Permanent Shifts in Monetary and Fiscal Policy
A permanent policy shift affects not only the current value of the government’s policy
instrument (the money supply, government spending, or taxes) but also the long-run
exchange rate. This in turn affects expectations about future exchange rates. Because
these changes in expectations have a major influence on the exchange rate prevailing in
the short run, the effects of permanent policy shifts differ from those of temporary
shifts. In this section we look at the effects of permanent changes in monetary and fiscal
policy, in both the short and long runs.10
To make it easier to grasp the long-run effects of policies, we assume that the economy
is initially at a long-run equilibrium position and that the policy changes we
examine are the only economic changes that occur (our usual “other things equal”
clause). These assumptions mean that the economy starts out at full employment with
the exchange rate at its long-run level and with no change in the exchange rate
expected. In particular, we know that the domestic interest rate must initially equal the
foreign rate, .
A Permanent Increase in the Money Supply
Figure 17-14 shows the short-run effects of a permanent increase in the money supply on
an economy initially at its full-employment output level (point 1). As we saw earlier,
even a temporary increase in causes the asset market equilibrium schedule to shift
upward from to . Because the increase in is now permanent, however, it also
affects the exchange rate expected for the future, . Chapter 15 showed how a permanent
increase in the money supply affects the long-run exchange rate: A permanent increase in
must ultimately lead to a proportional rise in . Therefore, the permanent rise in
causes , the expected future exchange rate, to rise proportionally.
Because a rise in accompanies a permanent increase in the money supply, the upward
shift of to is greater than that caused by an equal, but transitory, increase. At
point 2, the economy’s new short-run equilibrium, and are both higher than they would
be were the change in the money supply temporary. (Point 3 shows the equilibrium that
might result from a temporary increase in .)
Adjustment to a Permanent Increase in the Money Supply
The increase in the money supply shown in Figure 17-14 is not reversed by the central
bank, so it is natural to ask how the economy is affected over time. At the short-run
Ms
Y E
AA1 AA2
Ee
Ee
Ms E Ms
Ee
AA1 AA2 Ms
Ms
Yf
R*
10You may be wondering whether a permanent change in fiscal policy is always possible. For example, if a government
starts with a balanced budget, doesn’t a fiscal expansion lead to a deficit, and thus require an eventual
fiscal contraction? Problem 3 at the end of this chapter suggests an answer.
CHAPTER 17 Output and the Exchange Rate in the Short Run 443
equilibrium, shown as point 2 in Figure 17-14, output is above its full-employment
level and labor and machines are working overtime. Upward pressure on the price level
develops as workers demand higher wages and producers raise prices to cover their
increasing production costs. Chapter 15 showed that while an increase in the money
supply must eventually cause all money prices to rise in proportion, it has no lasting effect
on output, relative prices, or interest rates. Over time, the inflationary pressure that
follows a permanent money supply expansion pushes the price level to its new long-run
value and returns the economy to full employment.
Figure 17-15 will help you visualize the adjustment back to full employment.
Whenever output is greater than its full-employment level, , and productive factors are
working overtime, the price level is rising to keep up with rising production costs.
Although the DD and AA schedules are drawn for a constant price level , we have seen
how increases in cause the schedules to shift. A rise in makes domestic goods more
expensive relative to foreign goods, discouraging exports and encouraging imports.
A rising domestic price level therefore causes to shift to the left over time. Because
a rising price level steadily reduces the real money supply over time, also travels to
the left as prices rise.
The DD and AA schedules stop shifting only when they intersect at the full-employment
output level ; as long as output differs from , the price level will change and the two
schedules will continue to shift. The schedules’ final positions are shown in Figure 17-15 as
and . At point 3, their intersection, the exchange rate, , and the price level, ,
have risen in proportion to the increase in the money supply, as required by the long-run
neutrality of money. ( does not shift all the way back to its original position because
is permanently higher after a permanent increase in the money supply: It too has risen by
the same percentage as .)
Notice that along the adjustment path between the initial short-run equilibrium (point 2)
and the long-run equilibrium (point 3), the domestic currency actually appreciates (from
E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange rate behavior
Ms
AA2 Ee
DD2 AA3 E P
Yf Yf
AA2
DD1
P P
P
P
Yf
Y f
Exchange
rate, E
Output, Y
2
E 2
E1 1
Y 2
3
DD1
AA2
AA1
Figure 17-14
Short-Run Effects of a Permanent
Increase in the Money Supply
A permanent increase in the
money supply, which shifts AA1 to
AA2 and moves the economy
from point 1 to point 2, has
stronger effects on the exchange
rate and output than an equal
temporary increase, which moves
the economy only to point 3.
444 PART THREE Exchange Rates and Open-Economy Macroeconomics
is an example of the overshooting phenomenon discussed in Chapter 15, in which the exchange
rate’s initial response to some change is greater than its long-run response.11
We can draw on our conclusions to describe the proper policy response to a permanent
monetary disturbance. A permanent increase in money demand, for example, can be offset
with a permanent increase of equal magnitude in the money supply. Such a policy maintains
full employment, but because the price level would fall in the absence of the policy,
the policy will not have inflationary consequences. Instead, monetary expansion can move
the economy straight to its long-run, full-employment position. Keep in mind, however,
that it is hard in practice to diagnose the origin or persistence of a particular shock to the
economy.
A Permanent Fiscal Expansion
A permanent fiscal expansion not only has an immediate impact in the output market but
also affects the asset markets through its impact on long-run exchange rate expectations.
Figure 17-16 shows the short-run effects of a government decision to spend an extra $10
billion a year on its space travel program forever. As before, the direct effect of this rise in
on aggregate demand causes to shift right to . But because the increase in government
demand for domestic goods and services is permanent in this case, it causes a longrun
appreciation of the currency, as we saw in Chapter 16. The resulting fall in pushes
the asset market equilibrium schedule downward to . Point 2, where the new
schedules and intersect, is the economy’s short-run equilibrium, and at that point
the currency has appreciated to from its initial level while output is unchanged at .
The important result illustrated in Figure 17-16 is that when a fiscal expansion is
permanent, the additional currency appreciation caused by the shift in exchange rate
E2 Yf
DD2 AA2
AA1 AA2
Ee
G DD1 DD2
Yf
Exchange
rate, E
Output, Y
2
E 2
E1 1
Y2
3
DD1
DD2
E 3
AA3
AA2
AA1
Figure 17-15
Long-Run Adjustment to a
Permanent Increase in the
Money Supply
After a permanent money supply
increase, a steadily increasing
price level shifts the DD and AA
schedules to the left until a new
long-run equilibrium (point 3) is
reached.
11While the exchange rate initially overshoots in the case shown in Figure 17-15, overshooting does not have to
occur in all circumstances. Can you explain why, and does the “undershooting” case seem reasonable?
CHAPTER 17 Output and the Exchange Rate in the Short Run 445
expectations reduces the policy’s expansionary effect on output. Without this additional
expectations effect due to the permanence of the fiscal change, equilibrium
would initially be at point 3, with higher output and a smaller appreciation. The greater
the downward shift of the asset market equilibrium schedule, the greater the appreciation
of the currency. This appreciation “crowds out” aggregate demand for domestic
products by making them more expensive relative to foreign products.
Figure 17-16 is drawn to show a case in which fiscal expansion, contrary to what you
might have guessed, has no net effect on output. This case is not, however, a special one;
in fact, it is inevitable under the assumptions we have made. The argument that establishes
this point requires five steps; by taking the time to understand them, you will solidify your
understanding of the ground we have covered so far:
1. As a first step, convince yourself (perhaps by reviewing Chapter 15) that because
the fiscal expansion does not affect the money supply, ; the long-run values of the
domestic interest rate (which equals the foreign interest rate); or output , it can
have no impact on the long-run price level.
2. Next, recall our assumption that the economy starts out in long-run equilibrium with
the domestic interest rate, , just equal to the foreign rate, , and output equal to .
Observe also that the fiscal expansion leaves the real money supply, , unchanged in
the short run (that is, neither the numerator nor the denominator changes).
3. Now imagine, contrary to what Figure 17-16 shows, that output did rise above .
Because doesn’t change in the short run (Step 2), the domestic interest rate, ,
would have to rise above its initial level of to keep the money market in equilibrium.
Since the foreign interest rate remains at , however, a rise in to any level above
implies an expected depreciation of the domestic currency (by interest parity).
4. Notice next that there is something wrong with this conclusion. We already
know (from Step 1) that the long-run price level is not affected by the fiscal expansion,
so people can expect a nominal domestic currency depreciation just after the policy
R* Y Yf
R*
Ms/P R
Yf
Ms/P
R R* Yf
(Yf)
Ms
Yf
Exchange
rate, E
Output, Y
2
E1 1
E 2
AA2
DD2
DD1
AA1
3
AA2
Figure 17-16
Effects of a Permanent Fiscal
Expansion
Because a permanent fiscal
expansion changes exchange rate
expectations, it shifts AA1 leftward
as it shifts DD1 to the right. The
effect on output (point 2) is nil if
the economy starts in long-run
equilibrium. A comparable
temporary fiscal expansion, in
contrast, would leave the
economy at point 3.
446 PART THREE Exchange Rates and Open-Economy Macroeconomics
change only if the currency depreciates in real terms as the economy returns to longrun
equilibrium. Such a real depreciation, by making domestic products relatively
cheap, would only worsen the initial situation of overemployment that we have imagined
to exist, and thus would prevent output from ever actually returning to .
5. Finally, conclude that the apparent contradiction is resolved only if output does
not rise at all after the fiscal policy move. The only logical possibility is that the currency
appreciates right away to its new long-run value. This appreciation crowds out
just enough net export demand to leave output at the full-employment level despite the
higher level of .
Notice that this exchange rate change, which allows the output market to clear at full
employment, leaves the asset markets in equilibrium as well. Since the exchange rate has
jumped to its new long-run value, remains at . With output also at , however, the
long-run money market equilibrium condition still holds, as it did
before the fiscal action. So our story hangs together: The currency appreciation that a
permanent fiscal expansion provokes immediately brings the asset markets as well as the
output market to positions of long-run equilibrium.
We conclude that if the economy starts at long-run equilibrium, a permanent change in
fiscal policy has no net effect on output. Instead, it causes an immediate and permanent
exchange rate jump that offsets exactly the fiscal policy’s direct effect on aggregate demand.
A permanent policy shift affects not only the current value of the government’s policy
instrument (the money supply, government spending, or taxes) but also the long-run
exchange rate. This in turn affects expectations about future exchange rates. Because
these changes in expectations have a major influence on the exchange rate prevailing in
the short run, the effects of permanent policy shifts differ from those of temporary
shifts. In this section we look at the effects of permanent changes in monetary and fiscal
policy, in both the short and long runs.10
To make it easier to grasp the long-run effects of policies, we assume that the economy
is initially at a long-run equilibrium position and that the policy changes we
examine are the only economic changes that occur (our usual “other things equal”
clause). These assumptions mean that the economy starts out at full employment with
the exchange rate at its long-run level and with no change in the exchange rate
expected. In particular, we know that the domestic interest rate must initially equal the
foreign rate, .
A Permanent Increase in the Money Supply
Figure 17-14 shows the short-run effects of a permanent increase in the money supply on
an economy initially at its full-employment output level (point 1). As we saw earlier,
even a temporary increase in causes the asset market equilibrium schedule to shift
upward from to . Because the increase in is now permanent, however, it also
affects the exchange rate expected for the future, . Chapter 15 showed how a permanent
increase in the money supply affects the long-run exchange rate: A permanent increase in
must ultimately lead to a proportional rise in . Therefore, the permanent rise in
causes , the expected future exchange rate, to rise proportionally.
Because a rise in accompanies a permanent increase in the money supply, the upward
shift of to is greater than that caused by an equal, but transitory, increase. At
point 2, the economy’s new short-run equilibrium, and are both higher than they would
be were the change in the money supply temporary. (Point 3 shows the equilibrium that
might result from a temporary increase in .)
Adjustment to a Permanent Increase in the Money Supply
The increase in the money supply shown in Figure 17-14 is not reversed by the central
bank, so it is natural to ask how the economy is affected over time. At the short-run
Ms
Y E
AA1 AA2
Ee
Ee
Ms E Ms
Ee
AA1 AA2 Ms
Ms
Yf
R*
10You may be wondering whether a permanent change in fiscal policy is always possible. For example, if a government
starts with a balanced budget, doesn’t a fiscal expansion lead to a deficit, and thus require an eventual
fiscal contraction? Problem 3 at the end of this chapter suggests an answer.
CHAPTER 17 Output and the Exchange Rate in the Short Run 443
equilibrium, shown as point 2 in Figure 17-14, output is above its full-employment
level and labor and machines are working overtime. Upward pressure on the price level
develops as workers demand higher wages and producers raise prices to cover their
increasing production costs. Chapter 15 showed that while an increase in the money
supply must eventually cause all money prices to rise in proportion, it has no lasting effect
on output, relative prices, or interest rates. Over time, the inflationary pressure that
follows a permanent money supply expansion pushes the price level to its new long-run
value and returns the economy to full employment.
Figure 17-15 will help you visualize the adjustment back to full employment.
Whenever output is greater than its full-employment level, , and productive factors are
working overtime, the price level is rising to keep up with rising production costs.
Although the DD and AA schedules are drawn for a constant price level , we have seen
how increases in cause the schedules to shift. A rise in makes domestic goods more
expensive relative to foreign goods, discouraging exports and encouraging imports.
A rising domestic price level therefore causes to shift to the left over time. Because
a rising price level steadily reduces the real money supply over time, also travels to
the left as prices rise.
The DD and AA schedules stop shifting only when they intersect at the full-employment
output level ; as long as output differs from , the price level will change and the two
schedules will continue to shift. The schedules’ final positions are shown in Figure 17-15 as
and . At point 3, their intersection, the exchange rate, , and the price level, ,
have risen in proportion to the increase in the money supply, as required by the long-run
neutrality of money. ( does not shift all the way back to its original position because
is permanently higher after a permanent increase in the money supply: It too has risen by
the same percentage as .)
Notice that along the adjustment path between the initial short-run equilibrium (point 2)
and the long-run equilibrium (point 3), the domestic currency actually appreciates (from
E2 to E3) following its initial sharp depreciation (from E1 to E2). This exchange rate behavior
Ms
AA2 Ee
DD2 AA3 E P
Yf Yf
AA2
DD1
P P
P
P
Yf
Y f
Exchange
rate, E
Output, Y
2
E 2
E1 1
Y 2
3
DD1
AA2
AA1
Figure 17-14
Short-Run Effects of a Permanent
Increase in the Money Supply
A permanent increase in the
money supply, which shifts AA1 to
AA2 and moves the economy
from point 1 to point 2, has
stronger effects on the exchange
rate and output than an equal
temporary increase, which moves
the economy only to point 3.
444 PART THREE Exchange Rates and Open-Economy Macroeconomics
is an example of the overshooting phenomenon discussed in Chapter 15, in which the exchange
rate’s initial response to some change is greater than its long-run response.11
We can draw on our conclusions to describe the proper policy response to a permanent
monetary disturbance. A permanent increase in money demand, for example, can be offset
with a permanent increase of equal magnitude in the money supply. Such a policy maintains
full employment, but because the price level would fall in the absence of the policy,
the policy will not have inflationary consequences. Instead, monetary expansion can move
the economy straight to its long-run, full-employment position. Keep in mind, however,
that it is hard in practice to diagnose the origin or persistence of a particular shock to the
economy.
A Permanent Fiscal Expansion
A permanent fiscal expansion not only has an immediate impact in the output market but
also affects the asset markets through its impact on long-run exchange rate expectations.
Figure 17-16 shows the short-run effects of a government decision to spend an extra $10
billion a year on its space travel program forever. As before, the direct effect of this rise in
on aggregate demand causes to shift right to . But because the increase in government
demand for domestic goods and services is permanent in this case, it causes a longrun
appreciation of the currency, as we saw in Chapter 16. The resulting fall in pushes
the asset market equilibrium schedule downward to . Point 2, where the new
schedules and intersect, is the economy’s short-run equilibrium, and at that point
the currency has appreciated to from its initial level while output is unchanged at .
The important result illustrated in Figure 17-16 is that when a fiscal expansion is
permanent, the additional currency appreciation caused by the shift in exchange rate
E2 Yf
DD2 AA2
AA1 AA2
Ee
G DD1 DD2
Yf
Exchange
rate, E
Output, Y
2
E 2
E1 1
Y2
3
DD1
DD2
E 3
AA3
AA2
AA1
Figure 17-15
Long-Run Adjustment to a
Permanent Increase in the
Money Supply
After a permanent money supply
increase, a steadily increasing
price level shifts the DD and AA
schedules to the left until a new
long-run equilibrium (point 3) is
reached.
11While the exchange rate initially overshoots in the case shown in Figure 17-15, overshooting does not have to
occur in all circumstances. Can you explain why, and does the “undershooting” case seem reasonable?
CHAPTER 17 Output and the Exchange Rate in the Short Run 445
expectations reduces the policy’s expansionary effect on output. Without this additional
expectations effect due to the permanence of the fiscal change, equilibrium
would initially be at point 3, with higher output and a smaller appreciation. The greater
the downward shift of the asset market equilibrium schedule, the greater the appreciation
of the currency. This appreciation “crowds out” aggregate demand for domestic
products by making them more expensive relative to foreign products.
Figure 17-16 is drawn to show a case in which fiscal expansion, contrary to what you
might have guessed, has no net effect on output. This case is not, however, a special one;
in fact, it is inevitable under the assumptions we have made. The argument that establishes
this point requires five steps; by taking the time to understand them, you will solidify your
understanding of the ground we have covered so far:
1. As a first step, convince yourself (perhaps by reviewing Chapter 15) that because
the fiscal expansion does not affect the money supply, ; the long-run values of the
domestic interest rate (which equals the foreign interest rate); or output , it can
have no impact on the long-run price level.
2. Next, recall our assumption that the economy starts out in long-run equilibrium with
the domestic interest rate, , just equal to the foreign rate, , and output equal to .
Observe also that the fiscal expansion leaves the real money supply, , unchanged in
the short run (that is, neither the numerator nor the denominator changes).
3. Now imagine, contrary to what Figure 17-16 shows, that output did rise above .
Because doesn’t change in the short run (Step 2), the domestic interest rate, ,
would have to rise above its initial level of to keep the money market in equilibrium.
Since the foreign interest rate remains at , however, a rise in to any level above
implies an expected depreciation of the domestic currency (by interest parity).
4. Notice next that there is something wrong with this conclusion. We already
know (from Step 1) that the long-run price level is not affected by the fiscal expansion,
so people can expect a nominal domestic currency depreciation just after the policy
R* Y Yf
R*
Ms/P R
Yf
Ms/P
R R* Yf
(Yf)
Ms
Yf
Exchange
rate, E
Output, Y
2
E1 1
E 2
AA2
DD2
DD1
AA1
3
AA2
Figure 17-16
Effects of a Permanent Fiscal
Expansion
Because a permanent fiscal
expansion changes exchange rate
expectations, it shifts AA1 leftward
as it shifts DD1 to the right. The
effect on output (point 2) is nil if
the economy starts in long-run
equilibrium. A comparable
temporary fiscal expansion, in
contrast, would leave the
economy at point 3.
446 PART THREE Exchange Rates and Open-Economy Macroeconomics
change only if the currency depreciates in real terms as the economy returns to longrun
equilibrium. Such a real depreciation, by making domestic products relatively
cheap, would only worsen the initial situation of overemployment that we have imagined
to exist, and thus would prevent output from ever actually returning to .
5. Finally, conclude that the apparent contradiction is resolved only if output does
not rise at all after the fiscal policy move. The only logical possibility is that the currency
appreciates right away to its new long-run value. This appreciation crowds out
just enough net export demand to leave output at the full-employment level despite the
higher level of .
Notice that this exchange rate change, which allows the output market to clear at full
employment, leaves the asset markets in equilibrium as well. Since the exchange rate has
jumped to its new long-run value, remains at . With output also at , however, the
long-run money market equilibrium condition still holds, as it did
before the fiscal action. So our story hangs together: The currency appreciation that a
permanent fiscal expansion provokes immediately brings the asset markets as well as the
output market to positions of long-run equilibrium.
We conclude that if the economy starts at long-run equilibrium, a permanent change in
fiscal policy has no net effect on output. Instead, it causes an immediate and permanent
exchange rate jump that offsets exactly the fiscal policy’s direct effect on aggregate demand.
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