The DD Schedule
ECON3236 International Finance
Girish Bahal
Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 487-499
(Output and the Exchange Rate in the Short Run)
Understanding so far ...
Equilibrium in the foreign exchange market:
(Ee −E)
R
$
=RAC+
E
Equilibrium in the domestic money market:
MS
=L(R ,Y )
P $ AU
Equilibrium in the two asset markets determine R $ and E $/AC
This lecture studies the equilibrium in the output market
Learning Objectives
Understand ...
(cid:73)
The components of aggregate demand
(cid:73)
The DD schedule (equilibrium in the output market)
(cid:73)
The factors that affect the DD schedule
Aggregate Demand
Aggregate demand D
(cid:73)
Consumption C
(cid:73)
Investment I
(cid:73)
Government demand G
(cid:73)
Net exports EX −IM =CA
Aggregate Demand
(cid:16)EP∗ (cid:17)
D =C(Y −T)+I +G +CA ,Y −T
P
(cid:73)
Y −T is disposable income (total income – taxes)
(cid:73) EP∗/P is the home currency’s real exchange rate
(cid:73) P∗ is the foreign price level and P is the domestic price level
Key points
As disposable income (Y −T) ↑ ...
(cid:73)
Consumption ↑ → Aggregate demand ↑
(cid:73)
Imports ↑ → Current account ↓ → Aggregate demand ↓
The overall affect of (Y −T) ↑ is an ↑ in aggregate demand
As consumption is composed of spending on domestic and foreign products
Key points
The CA improves if ...
(cid:73)
EX ↑ or IM ↓
(cid:73) $ depreciates against the AC in real terms (E ↑ or P∗ ↑ or P ↓)
(cid:73)
Disposable income Y −T ↓
Hence, aggregate demand D is a function of EP∗/P, Y −T, I, and G
Aggregate Demand as a function of output
Everything else constant, D ↑ as Y ↑
C ↑ by a proportion of the total ↑ in Y
Further, since part of the ↑ in C is
composed of ↑ spending on imports
The ↑ in D < the ↑ in C
→ the ↑ in D < the ↑ in C < the ↑ in Y
Output in the short run...
Output market is in equilibrium:
Y =D(EP∗/P,Y −T,I,G)
At point 2, D > (excess demand) → firms
increase production
At point 3, Y >D (excess supply) → firms
decrease production
Output effect of currency depreciation
Keeping P,P∗,T,I, & G fixed, as E ↑ →
D ↑
The demand curve shifts up
Domestic output ↑ from Y1 to Y2
The effect is qualitatively the same if P∗ ↑
or if P ↓
The DD Schedule: Equilibrium in the Output Market
The DD schedule shows all combinations of
Y and E for which the output market is in
short-run equilibrium
The DD schedule slopes upward
As exchange rate ↑ from E1 to E2 output ↑
from Y1 to Y2
Factors that shift DD schedule
For a given E :
0
As G ↑ →DD shifts to the right
As I ↑ →DD shifts to the right
As T ↑ →DD shifts to the left
Factors that shift DD schedule
As P ↑ → Net exports ↓ → DD shifts to
the left
As P∗ ↑ → Net exports ↑ → DD shifts to
the right
Any disturbance that ↑ aggregate demand
shifts the DD schedule to the right
Any disturbance that ↓ aggregate demand
shifts the DD schedule to the left
