9 Aug 2016
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Chapter #6 Notes
Macroeconomic changes that affect exchange rates, interest rates, and price levels may also affect
output. We’re going to be using short run model of the output market in an open economy to
analyze:
The effects of macro policy tools on output and current account
As well as how these macro policy tools can be used to maintain full employment
Determinants of Aggregate Demand
Aggregate demand is the amount of a country’s goods and services demanded by
households, firms, and governments throughout the world.
The aggregate demand for an open economy’s output consists of four components:
1.consumption demand (C)
2.investment demand (I)
3.government demand (G)
4.net export demand: the current account (CA)
Determinants of consumption demand
Disposable Income (Yd) = national income (Y) - taxes (T).
C=C(Yd)
Where C,Y,T are measured in terms of domestic output units.
More disposable income means more consumption expenditure, but consumption typically
increases less than the amount that disposable income increases.
Determinants of the current account
(1)Real exchange rate (q): prices of foreign products (EP*) relative to the prices of domestic
products (P), both measured in domestic currency:
q=EP*/P
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q: the price of a typical foreign basket in terms of domestic basketIs calculation above wrong
then?
As the prices of foreign products rise relative to those of domestic products, expenditure
on domestic products rises, and expenditure on foreign products falls.
(2) Disposable income (Yd): more disposable income means more expenditure on foreign
products (imports).
CA=CA (EP*/P, ) = CA (q, Yd)
How Real Exchange Rate Changes Affect the Current Account
The current account measures the value of exports relative to the value of imports:
CA = EX –IM.
When the real exchange rate q (i.e. EP*/P) rises, the prices of foreign products rise relative
to the prices of domestic products, then:
The volume of EX rises.
The volume of imports that are bought by domestic residents falls. The value of IM
in terms of domestic products rises, since foreign products are more valuable.
IM denotes the value of imports measured in terms of domestic output, NOT the volume of
foreign products imported.
Whether the CA improves or worsens depends on which effect of a real exchange rate
change is dominant, the volume effect or the value effect.
Volume effect: the effect of consumer spending shifts on exports and import quantities
Value effect: the changes of the domestic output worth of a given volume of foreign imports
We assume that the volume effect always dominates the value effect. A real depreciation
leads to an increase in the current account.
How Disposable Income Changes Affect the Current Account
A rise is disposable income (Yd) causes domestic consumers to increase their
spending on all goods, including imports from abroad, an increase in Yd
worsens the current account.
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Note: An increase in disposable income (Yd) has no effect on export demand
because the foreign income is held constant.
Determinants of Aggregate Demand
Consumption expenditure depends on the disposable income.
Determinants of the current account include:
Real exchange rate: an increase in the real exchange rate increases the current account, and
therefore increases aggregate demand of domestic products.
Disposable income: an increase in the disposable income increases consumption expenditure,
but decreases the current account.
Since consumption expenditure is usually greater than expenditure on foreign
Products, the first effect dominates the second effect.
We assume that exogenous political factors determine government purchases G and the level
of taxes T. The investment expenditure I is determined by exogenous business decisions.
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