National income, exchange rates, earnings growth and stock markets (I)
Output, exchange rates, earnings growth and stock markets (I)
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FINC5090 Finance in The Global Economy
DR ALESSIO GALLUZZI
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Lecture 7 National income, exchange rate, earnings growth and stock markets (I)
Real exchange rate and aggregate demand
Short-run equilibrium analysis for an open economy
Temporary changes in monetary and fiscal policy
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Long-run models are useful when all prices of inputs and outputs have time to adjust.
In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about willingness of customers to pay at different prices.
This chapter builds on the short-run and long-run models of exchange rates to explain how output is related to exchange rates in the short run.
It shows how macroeconomic policies can affect production, employment, and the current account.
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1. Real exchange rate and aggregate demand: aggregate demand
Aggregate demand is the aggregate amount of goods and services that individuals and institutions are willing to buy:
consumption expenditure (C)
investment expenditure (I)
government purchases (G)
net expenditure by foreigners: the current account (CA)
For now, we assume taxes T, investment demand I and government purchases G are all fixed (i.e. exogenous factors).
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1. Real exchange rate and aggregate demand: consumption expenditure
Determinants of consumption expenditure include:
Disposable income: income from production (Y) minus taxes (T).
More disposable income means more consumption expenditure, but consumption typically increases less than the amount that disposable income increases.
Real interest rates may influence the amount of saving and spending on consumption goods, but we assume that they are relatively unimportant here.
Wealth may also influence consumption expenditure, but we assume that it is relatively unimportant here.
Consumption expenditure is modeled as a function of disposable income: C(Y-T)
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1. Real exchange rate and aggregate demand: current account
Determinants of the current account include:
Real exchange rate: prices of foreign products (P*) relative to the prices of domestic products (P), both measured in domestic currency:
As the prices of foreign products rise relative to those of domestic products, expenditure on domestic products rises, and expenditure on foreign products falls.
Disposable income: more disposable income means more expenditure on foreign products (imports).
Current account is modeled as a function of real exchange rate and disposable income:
CA(Y-T, )
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1. Real exchange rate and aggregate demand: current account
Assume that a real depreciation leads to an increase in the current account: the volume effect (import decreases) dominates the value effect (import value increases due to the higher real exchange rate).
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1. Real exchange rate and aggregate demand: aggregate demand a function of output
Aggregate demand is therefore expressed as:
where C, CA, Y, T, I , G and EP*/P are defined the same as in the previous slides.
Or more simply:
Note T, I and G are exogenous.
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1. Real exchange rate and aggregate demand: aggregate demand a function of output
If all other factors remain unchanged, a rise in output (real income), Y, increases aggregate demand. Because the increase in aggregate demand is less than the increase in output, the slope of the aggregate demand function is less than 1 (as indicated by its position within the 45-degree angle).
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1. Real exchange rate and aggregate demand: aggregate demand a function of output
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.
As income increases for a given level of taxes, aggregate consumption expenditure and aggregate demand increase by less than income.
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1. Real exchange rate and aggregate demand: short-run equilibrium for AD and output
Equilibrium is achieved when the value of output and income from production Y equals the value of aggregate demand D
where aggregate demand is a function of the real exchange rate, disposable income, investment expenditure and government purchases.
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1. Real exchange rate and aggregate demand: short-run equilibrium for AD and output
In the short run, output settles ate Y1 (point 1), where aggregate demand, D1, equals aggregate output Y1.
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1. Short-run equilibrium analysis (open economy): DD schedule
How does the exchange rate affect the short-run equilibrium of aggregate demand and output?
With fixed domestic and foreign levels of average prices, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services. (note in the short-run, P remains unchanged)
A rise in the nominal exchange rate (a domestic currency depreciation) increases aggregate demand of domestic products.
In equilibrium, production will increase to match the higher aggregate demand.
The DD schedule displays the trajectory of the changes in the equilibrium aggregate demand driven by the changes in the nominal exchange rate.
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Deriving the DD Schedule
The DD schedule:
shows combinations of output and the exchange rate at which the output market is in short-run equilibrium (such that aggregate demand = aggregate output).
slopes upward because a rise in the exchange rate from E1 to E2 all else equal, causes output to rise from Y1 to Y2.
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Shifting the DD curve
Changes in the exchange rate cause movements along a DD curve. Other changes cause it to shift:
Changes in G: more government purchases cause higher aggregate demand and output in equilibrium. Output increases for every exchange rate: the DD curve shifts right.
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1. Short-run equilibrium analysis (open economy): shifting DD schedule
Changes in T: lower taxes generally increase consumption expenditure, increasing aggregate demand and output in equilibrium for every exchange rate: the DD curve shifts right.
Changes in I: higher investment expenditure is represented by shifting the DD curve right.
Changes in P relative to P*: lower domestic prices relative to foreign prices are represented by shifting the DD curve right.
Changes in C: willingness to consume more and save less is represented by shifting the DD curve right.
Changes in demand of domestic goods relative to foreign goods: willingness to consume more domestic goods relative to foreign goods is represented by shifting the DD curve right.
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2. Short-run equilibrium analysis (open economy): AA schedule
The DD schedule shows the exchange rate and output levels that set output market in equilibrium in the short-run.
Equilibrium in the economy as a whole requires equilibrium in the asset market (i.e. exchange market and money market) as well.
The schedule of exchange rate and output combinations that are consistent with equilibrium in domestic money market and the foreign exchange market is called the AA schedule.
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2. Short-run equilibrium analysis (open economy): AA schedule
Foreign exchange markets
interest parity represents equilibrium:
Money market
Equilibrium occurs when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded:
A rise in income from production causes the demand of real monetary assets to increase (notice the downward shift of the L(R, Y) curve in the lower part of the graph).
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2. Short-run equilibrium analysis (open economy): AA schedule
When income and production increase,
demand of real monetary assets increases,
leading to an increase in domestic interest rates,
leading to an appreciation of the domestic currency.
Recall that an appreciation of the domestic currency is represented by a fall in E.
The inverse relationship between output and exchange rates needed to keep the foreign exchange markets and the money market in equilibrium is summarized as the AA curve.
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2. Short-run equilibrium analysis (open economy): shifting the AA curve
1. Changes in Ms: an increase in the money supply reduces interest rates in the short run, causing the domestic currency to depreciate (a rise in E) for every Y: the AA curve shifts up (right).
2. Changes in P: An increase in the level of average domestic prices decreases the supply of real monetary assets, increasing interest rates, causing the domestic currency to appreciate (a fall in E): the AA curve shifts down (left).
3. Changes in the demand of real monetary assets: if domestic residents are willing to hold a lower amount of real money assets and more non-monetary assets, interest rates on nonmonetary assets would fall, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up (right).
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2. Short-run equilibrium analysis (open economy): shifting the AA curve
4. Changes in R* : An increase in the foreign interest rates makes foreign currency deposits more attractive, leading to a depreciation of the domestic currency (a rise in E): the AA curve shifts up (right).
5. Changes in Ee : if market participants expect the domestic currency to depreciate in the future, foreign currency deposits become more attractive, causing the domestic currency to depreciate (a rise in E): the AA curve shifts up (right).
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2. Short-run equilibrium analysis (open economy): putting the DD and AA curves together
A short-run equilibrium means a nominal exchange rate and level of output such that
equilibrium in the output markets holds: aggregate demand equals aggregate output.
equilibrium in the foreign exchange markets holds: interest parity holds.
equilibrium in the money market holds: the quantity of real monetary assets supplied equals the quantity of real monetary assets demanded.
A short-run equilibrium occurs at the intersection of the DD and AA curves:
output markets are in equilibrium on the DD curve
asset markets are in equilibrium on the AA curve
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2. Short-run equilibrium analysis (open economy): putting the DD and AA curves together
The short-run equilibrium of the economy occurs at point 1, where the output market (whose equilibrium points are summarized by the DD curve) and the asset market (whose equilibrium points are summarized by the AA curve) simultaneously clear.
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2. Short-run equilibrium analysis (open economy): putting the DD and AA curves together
Imagine the economy is instead at point 2, where both the output and asset markets are out of equilibrium.
Because asset markets adjust very quickly, the exchange rate jumps immediately from point 2 to point 3 on AA*. The economy then moves to point 1 along AA as output rises to meet aggregate demand**.
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*the domestic currency is currently undervalued, making domestic deposits more attractive relative to the foreign ones. Thus demand on domestic currency rises and E will drop from E2 to E3
** At both point 2 and 3, the exchange rates are not low enough to clear the output market (excess demand for domestic output). Firms increase production and economy travels along AA to point 1.
3. Temporary changes in monetary and fiscal policy
Temporary changes in monetary policy
An increase in the quantity of monetary assets supplied lowers interest rates in the short run, causing the domestic currency to depreciate (E rises).
The AA shifts up (right).
Domestic products relative to foreign products are cheaper, so that aggregate demand and output increase until a new short-run equilibrium is achieved.
By shifting AA1 upward, a temporary increase in the money supply causes a currency depreciation and a rise in output.
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3. Temporary changes in monetary and fiscal policy
Temporary changes in fiscal policy
An increase in government purchases or a decrease in taxes increases aggregate demand and output in the short run.
The DD curve shifts right.
Higher output increases the demand for real monetary assets,
thereby increasing interest rates,
causing the domestic currency to appreciate (E falls).
By shifting DD1 to the right, a temporary fiscal expansion causes a currency appreciation and a rise in output.
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3. Temporary changes in monetary and fiscal policy: policies to maintain full employment
Resources used in the production process can either be over-employed or underemployed.
When resources are used effectively and sustainably, economists say that production is at its potential or natural level.
When resources are not used effectively, resources are underemployed: high unemployment, few hours worked, idle equipment, lower than normal production of goods and services.
When resources are not used sustainably, labor is over-employed: low unemployment, many overtime hours, over-utilized equipment, higher than normal production of goods and services.
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3. Temporary changes in monetary and fiscal policy
Policies to maintain full employment
A temporary fall in world demand shifts DD1 to DD2, reducing output from Yf to Y2 and causing the currency to depreciate from E1 to E2 (point 2).
Temporary fiscal expansion can restore full employment (point 1) by shifting the DD schedule back to its original position.
Temporary monetary expansion can restore full employment (point 3) by shifting AA1 to AA2.
The two policies differ in their exchange rate effects: The fiscal policy restores the currency to its previous value (E1), whereas the monetary policy causes the currency to depreciate further, to E3.
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3. Temporary changes in monetary and fiscal policy
Policies to maintain full employment
After a temporary money demand increase (shown by the shift from AA1 to AA2), either an increase in the money supply or temporary fiscal expansion can be used to maintain full employment.
The two policies have different exchange rate effects: The monetary policy restores the exchange rate back to E1, whereas the fiscal policy leads to greater appreciation (E3).
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3. Temporary changes in monetary and fiscal policy: policies to maintain full employment
Policies to maintain full employment may seem easy in theory, but are hard in practice.
We have assumed that prices and expectations do not change, but people may anticipate the effects of policy changes and modify their behavior.
Workers may require higher wages if they expect overtime and easy employment, and producers may raise prices if they expect high wages and strong demand due to monetary and fiscal policies.
Fiscal and monetary policies may therefore create price changes and inflation, thereby preventing high output and employment: inflationary bias.
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3. Temporary changes in monetary and fiscal policy: policies to maintain full employment
Economic data are difficult to measure and to understand.
Policy makers cannot interpret data about asset markets and aggregate demand with certainty, and sometimes they make mistakes.
Changes in policies take time to be implemented and to affect the economy.
Because they are slow, policies may affect the economy after the effects of an economic change have dissipated.
Policies are sometimes influenced by political or bureaucratic interests.
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Outputs, exchange rate, earnings growth and stock market (II)
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Important Reminders
Mid-semester exam is next week, Tuesday April 12 3-4pm Sydney local time. Please be aware of daylight savings since
FINC5090 Record+ (Type B) Mid-semester exam Canvas site is ready
Familiarise yourself with the test format and make sure ProctorU is set up correctly
Exam is closed book. A formula sheet will be provided with the exam questions
If you have not done so yet, reach out to the team members about the Group Assignment
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