This document provides a summary of lecture notes on introducing aggregate demand (DD) and asset market (AA) curves. It discusses the components of aggregate demand, including consumption, investment, government spending, and the current account. It then introduces the DD curve to show the relationship between output and the exchange rate, and the AA curve to show the relationship between output and the exchange rate based on money market equilibrium. The two curves are combined to show the overall general equilibrium in the goods and asset markets, where the intersection of the DD and AA curves indicates macroeconomic equilibrium.
This document provides a summary of lecture notes on introducing aggregate demand (DD) and asset market (AA) curves. It discusses the components of aggregate demand, including consumption, investment, government spending, and the current account. It then introduces the DD curve to show the relationship between output and the exchange rate, and the AA curve to show the relationship between output and the exchange rate based on money market equilibrium. The two curves are combined to show the overall general equilibrium in the goods and asset markets, where the intersection of the DD and AA curves indicates macroeconomic equilibrium.
This document provides a summary of lecture notes on introducing aggregate demand (DD) and asset market (AA) curves. It discusses the components of aggregate demand, including consumption, investment, government spending, and the current account. It then introduces the DD curve to show the relationship between output and the exchange rate, and the AA curve to show the relationship between output and the exchange rate based on money market equilibrium. The two curves are combined to show the overall general equilibrium in the goods and asset markets, where the intersection of the DD and AA curves indicates macroeconomic equilibrium.
revised 4/24/01 Lecture 5A: Introduce DD and AA Curves (first half of chapter 16) Topics: Aggregate Demand Equilibrium in the goods market: DD curve Asset market: AA curve Overall Equilibrium 1) Aggregate Demand a) Def: amount of countrys goods and services that people at home and abroad together are willing and able to purchase. Represent with D. Are several components to aggregate demand: D = C + I + G + CA (demand is sum of consumption, investment , government expenditure and foreign demand) b) Consumption: What determines consumption: Main determinant here is disposable income: Def: Y d = national income - taxes. Write this: C = C(Y d ). Means consumption is a function of disposable income, positive function. c) Consider what determines current account Regard this as EX - IM 1) Yd saw increase in Yd makes consumers want consume more goods - foreign as well as domestic. So imports rise, CA falls. 2) Real exchange rate: E P*/P Recall this is relative price of representative basket in foreign country in terms of representative home basket. Real E affects CA because affects price of domestic goods relative to foreign. For example: if EP*/P rises, means foreign products are more expensive. IF change any element, will make more expensive (E,P*,P) increases exports, because your goods are cheaper and more attractive. Affect imports: ambiguous: decreases number Jaguars will buy, because are more expensive, but since each Jaguar is worth more $, is possible that the total # of dollars being spent on importing jaguars rises. We assume for now that CA will improve when real E rises. 2 d) Summarize in equation of aggregate demand: D = C(Y-T) + I + G + CA(EP*/P, Y-T) or summarizing more: D = D(EP*/P, Y-T, I, G) Conclusions: Effect on D: 1) A real depreciation (rise in EP*/P) makes domestic goods cheaper relative to foreign goods, so it shifts domestic and foreign spending from foreign goods to domestic goods, so CA increases and aggregate D increases. 2) A rise in income a) raises consumption, which raises D b) part of this consumption is on foreign goods, rise in imports, so CA falls, which would tend to lower D. Overall, increase in Y causes D to rise, but less so than in closed economy where didnt consider CA. Graph: Idea: as increase Y, stimulates demand also, but part leaks away abroad because imports rise. So is flatter than 45 degrees. Note: start at positive intercept: because even if no income, still want to consume something, and government expend constant at some level regardless of Y. Y D D(EP*/P,Y-T,I,G) 3 2) Equilibrium in the goods market Equilibrium condition: demand for goods and services equals amount being produced: aggregate demand equals output. Y = D(EP*/P,Y-T,I,G) Graph this. Line for Y=D: 45 deg line at origin. Graph: Equilibrium is at Y1. Equilibrating forces: If at Y2: is D exceeds output. Depletes inventories of firms, so they produce more. Y increases until equals D. If at Y#, D is less than Y: Firms inventories build up, so produce less, until Y equals D. This should be familiar from previous macro classes. But now want to consider relationship to exchange rate. Y D D(EP*/P,Y-T,I,G) D=Y D+Y Y1 Y2 Y3 4 3) DD Curve This is taking E as given. What if E rises (domestic currency depreciates)? Given fixed prices, this will cause the real exchange rate to rise (home goods become cheaper). This shifts D up, because $ depreciation stimulates exports and dampens imports. New equilibrium in goods market. Increased demand will deplete inventories and cause firms to produce more. As E rises (home currency depreciated), shifts up D-line, and raises equilibrium output. Cans summarize this in a curve. DD curve. Graph: So DD curve summarizes the effect on equilibrium goods market of change in Y. Y Y D E D=Y D+Y Y2 Y2 Y1 Y1 D(E1,Y-T,I,G) D D D(E2,Y-T,I,G) 5 What shifts DD curve to right: (draw new double graph: shift D and Shift DD) a) Increase in government expenditure: (example: need anti-missile shield) Top graph: Increase D (aggregate demand) for any given output level there is more demand. So Equilibrium Y will be higher, even if E is same. Bottom graph: equilibrium Y is higher for any given E. Therefore must shift DD to right. So Increases in G cause DD to shift to right. b) Fall in taxes: Top part: higher disposable income, so consumption rises, so D curve shift out. And higher equilibrium Y. Bottom part, higher equilibrium Y for any given E, so DD curve shift right. c) increase in I: like G here d) Increase in overall C function: If suddenly decide to consume more of everything. Happened in US in 80s. Shifts D and DD like above. e) Switch tastes away from foreign goods to home: tastes change. In 80s, when oil price drops, tastes shift back to bigger US cars. General principle: if shock increase aggregate Demand for a given E, will shift DD to right. Note distinction between movement along the curve and shifts in the curve. 6 4) AA curve Lets consider Asset market again now. Had been taking Y as given. But didnt need to. Change in Y can affect Asset market. What does change in Y do? Affects money demand. Increase output increases money demand, because more goods want to buy. Graph: shift out demand. This increases the interest rate, because need to ration out the existing supply of money. In foreign exchange market, makes current E fall (domestic currency appreciates). (Assume this is a temporary increase in Y, so no change here in E expected for future.) L(R,Y 2 ) Total returns M s US /P US U.S. real money supply E $/DM R $ 0 L(R,Y 1 ) 7 So increase in Y, made currency depreciate in short run because of money market. Can summarize this on graph of Y and E, as did for DD curve, but deals with asset market instead, and is sloped other way. Graph: So change in E traces out AA, as move along it as Y changes. What shifts AA right: a) increase in money supply: Know shift MS line will cause the home currency to depreciate. So for a given level of output, E is higher after the rise in MS. Increase money supply shifts AA curve to right. b) fall in price level: raises real money supply, so acts like case above. MS/P line shifts, R falls, currency depreciates. So for given Y, E is higher. c) rise in expected exchange rate: recall this shifts foreign return line right and makes current E rise. d) rise in foreign interest rate: just like a above. e) fall in money demand (for any given Y or R): shifts L curve left, R falls, currency depreciates for any given Y. So AA shifts right. A A Y E Y1 Y2 E1 E2 8 5) Putting DD and AA curves together Have two curves that show relation E and Y. Put together. Asset market says given a Y, will have a certain E. Y implies a MD, which implies an R, which implies a certain demand for the domestic currency deposits, which by irp implies a certain E. AA:Y MD R E
Goods market says given an E, will have a certain Y. E implies relative price of home and foreign goods, implies a certain CA, implies a certain Y. DD: E CA Y Intersection represents equilibrium for an open economy. Graph: Point 1 is equilibrium. Suppose instead started off at point 2. 1) Jump up to AA to point 3: Currency is overvalued relative to what IRP says it should be: given expected future E, expected depreciation is larger that interest rate differential, so get out of $ deposits, lead to $ depreciation. Jump up to AA, point 3.
2) Still below DD: goods market not in equilibrium. High value of domestic currency makes home goods expensive: CA is low, means aggregate demand < output, means will lower production and output falls; Move left.
3) As move left, are below AA again, so E depreciate some more, move up. (As output fall, MD fall, R rise, current E must fall.) As move left, stay on AA curve, because E keeps depreciating. 4)Forces at rest when at point 1. A A D D Y E 1 2 3