Macroeconomic Policy II
ECON3236 International Finance
Girish Bahal
Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 509-513
(Output and the Exchange Rate in the Short Run)
Learning Objectives
Understand ...
(cid:73)
The impact of a permanent change in monetary policy on the short-run
equilibrium
(cid:73)
The impact of a permanent change in fiscal policy on the short-run
equilibrium
(cid:73)
Why, under certain conditions, a permanent change in fiscal policy has no
affect on output even in the short-run.
Permanent change in monetary policy
A permanent policy shift affects...
(cid:73) The current policy instrument (e.g. Ms, G, or T)
(cid:73)
The long-run exchange rate
(cid:73)
Expectation about future exchange rates
Permanent change in monetary policy
Initially:
(cid:73) Output is Yf
(cid:73)
E is at its long-run level
(cid:73) E =Ee
A permanent ↑ in Ms →R ↓
But Ee increases as well
Permanent change in monetary policy
Domestic currency depreciates by a
large amount to E2
AA shifts from AA1 to AA2
Note: an equal but temporary ↑ in Ms
shifts AA till point 3
Permanent change in monetary policy: transition to
long-run equilibrium
DD schedule:
(cid:73)
Over time, prices steadily ↑
(cid:73)
Aggregate demand ↓ → DD shifts
to the left over time
AA schedule:
(cid:73)
As prices steadily ↑, real money
supply ↓
(cid:73)
AA shifts left over time as well
Permanent change in monetary policy
The DD and AA schedules stop shifting
at point 3, at Yf
AA curve does not shift back to AA1 as
Ee is permanently higher
At point 3, P and E have risen in
proportion to the rise in Ms
The domestic currency depreciates more
in the short-run than in the long-run
Permanent fiscal expansion
A permanent ↑ in G → aggregate
demand for domestic output ↑
DD shifts from DD1 to DD2
But since the ↑ in government demand
for domestic goods is permanent
(cid:73)
this causes a long run appreciation
of the domestic currency (Ee ↓)
(cid:73) AA shifts from AA1 to AA2
Permanent fiscal expansion
If the economy starts at long-run equilibrium, a permanent fiscal expansion has
no net effect on output
An immediate and permanent Ex rate jump exactly offsets the fiscal policy’s
direct effect on aggregate demand
A fall in net export demand exactly counteracts the rise in government demand
Note: output cannot increase (even by a small amount) in the short run
Permanent fiscal expansion
1) A permanent ↑ in G does not effect on Ms; R (=R∗), or Yf in the long-run
→ no effect on long-run prices
2) A permanent ↑ in G has no effect on Ms or P in the short-run. Also,
R =R∗; Y =Yf initially
3) If Y >Yf → R ↑(as real money supply is fixed)
→ R −R∗ =(Ee −E)/E >0
Permanent fiscal expansion
4) But since P is not expected to change in the long-run → the domestic
currency is expected to depreciate in real terms (over the long run)
However, a real depreciation of home currency will only exacerbate the
over-employment problem (as NX ↑ over time)
5) The apparent contradiction is resolved only if Y does not rise at all after a
permanent ↑ in G
This happens only if domestic currency appreciates immediately to its new
long-run value such that the ↓ net exports = ↑ in G
