Chapter 16 International Economics Udayan Roy Long Run and Short Run Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand ID: 732366
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Slide1
Price Levels and the Exchange Rate in the Long Run
Chapter 16
International Economics
Udayan
RoySlide2
What is a theory expected to do?
A theory is expected to make a logically explained prediction on how a change in one specified variable would affect another specified variable
For example, a theory might
make a logically explained prediction
on how a tax cut would affect the interest rate
The theory may have no idea why the tax rate would fall.
The tax rate is an
exogenous variable
in this example
However, the theory must explain what would happen to the interest rate
The interest rate is an
endogenous variable
in this exampleSlide3
Exogenous and Endogenous Variables
Endogenous variables are those variables whose increases and decreases the
theory is trying to
explain
A theory may explain how an increase in an exogenous variable affects an endogenous variable
But the
theory
doesn’t know why
the exogenous
variable increased in the first place. Slide4
Exogenous and Endogenous Variables
Every theory must provide:a list of its exogenous variables and a list of its endogenous variables
Then the theory must explain how an increase in a specified exogenous variable affects every endogenous variable
By definition, an exogenous variable cannot affect another exogenous variable; it can only affect endogenous variablesSlide5
Long Run and Short Run
Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand.
In the short run, some prices of inputs and outputs may not have time to
adjust
This could be
due to labor contracts, costs of adjustment, or imperfect information about market demand.
This chapter discusses a theory of the
long run
behavior of a “
small
” economy with flexible exchange rates under perfect capital mobility
16-
5Slide6
Long Run and Short Run
Variable
Long Run Theory
Short Run Theory
P
, the overall price level
Endogenous
Exogenous
Y
, inflation-adjusted GNP
Exogenous
Endogenous
E
e
, expected future value of the exchange rate
Endogenous
ExogenousSlide7
Real and Nominal Variables
Real variables are economic variables that can be meaningfully measured even in a barter economyFor example, a nation’s unemployment rate at a particular date or its annual wheat output are real variables
Even when a real variable is measured in currency units, it is measured in inflation-adjusted currency units
For example, in 2018 U.S. Real GDP was $18,638 billion in 2012 US dollars
So, a real variable does not need to be further adjusted for inflationSlide8
Real and Nominal VariablesNominal variables are measured in monetary units
These variables are not adjusted for inflationFor example, U.S. Nominal GDP was $20,580 billion in 2018 and $19,519 billion in 2017.
But, as
these two numbers
are not inflation adjusted, they cannot be meaningfully compared.Slide9
Ch. 16 Real Variables
In this presentation, I will discuss the long-run international macroeconomic theory of real variablesThis theory works under both flexible exchange rate systems and fixed exchange rate systems (Ch. 18)
The
long-run international macroeconomic theory of
nominal
variables will be discussed in a separate presentation
This theory depends on the exchange rate system
S
hort-run theories will be discussed in other presentationsSlide10
National Income
National income in a specified period of time is the inflation-adjusted income of the residents of the domestic country in that period of timeNational income will also be referred to as real gross domestic product (GDP) or real gross national product (GNP) even though there are small technical differences between them
National income will be denoted by the symbol
YSlide11
National Income: The Long Run
The national income produced when all resources are fully utilized is known by various names:
Long-run
national income
Natural
national income
Potential national income
Full-employment
national
income
(Yf)Assumption: In the long run, the economy makes full use of all its resourcesTherefore, in long-run equilibrium,
Y
=
Y
f
.Slide12
National Income: The Long Run
The full-employment output, Yf, is
assumed
to be exogenous
As a result,
Y
=
Y
f
is what we call a
solution A solution expresses an endogenous variable entirely in terms of exogenous variablesY = Y
f
tells us two things:
Any change in
Y
f
will cause an identical change in
Y
No other exogenous variable can affect
Y
.Slide13
Goods market equilibriumSlide14
Determinants of Aggregate Demand
Aggregate demand (
D
) is the aggregate amount of
domestically produced final goods
and services that
people
are willing to buy.
It consists of the following types of expenditure:
consumption expenditure (
C)investment expenditure (I)
government purchases (
G
)
net expenditure by
foreigners
(
CA
), also called the current account or net exports, which is exports – imports
So, aggregate demand for the domestic country’s output is
16-
14Slide15
The Four Components of Aggregate Demand
We need to specify the factors that determine
C
,
I
,
G
, and
CA
Slide16
Disposable Income
The inflation-adjusted net tax revenues of the government of the domestic country will be denoted
T
T
is assumed exogenous
Disposable income is
Y
d
=
Y
– T Slide17
Determinants of Aggregate Demand
Assumption
:
Consumption expenditure (
C
) increases when
disposable income
increases
… but by less than the increase in disposable income
Real interest rates may influence the amount of saving and consumption, but we
assume
that they are relatively unimportant here.
Wealth may also influence consumption, but we
assume
that it is relatively unimportant here
.
All factors other than disposable income that increase consumption expenditure will be denoted
C
0
and referred to as
consumption shock
. It is assumed exogenous.
16-
17Slide18
Consumption: Long Run
This will be called the
Consumption Function
As
Y
=
Y
f
in the long-run outcome,
in the long-run
outcome
Note that
expresses the endogenous variable
C
entirely in terms of exogenous variables
C
0
,
Y
f
, and
T
C
is increasing in the first two and decreasing in the third
Slide19
Determinants of Aggregate Demand
Assumption: Both investment spending (I) and government spending (G
) are exogenous
Consequently, although our theory does discuss how changes in
I
and
G
affect endogenous variables such as
Y
and
CA, our theory has no idea what makes I and G increase or decreaseSlide20
Determinants of Aggregate Demand
Therefore,
Slide21
Equilibrium in the Goods Market
For the goods market to be in equilibrium, national income must equal aggregate demand:
Therefore,
becomes
This equation represents equilibrium in the domestic country’s goods markets
Slide22
The Current Account in the long run
The balance on a country’s current account (CA) is roughly its net exportsWhat does
CA
depend on in the long run?Slide23
The Current Account: The Long Run
Recall that
in the long run
So
,
in the long run
Recall that
C
0
,
I
,
G
,
T
, and
Y
f
are
exogenous.
So, the previous equation expresses the endogenous variable
CA
entirely in terms of exogenous variables
Slide24
The Current Account: The Long Run
in the long run
Recall my assumption that when
Y
–
T
increases, so does
C
but by a smaller amount.
Therefore, when
Y
f
increases,
Y
f
–
C
also increases.
Therefore,
CA
increases
.
That is,
when
Y
f
increases,
CA
increases
.
And vice
v
ersa
Slide25
The Current Account: The Long Run
in the long run
When
T
increases,
Y
–
T
decreases
Therefore,
C
decreases.
Therefore,
CA
increases
.
That is,
when
T
increases,
CA
increases
.
And vice
v
ersa
Slide26
The Current Account: The Long Run
in the long run
Recall that
C
0
represents a positive consumption shock
When
C
0
increases,
C
increases
Therefore
,
CA
decreases.
In the same way, when either
I
or
G
increases,
CA
decreases
That is,
when
C
0
, or
I
, or
G
increases
,
CA
decreases
.
And vice
v
ersa
Slide27
The Current Account: The Long Run
To summarize, in the long run,
CA
is
directly related with
Y
f
and
T
, and
inversely related with
C
0
,
I
and
G
The key things are domestic supply and demand.
When domestic supply increases or domestic demand decreases, net exports increases.
CA
Y
f
,
T
+
C
0
,
I
,
G
−Slide28
The Current Account: The Long Run
We just saw that, in the long run, CA is
directly related with
Y
f
and
T
, and
inversely related with
C
0, I
and
G
It also follows that
no other exogenous variable
can affect net exports (
CA
) in the long run
Coming to government policy, the only way for a government to increase the current account is
contractionary fiscal policy
.
CA
Y
f
,
T
+
C
0
,
I
,
G
−Slide29
The Current Account: The Long RunFiscal policy refers to the use of a government’s budget—its plans for spending and taxation—to steer the economy
Contractionary fiscal policy or “fiscal austerity”
or “belt tightening” (
T
↑ or
G
↓) is
the
only
way for a government to raise a country’s net exports (
CA
↑
) in the long run
In particular, tariffs will be of no use
Monetary policy, which refers to the tools used by the central bank to steer the economy,
will be of no useSlide30
The real exchange rate
See subsection “The Real Exchange Rate” of Chapter 16Slide31
The Real Exchange RateWe discussed exchange rates in Chapter 14
Example: €1 = $1.50
Those exchange rates were
nominal
exchange rates
Now we’ll discuss
real
exchange ratesSlide32
The Real Exchange Rate
Let us consider the price of an iPhone in US and Europe:
In US, it is
P
US
= $200
In Europe, it is
P
E
=
€150The value of the euro is E
= 2 dollars per euro
So, Europe’s price
in dollars
is
E
×
P
E
= $300
So, each iPhone in Europe costs as much as 1.5 iPhones in US
E
×
P
E
/
P
US
= 1.5
This is the real dollar/euro exchange rate for iPhonesSlide33
The Real Exchange Rate
In general, the real exchange rate is a broad summary measure of the prices of
the foreign
country’s goods and services relative to the domestic country’s goods and services
.
The
real
dollar/euro exchange rate is the number of US reference commodity baskets—not just iPhones—that one European reference commodity basket is worth
Equation (16-6) in KOM 10e
E
$/
€
is the nominal exchange rate, the price of one euro in dollars
P
E
is the overall price level in Europe, such as the consumer price index
P
US
is the overall price level in the United StatesSlide34
Depreciation and Appreciation
Euro
Dollar
Europe’s exports
America’s exports
q
$/
€
↑
Real Appreciation
Real Depreciation
More expensive
Less expensive
q
$/
€
↓
Real Depreciation
Real Appreciation
Less expensive
More expensiveSlide35
The Real Exchange Rate
Example: If the European reference commodity basket costs
€100, the U.S. basket costs $120, and the nominal exchange rate is $1.20 per euro, then the real dollar/euro exchange rate (
q
$/
€
) is 1 U.S. basket per European basket.Slide36
Real Depreciation and Appreciation
Real depreciation of the dollar against the euro
A rise in the real dollar/euro exchange rate (
q
$/
€
↑
)
is a fall in the purchasing power of a dollar within Europe’s borders relative to its purchasing power within the United States
Or alternatively, a fall in the purchasing power of America’s products in general over Europe’s.
Real appreciation of the dollar against the euro is the opposite of a real depreciation: a fall in q$/€
.Slide37
Real exchange rate in the long run I: absolute ppp
This is the simplest long-run theory of the real exchange rate. It is also called the Law of One PriceSlide38
Absolute PPP
A very simple theory of the real exchange rate is called Absolute Purchasing Power Parity
It says that:
q
= 1
Why?Slide39
Law of One Price
Going back for a second to the
iPhone example
, one can argue that
P
US
, the dollar price in the US, ought to be equal to
E
×
P
E, the dollar price in Europe. That is,E
×
P
E
=
P
US
.
In general,
E
$/
€
x
P
E
=
P
US
.
Therefore,
q$/€
= (
E
$/
€
x
P
E
)/
P
US
= 1
.This is the Law of One Price or Absolute Purchasing Power Parity.Slide40
Law of One Price for Hamburgers?Slide41
Some Meaty Evidence on the Law of One PriceSlide42
Empirical Evidence on PPP and the Law of One Price
International price comparisons typically conclude that absolute PPP is way off the mark
The prices of identical goods, when converted to a single currency, differ substantially across countries
So, we need a different theory
For that we’ll look at equilibrium in the goods marketSlide43
Real exchange rate in The long run II: relative PPP
This is our second theory of the real exchange rate in the long run. Equilibrium in the markets for goods and services requires that the output of goods and services be equal to the demand
for goods and services
This is from Chapter 17, but let’s do it now anywaySlide44
Aggregate Demand under RPPP
Recall that the real exchange rate (q) is the price of foreign goods (measured in units of domestic goods)
Therefore, the theory of relative purchasing power parity (RPPP) assumes that the domestic country’s net exports (
CA
) depends directly on the real exchange rate
As a result, domestic country’s aggregate demand (
D
=
C
+
I + G + CA) depends directly on the real exchange rate (
q
)
Finally, RPPP says that
q
takes the value that makes supply equal demand (
Y
=
D
)Slide45
Determinants of Aggregate Demand
Recall that the goods market is in equilibrium when
Recall also that consumption obeys
and that both
I
and
G
are assumed exogenous
That leaves
CA
, the last of our four sources of aggregate demand
Slide46
Determinants of Aggregate Demand
Assumption
: The balance on the current account (
CA
) increases …
… when the
real exchange rate
(
q
) increases
Recall that the real exchange rate is the price of foreign products relative to the price of domestic products: q = EP*/P… when
disposable income
decreases
more disposable income (
Y-T
) means more expenditure on foreign products (imports). Therefore,
when
Y
−
T
rises,
CA
falls
.
… when other factors, denoted by
CA
0
, increase. Call this the
current account shock
.
16-
46Slide47
Determinants of Aggregate Demand
An increase in the current account shock,
CA
0
, could represent:
A swing in consumer preferences away from foreign goods and towards domestic goods
An increase in the domestic country’s tariffs on imports
16-
47Slide48
Goods Market Equilibrium
So, we now have:
, the Consumption Function
I
and
G
are assumed exogenous, and
This will be called the
Current Account Function
Therefore, the goods market equilibrium condition becomes:
Slide49
Goods Market Equilibrium
Recall that
Y
=
Y
f
in the long-run outcome
Therefore, the goods market equilibrium in the long run is:
Slide50
Real Exchange Rate: Long Run
Suppose
C
0
↑ or
I
↑ or
G
↑
.
These exogenous variables cannot affect any other exogenous variable, such as
Y
f
.
Therefore,
Y
f
is unchanged and
C
+
I
+
G
↑
.
Therefore
,
must
↓
.
Therefore,
q
must
↓
, as there is no other way for
CA
to
↓.
16-
50Slide51
Real Exchange Rate: Long Run
Suppose
CA
0
↑
. (What could be the reason?)
C
,
I
,
G
, and
Y
f
must remain unchanged.
Therefore
,
must remain
unchanged.
Recall that
is
increasing in
CA
0
and in
q
Therefore,
q
must
↓
to ensure
is unchanged despite
CA
0
↑
16-
51Slide52
Real Exchange Rate: Long Run
Suppose
Y
f
↑
.
By my assumption,
must
↑
but by less than the ↑ in
Y
f
.
Therefore, as
I
and
G
are unchanged,
must
↑.
Recall that
is
increasing
in
q
and decreasing in
Y
f
.
Therefore,
q
must ↑
to ensure
increases despite
Y
f
↑.
16-
52Slide53
Real Exchange Rate: Long Run
Suppose
T
↑
.
By my assumption,
↓.
As
Y
f
,
I
, and
G
are unchanged,
must
↑ by the
same amount
as the decrease in
.
By my assumption, the effect of
Y
f
– T alone on
CA
is the
reverse
of its effect on
C
and
smaller
in magnitude
Therefore
,
q
must ↑
to ensure
increases by the same amount that
C
decreases.
16-
53Slide54
Real Exchange Rate: Long Run
The results derived in the previous slides are pure supply-demand common sense:When
C
0
↑ or
I
↑ or
G
↑ or
CA0↑ or T↓, the aggregate demand for the domestic country’s goods and services (D = C
+
I
+
G
+
CA
)
must increase.
So, the relative price of the domestic country’s goods and services must
increase
.
But this implies that the
relative price of the
foreign
country’s goods and services must
decrease
. Therefore,
q↓.Slide55
Real Exchange Rate: Long RunThe results derived in the previous slides are pure supply-demand common sense:
When Yf
↑
, the aggregate supply of the
domestic country’s goods and services increases, by definition.
So, the relative price of the domestic country’s goods and services must decrease.
But this implies that the
relative price of the
foreign
country’s goods and services must increase. Therefore, q↑.Slide56
Summary: Long-Run, Real Variables
Y
CA
q
Y
f
+
+
+
C
0
+
I
+
G
–
–
CA
0
–
T
+
+
The predictions derived so far are shown in this
predictions table
.
The
first
column
lists the
exogenous
variables.
The first
row
lists the
endogenous
variables. The content of each cell predicts
the effect of the corresponding exogenous variable on the corresponding endogenous variable
.
A
blank cell
indicates
no effect
. Further,
‘+’
indicates a
direct effect
,
‘–’
an
inverse effect
, and
‘?’
indicates an
ambiguous effect
.Slide57
Summary: Long-Run, Real Variables
I
and
G
are assumed exogenous, and
Therefore, the goods market equilibrium becomes:
In the long run,
Y
=
Y
f
. Therefore, in the long run:
Slide58
Exercises
How is the real exchange rate affected in the long run by a permanent increase in:
fiscal stimulus?
money supply?
f
oreigners’ preference for domestic products?
t
ariffs on imported goods?
f
oreign/domestic income and household wealth?Slide59
Absolute and Relative PPP
This chapter considers both Absolute PPP
and
Relative PPP
Absolute PPP:
q
= 1
Relative PPP:
q
=
a constant, not necessarily 1Either way, the simplifying assumption is that over time things will work out so that the real exchange rate will be constantThe results
on
the following
slide
are true under both APPP and RPPP
Slide60
The Long Run and Monetary Neutrality
The macroeconomic analysis of the long run is characterized by the concept of monetary neutralityThat is,
monetary arrangements and monetary policy have no effect on the behavior of real variables
Therefore, the predictions summarized on the previous slide are true for both the flexible exchange rate system of this chapter and the fixed exchange rate system of Chapter 18Slide61
Growth rate mathSlide62
The Algebra of Growth Rates
The growth rate of the ratio
of two variables equals the growth rate of the numerator
minus
the growth rate of the
denominator.
The growth rate of the
product
of two variables equals the
sum
of their growth rates.
The growth rate of a variable
raised to
an exponent, is the growth rate of the variable
times
the exponent.Slide63
Proof: If Z = X × Y then gz =
gx + gy
The growth rates here are in
decimal
form: for example, if
X
grows at the rate of 5%, then
g
x
= 0.05. The product of two decimals is small enough to be ignored: for example, 0.05 × 0.04 = 0.0020.Slide64
If Z = X ÷ Y then gz = gx – g
y Slide65
If Z = Xa then
gz = a × gx
(
x
multiplied by itself,
a
times)
Slide66Slide67
Exchange Rate Systems
In Chapters 16 and 17, we assume a flexible exchange rate systemIn Chapter 18, we will study a
fixed
exchange rate system
Nowadays, flexible exchange rates are more commonSlide68
Exchange Rate SystemsIn the analysis of flexible exchange rate systems,
The (nominal) exchange rate, E
, is an endogenous variable
. So, its fluctuations must be explained by the theory, and
The money supply,
M
s
, is an exogenous variable
. So, its level and growth rate are assumed known.
In
the analysis of fixed exchange rate systems, it’s the other way around. (See Ch. 18.)Slide69
Prices and the Exchange Rate
Relative PPP says:
Therefore,
Therefore, as
is assumed constant in the long run, the
faster
domestic prices (
P
) grow, the
faster
the foreign currency’s exchange value (
E
) will grow
And, the
faster
foreign prices (
P
*
) grow, the
slower
the foreign currency’s exchange value (
E
) will grow
Slide70
Prices and the Exchange Rate
In general,
where
E
g
is the growth rate of
E
. This is the
appreciation rate of the foreign currency
π
*
is the foreign inflation rate, and
π is the domestic inflation rate
Example: If US inflation is 3% a year and Canadian inflation is 1% a year, then the exchange value of the Canadian dollar, measured in US dollars, will increase 2% a year
Equation (16-2) of the textbook, KOM 10eSlide71
The Interest Rate
We have seen in Chapter 14 that the interest parity equation is
The second term on the right-hand side is the
expected
appreciation rate of the foreign currency
Assumption
: The
expected
appreciation rate is assumed to be equal to the
actual
appreciation rate (
E
g
), in the long run
Slide72
The Interest Rate
Therefore,
We saw two slides earlier that
Therefore,
Assumption
: The foreign interest rate (
R
*
) and the foreign inflation rate (
π
*
) will be assumed to be exogenous constants
Equation (16-5) of the textbook, KOM 10eSlide73
The Interest Rate: Fisher Effect
As the foreign interest rate (
R
*
) and the foreign inflation rate (
π
*
) are assumed to be exogenous constants,
any change in the domestic inflation rate will cause an equal change (both in magnitude and direction) in the domestic nominal interest rate
This is called the
Fisher Effect
See “The Fisher Effect” in Ch. 16 of the textbook
Slide74
Real Interest Rate Parity
implies
R
is the
nominal
interest rate.
It tells you how fast the
dollar value
of your wealth is increasing
R
–
π
is the
real
(or, inflation-adjusted) interest rate.
It tells you how fast the
purchasing power
of your wealth is increasing
We now see that
in the long run equilibrium, real interest rates must be equal in all countries
Slide75
The Interest Rate
Assumption: The domestic inflation rate (
π
) is constant in the long run equilibrium
Then
must also be constant in the long run equilibrium
We will now use this constancy of
R
to get a theory of long run inflation
Slide76
Inflation
We have seen in Chapter 15 that equilibrium in the money market implies
Moreover,
Therefore, in equilibrium,
Therefore,
Slide77
Inflation
Therefore, in the long-run,
We saw three slides back that
R
is constant in the long run equilibrium. Also,
Assumption
:
L
0
is an exogenous constant.
Therefore, the
faster
the money supply (
M
s
) grows, the
faster
the price level (
P
) will grow
And, the
faster
potential GDP (
Y
f
) grows, the
slower
the price level (
P
) will grow
Slide78
Inflation
In general,
Note that this is a
solution
because
it expresses an endogenous
variable,
π
,
entirely
in terms of exogenous variables
For example, if the Federal Reserve expands US money supply at the rate of 5% a year and if the US economy’s potential GDP increases at the rate of 3% a year, then, in the long run, the US inflation rate will be 2% a year.
Slide79
The Interest Rate, again
So far, we have shown that
(interest parity),
, and
Therefore, the domestic nominal interest rate in the long run is
, a constant
Note that this is a
solution
because it expresses an endogenous variable,
R
,
entirely
in terms of exogenous
variables
Slide80
The Price Level
A few slides back, we saw that in the long run the domestic price level is
Moreover, we just saw that
Therefore, in the long run, the domestic price level is
Note that this is a
solution
for the long-run equilibrium value of
P
as all variables to the right of the equals sign are exogenous
Slide81
Appreciation Rate of the Foreign Currency
We saw earlier that the foreign currency appreciates at the rate
, and
the inflation rate is
,
Therefore,
Note that this is a
solution
because it expresses an endogenous variable,
E
g
,
entirely
in terms of exogenous variables
Slide82
The Exchange Rate
Recall that under relative purchasing power parity, we have
, which implies
We have also seen two slides back that
Therefore,
Slide83
Summary: Long-Run, Flexible Exchange Rates
Relative PPP:
yields
q
Absolute PPP:
Y
=
Y
f
Note that, except for the equation for
q
under Relative Purchasing Power Parity,
the variables on the right-hand sides of these equations are all exogenous. As
exogenous
variables are ‘mystery variables’ about which our theory has nothing to say, the equations on this slide say
all
that our theory can say about the
endogenous
variables on the left-hand sides of these equations.Slide84
Summary: Long-Run, Flexible Exchange Rates
Keep in mind that we are talking about the
long run
here. So, these equations show us the long run effects of
permanent
changes in the exogenous variables on the right-hand sides
of these equations
’.
Relative PPP:
yields
q
Absolute PPP:
Y
=
Y
f
Slide85
Summary: Long-Run, Flexible Exchange Rates
The first
three
variables are
real
variables --
they can be measured even in barter (or, non-monetary) economies. The remaining variables are
nominal
variables -- they make sense only on monetary economies.Note that the money supply (Ms) has no effect on real variables. This is an instance of monetary neutrality
in the long run.
Relative PPP:
yields
q
Absolute PPP:
Y
=
Y
f
Slide86
Summary: Long-Run, Flexible Exchange Rates
Flashback to Ch. 15 of the textbook (KOM 10e):
“
A change in the supply of money has no effect on the long-run values of the interest rate or real output
.” (p. 395)
“
A permanent increase in the money supply causes a proportional increase
in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.
” (p. 396)
Relative PPP:
yields
q
Absolute PPP:
Y
=
Y
f
Slide87
Summary: Long-Run, Flexible Exchange Rates
The
effect of full-employment output (
Y
f
) on the foreign currency’s value (
E
) is ambiguous.
Why? When full-employment output
increases
, both the numerator and the denominator of the equation for E increase. So, the effect on E is indeterminate.
Relative PPP:
yields
q
Absolute PPP:
Y
=
Y
f
Slide88
Summary: Long-Run, Flexible Exchange Rates
Y
CA
q
E
E
g
R
P
π
Y
f
+
+
+
?
–
C
0
+
I
+
G
–
–
–
T
+
+
+
CA
0
–
–
M
s
+
+
L
0
–
–
R
*
+
+
+
M
s
g
–
Y
f
g
+
+
+
+
+
π*
–
–
–
–
P
*
–
The predictions implied by the solution equations on the previous slide are shown in this
predictions table
.
The
first
column
lists the
exogenous
variables.
The first
row
lists the
endogenous
variables. The content of each cell predicts
the effect of the corresponding exogenous variable on the corresponding endogenous variable
.
A
blank cell
indicates
no effect
. Further,
‘+’
indicates a
direct effect
,
‘–’
an
inverse effect
, and
‘?’
indicates an
ambiguous effect
.Slide89
Exercises
What are long-run effects of expansionary fiscal policy (
G
↑ and/or
T
↓) under flexible exchange rates?
What are long-run effects of
expansionary
monetary policy
(Ms↑) under flexible exchange rates?What are the effects of an increase in R*−
π
*
?
What are the effects of an increase in
P
*
?