Output Market Equilibrium in the Short Run:
The DD Schedule
Now that we understand how output is determined for a given real exchange rate ,
let’s look at how the exchange rate and output are simultaneously determined in the short
run. To understand this process, we need two elements. The first element, developed in
this section, is the relationship between output and the exchange rate (the DD schedule)
that must hold when the output market is in equilibrium. The second element, developed
in the next section, is the relationship between output and the exchange rate that must hold
when the home money market and the foreign exchange market (the asset markets) are in
equilibrium. Both elements are necessary because the economy as a whole is in equilibrium
only when both the output market and the asset markets are in equilibrium.
Output, the Exchange Rate, and Output Market Equilibrium
Figure 17-3 illustrates the relationship between the exchange rate and output implied by
output market equilibrium. Specifically, the figure illustrates the effect of a depreciation of
the domestic currency against foreign currency (that is, a rise in from to ) for fixed
values of the domestic price level, , and the foreign price level, . With fixed price levels
at home and abroad, the rise in the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goods and services. This relative price
change shifts the aggregate demand schedule upward.
The fall in the relative price of domestic output shifts the aggregate demand schedule
upward because at each level of domestic output, the demand for domestic products is
higher. For example, foreign and American consumers of autos alike shift their demands
toward American models when the dollar depreciates. Output expands from to as
firms find themselves faced with excess demand at initial production levels.
Although we have considered the effect of a change in with and held fixed, it is
straightforward to analyze the effects of changes in P or P* on output. Any rise in the real
E P P*
Y1 Y2
P P*
E E1 E2
EP*/P
Aggregate
demand, D
Y1 Y2 Output, Y
1
2
D = Y
Aggregate demand (E2)
Aggregate demand (E1)
Currency
depreciates
Figure 17-3
Output Effect of a Currency
Depreciation with Fixed
Output Prices
A rise in the exchange rate
from E1 to E2 (a currency
depreciation) raises aggregate
demand to Aggregate demand
(E2) and output to Y2, all else
equal.
CHAPTER 17 Output and the Exchange Rate in the Short Run 429
exchange rate (whether due to a rise in E, a rise in , or a fall in P) will cause an
upward shift in the aggregate demand function and an expansion of output, all else equal.
(A rise in , for example, has effects qualitatively identical to those of a rise in .)
Similarly, any fall in , regardless of its cause (a fall in E, a fall in , or a rise in P),
will cause output to contract, all else equal. (A rise in , with E and held fixed, for
example, makes domestic products more expensive relative to foreign products, reduces
aggregate demand for domestic output, and causes output to fall.)
Deriving the DD Schedule
If we assume and are fixed in the short run, a depreciation of the domestic currency
(a rise in ) is associated with a rise in domestic output, , while an appreciation (a fall in )
is associated with a fall in . This association provides us with one of the two relationships
between and needed to describe the short-run macroeconomic behavior of an open
economy. We summarize this relationship by the DD schedule, which shows all combinations
of output and the exchange rate for which the output market is in short-run equilibrium
.
Figure 17-4 shows how to derive the DD schedule, which relates and when and
are fixed. The upper part of the figure reproduces the result of Figure 17-3 (a depreciation
of the domestic currency shifts the aggregate demand function upward, causing output to
rise). The DD schedule in the lower part graphs the resulting relationship between the
exchange rate and output (given that and are held constant). Point 1 on the DD schedule
gives the output level, , at which aggregate demand equals aggregate supply when the
exchange rate is . A depreciation of the currency to leads to the higher output level
according to the figure’s upper part, and this information allows us to locate point 2 on DD.
Factors That Shift the DD Schedule
A number of factors affect the position of the DD schedule: the levels of government
demand, taxes, and investment; the domestic and foreign price levels; variations in
domestic consumption behavior; and the foreign demand for home output. To understand
the effects of shifts in each of these factors, we must study how the DD schedule shifts
when it changes. In the following discussions, we assume that all other factors remain fixed.
1. A change in G. Figure 17-5 shows the effect on DD of a rise in government purchases
from to , given a constant exchange rate of An example would be the increase
in U.S. military and security expenditures following the September 11, 2001, attacks. As
shown in the upper part of the figure, the exchange rate leads to an equilibrium output
level at the initial level of government demand; so point 1 is one point on
An increase in causes the aggregate demand schedule in the upper part of the
figure to shift upward. Everything else remaining unchanged, output increases from
to . Point 2 in the bottom part shows the higher level of output at which aggregate
demand and supply are now equal, given an unchanged exchange rate of Point 2 is
on a new DD curve,
For any given exchange rate, the level of output equating aggregate demand and
supply is higher after the increase in . This implies that an increase in causes DD
to shift to the right, as shown in Figure 17-5. Similarly, a decrease in causes DD to
shift to the left.
The method and reasoning we have just used to study how an increase in shifts the
DD curve can be applied to all the cases that follow. Here we summarize the results.
To test your understanding, use diagrams similar to Figure 17-5 to illustrate how the
economic factors listed below change the curves.
G
G
G G
DD2.
E0.
Y2
Y1
G
Y1 DD1.
E0
G1 G2 E0.
E1 E2 Y2
Y1
P P*
E Y P P*
(aggregate demand = aggregate output)
E Y
Y
E Y E
P P*
P P*
EP*/P P*
P* E
EP*/P P*
430 PART THREE Exchange Rates and Open-Economy Macroeconomics
2. A change in T. Taxes, , affect aggregate demand by changing disposable income,
and thus consumption, for any level of . It follows that an increase in taxes
causes the aggregate demand function of Figure 17-1 to shift downward given the
exchange rate . Since this effect is the opposite of that of an increase in , an
increase in must cause the DD schedule to shift leftward. Similarly, a fall in ,
such as the tax cut enacted after 2001 by President George W. Bush, causes a
rightward shift of DD.
3. A change in I. An increase in investment demand has the same effect as an increase
in : The aggregate demand schedule shifts upward and DD shifts to the right. A fall
in investment demand shifts DD to the left.
4. A change in P. Given and , an increase in makes domestic output more expensive
relative to foreign output and lowers net export demand. The DD schedule shifts
to the left as aggregate demand falls. A fall in makes domestic goods cheaper and
causes a rightward shift of DD.
P
E P* P
G
T T
E G
Y
T
Exchange
rate, E
Y1 Y2 Output, Y
1
2
DD
Aggregate
demand, D
Y1 Y2 Output, Y
E2
E1
D = Y
Aggregate demand (E2)
Aggregate demand (E1)
Figure 17-4
Deriving the DD Schedule
The DD schedule (shown in
the lower panel) slopes upward
because a rise in the exchange
rate from E1 to E2, all else equal,
causes output to rise from Y1
to Y 2.
CHAPTER 17 Output and the Exchange Rate in the Short Run 431
Exchange
rate, E
Y1 Y 2 Output, Y
1
Aggregate
demand, D
Y1 Y 2 Output, Y
E0
D = Y
D(E0P*/P, Y – T, I, G2)
DD1 DD2
2
D(E0P*/P, Y – T, I, G1)
Government Aggregate demand curves
spending
rises
Figure 17-5
Government Demand and the Position of the DD Schedule
A rise in government demand from G1 to G2 raises output at every level of the exchange
rate. The change therefore shifts DD to the right.
5. A change in . Given and , a rise in makes foreign goods and services relatively
more expensive. Aggregate demand for domestic output therefore rises and DD
shifts to the right. Similarly, a fall in causes DD to shift to the left.
6. A change in the consumption function. Suppose residents of the home economy suddenly
decide they want to consume more and save less at each level of disposable income. This
could occur, for example, if home prices increase and homeowners borrow against their
additional wealth. If the increase in consumption spending is not devoted entirely to
imports from abroad, aggregate demand for domestic output rises and the aggregate
demand schedule shifts upward for any given exchange rate E. This implies a shift to the
P*
P* E P P*
432 PART THREE Exchange Rates and Open-Economy Macroeconomics
right of the DD schedule. An autonomous fall in consumption (if it is not entirely due to
a fall in import demand) shifts DD to the left.
7. A demand shift between foreign and domestic goods. Suppose there is no change in the
domestic consumption function but domestic and foreign residents suddenly decide to
devote more of their spending to goods and services produced in the home country.
(For example, fears of mad cow disease abroad raise the demand for U.S. beef products.)
If home disposable income and the real exchange rate remain the same, this shift
in demand improves the current account by raising exports and lowering imports. The
aggregate demand schedule shifts upward and DD therefore shifts to the right. The
same reasoning shows that a shift in world demand away from domestic products and
toward foreign products causes DD to shift to the left.
You may have noticed that a simple rule allows you to predict the effect on DD of any
of the disturbances we have discussed: Any disturbance that raises aggregate demand for
domestic output shifts the DD schedule to the right; any disturbance that lowers aggregate
demand for domestic output shifts the DD schedule to the left.
The DD Schedule
Now that we understand how output is determined for a given real exchange rate ,
let’s look at how the exchange rate and output are simultaneously determined in the short
run. To understand this process, we need two elements. The first element, developed in
this section, is the relationship between output and the exchange rate (the DD schedule)
that must hold when the output market is in equilibrium. The second element, developed
in the next section, is the relationship between output and the exchange rate that must hold
when the home money market and the foreign exchange market (the asset markets) are in
equilibrium. Both elements are necessary because the economy as a whole is in equilibrium
only when both the output market and the asset markets are in equilibrium.
Output, the Exchange Rate, and Output Market Equilibrium
Figure 17-3 illustrates the relationship between the exchange rate and output implied by
output market equilibrium. Specifically, the figure illustrates the effect of a depreciation of
the domestic currency against foreign currency (that is, a rise in from to ) for fixed
values of the domestic price level, , and the foreign price level, . With fixed price levels
at home and abroad, the rise in the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goods and services. This relative price
change shifts the aggregate demand schedule upward.
The fall in the relative price of domestic output shifts the aggregate demand schedule
upward because at each level of domestic output, the demand for domestic products is
higher. For example, foreign and American consumers of autos alike shift their demands
toward American models when the dollar depreciates. Output expands from to as
firms find themselves faced with excess demand at initial production levels.
Although we have considered the effect of a change in with and held fixed, it is
straightforward to analyze the effects of changes in P or P* on output. Any rise in the real
E P P*
Y1 Y2
P P*
E E1 E2
EP*/P
Aggregate
demand, D
Y1 Y2 Output, Y
1
2
D = Y
Aggregate demand (E2)
Aggregate demand (E1)
Currency
depreciates
Figure 17-3
Output Effect of a Currency
Depreciation with Fixed
Output Prices
A rise in the exchange rate
from E1 to E2 (a currency
depreciation) raises aggregate
demand to Aggregate demand
(E2) and output to Y2, all else
equal.
CHAPTER 17 Output and the Exchange Rate in the Short Run 429
exchange rate (whether due to a rise in E, a rise in , or a fall in P) will cause an
upward shift in the aggregate demand function and an expansion of output, all else equal.
(A rise in , for example, has effects qualitatively identical to those of a rise in .)
Similarly, any fall in , regardless of its cause (a fall in E, a fall in , or a rise in P),
will cause output to contract, all else equal. (A rise in , with E and held fixed, for
example, makes domestic products more expensive relative to foreign products, reduces
aggregate demand for domestic output, and causes output to fall.)
Deriving the DD Schedule
If we assume and are fixed in the short run, a depreciation of the domestic currency
(a rise in ) is associated with a rise in domestic output, , while an appreciation (a fall in )
is associated with a fall in . This association provides us with one of the two relationships
between and needed to describe the short-run macroeconomic behavior of an open
economy. We summarize this relationship by the DD schedule, which shows all combinations
of output and the exchange rate for which the output market is in short-run equilibrium
.
Figure 17-4 shows how to derive the DD schedule, which relates and when and
are fixed. The upper part of the figure reproduces the result of Figure 17-3 (a depreciation
of the domestic currency shifts the aggregate demand function upward, causing output to
rise). The DD schedule in the lower part graphs the resulting relationship between the
exchange rate and output (given that and are held constant). Point 1 on the DD schedule
gives the output level, , at which aggregate demand equals aggregate supply when the
exchange rate is . A depreciation of the currency to leads to the higher output level
according to the figure’s upper part, and this information allows us to locate point 2 on DD.
Factors That Shift the DD Schedule
A number of factors affect the position of the DD schedule: the levels of government
demand, taxes, and investment; the domestic and foreign price levels; variations in
domestic consumption behavior; and the foreign demand for home output. To understand
the effects of shifts in each of these factors, we must study how the DD schedule shifts
when it changes. In the following discussions, we assume that all other factors remain fixed.
1. A change in G. Figure 17-5 shows the effect on DD of a rise in government purchases
from to , given a constant exchange rate of An example would be the increase
in U.S. military and security expenditures following the September 11, 2001, attacks. As
shown in the upper part of the figure, the exchange rate leads to an equilibrium output
level at the initial level of government demand; so point 1 is one point on
An increase in causes the aggregate demand schedule in the upper part of the
figure to shift upward. Everything else remaining unchanged, output increases from
to . Point 2 in the bottom part shows the higher level of output at which aggregate
demand and supply are now equal, given an unchanged exchange rate of Point 2 is
on a new DD curve,
For any given exchange rate, the level of output equating aggregate demand and
supply is higher after the increase in . This implies that an increase in causes DD
to shift to the right, as shown in Figure 17-5. Similarly, a decrease in causes DD to
shift to the left.
The method and reasoning we have just used to study how an increase in shifts the
DD curve can be applied to all the cases that follow. Here we summarize the results.
To test your understanding, use diagrams similar to Figure 17-5 to illustrate how the
economic factors listed below change the curves.
G
G
G G
DD2.
E0.
Y2
Y1
G
Y1 DD1.
E0
G1 G2 E0.
E1 E2 Y2
Y1
P P*
E Y P P*
(aggregate demand = aggregate output)
E Y
Y
E Y E
P P*
P P*
EP*/P P*
P* E
EP*/P P*
430 PART THREE Exchange Rates and Open-Economy Macroeconomics
2. A change in T. Taxes, , affect aggregate demand by changing disposable income,
and thus consumption, for any level of . It follows that an increase in taxes
causes the aggregate demand function of Figure 17-1 to shift downward given the
exchange rate . Since this effect is the opposite of that of an increase in , an
increase in must cause the DD schedule to shift leftward. Similarly, a fall in ,
such as the tax cut enacted after 2001 by President George W. Bush, causes a
rightward shift of DD.
3. A change in I. An increase in investment demand has the same effect as an increase
in : The aggregate demand schedule shifts upward and DD shifts to the right. A fall
in investment demand shifts DD to the left.
4. A change in P. Given and , an increase in makes domestic output more expensive
relative to foreign output and lowers net export demand. The DD schedule shifts
to the left as aggregate demand falls. A fall in makes domestic goods cheaper and
causes a rightward shift of DD.
P
E P* P
G
T T
E G
Y
T
Exchange
rate, E
Y1 Y2 Output, Y
1
2
DD
Aggregate
demand, D
Y1 Y2 Output, Y
E2
E1
D = Y
Aggregate demand (E2)
Aggregate demand (E1)
Figure 17-4
Deriving the DD Schedule
The DD schedule (shown in
the lower panel) slopes upward
because a rise in the exchange
rate from E1 to E2, all else equal,
causes output to rise from Y1
to Y 2.
CHAPTER 17 Output and the Exchange Rate in the Short Run 431
Exchange
rate, E
Y1 Y 2 Output, Y
1
Aggregate
demand, D
Y1 Y 2 Output, Y
E0
D = Y
D(E0P*/P, Y – T, I, G2)
DD1 DD2
2
D(E0P*/P, Y – T, I, G1)
Government Aggregate demand curves
spending
rises
Figure 17-5
Government Demand and the Position of the DD Schedule
A rise in government demand from G1 to G2 raises output at every level of the exchange
rate. The change therefore shifts DD to the right.
5. A change in . Given and , a rise in makes foreign goods and services relatively
more expensive. Aggregate demand for domestic output therefore rises and DD
shifts to the right. Similarly, a fall in causes DD to shift to the left.
6. A change in the consumption function. Suppose residents of the home economy suddenly
decide they want to consume more and save less at each level of disposable income. This
could occur, for example, if home prices increase and homeowners borrow against their
additional wealth. If the increase in consumption spending is not devoted entirely to
imports from abroad, aggregate demand for domestic output rises and the aggregate
demand schedule shifts upward for any given exchange rate E. This implies a shift to the
P*
P* E P P*
432 PART THREE Exchange Rates and Open-Economy Macroeconomics
right of the DD schedule. An autonomous fall in consumption (if it is not entirely due to
a fall in import demand) shifts DD to the left.
7. A demand shift between foreign and domestic goods. Suppose there is no change in the
domestic consumption function but domestic and foreign residents suddenly decide to
devote more of their spending to goods and services produced in the home country.
(For example, fears of mad cow disease abroad raise the demand for U.S. beef products.)
If home disposable income and the real exchange rate remain the same, this shift
in demand improves the current account by raising exports and lowering imports. The
aggregate demand schedule shifts upward and DD therefore shifts to the right. The
same reasoning shows that a shift in world demand away from domestic products and
toward foreign products causes DD to shift to the left.
You may have noticed that a simple rule allows you to predict the effect on DD of any
of the disturbances we have discussed: Any disturbance that raises aggregate demand for
domestic output shifts the DD schedule to the right; any disturbance that lowers aggregate
demand for domestic output shifts the DD schedule to the left.
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