Output and the Exchange

Output and the Exchange
Rate in the Short Run
The U.S. and Canadian economies registered similar negative rates of
output growth during 2009, a year of deep global recession. But while the
U.S. dollar depreciated against foreign currencies by about 8 percent over
the year, the Canadian dollar appreciated by roughly 16 percent. What explains
these contrasting experiences? By completing the macroeconomic model built in
the last three chapters, this chapter will sort out the complicated factors that
cause output, exchange rates, and inflation to change. Chapters 15 and 16
presented the connections among exchange rates, interest rates, and price levels
but always assumed that output levels were determined outside of the model.
Those chapters gave us only a partial picture of how macroeconomic changes
affect an open economy because events that change exchange rates, interest
rates, and price levels may also affect output. Now we complete the picture by
examining how output and the exchange rate are determined in the short run.
Our discussion combines what we have learned about asset markets and the
long-run behavior of exchange rates with a new element, a theory of how the
output market adjusts to demand changes when product prices in the economy
are themselves slow to adjust. As we learned in Chapter 15, institutional factors
like long-term nominal contracts can give rise to “sticky” or slowly adjusting
output market prices. By combining a short-run model of the output market
with our models of the foreign exchange and money markets (the asset markets),
we build a model that explains the short-run behavior of all the important
macroeconomic variables in an open economy. The long-run exchange rate
model of the preceding chapter provides the framework that participants in the
asset markets use to form their expectations about future exchange rates.
Because output changes may push the economy away from full employment,
the links among output and other macroeconomic variables, such as the merchandise
trade balance and the current account, are of great concern to economic
policy makers. In the last part of this chapter, we use our short-run model
to examine how macroeconomic policy tools affect output and the current
account, and how those tools can be used to maintain full employment.
422 PART THREE Exchange Rates and Open-Economy Macroeconomics
1 A more complete model would allow other factors, such as real wealth, expected future income, and the real
interest rate, to affect consumption plans. This chapter’s Appendix 1 links the formulation here to the microeconomic
theory of the consumer, which was the basis of the discussion in the appendix to Chapter 6.
LEARNING GOALS
After reading this chapter, you will be able to:
• Explain the role of the real exchange rate in determining the aggregate
demand for a country’s output.
• See how an open economy’s short-run equilibrium can be analyzed as the
intersection of an asset market equilibrium schedule (AA) and an output
market equilibrium schedule (DD).
• Understand how monetary and fiscal policies affect the exchange rate and
national output in the short run.
• Describe and interpret the long-run effects of permanent macroeconomic changes.
• Explain the relationship among macroeconomic policies, the current
account balance, and the exchange rate.