Output and the Exchange Rate in the Short Run

In: Business and Management

Submitted By gijoe123
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Long run theories are useful when all prices of inputs and outputs have enough time to adjust fully to changes in supply and demand.
In the short run, some prices of inputs and outputs may not have time to adjust, due to labor contracts, costs of adjustment, or imperfect information about market demand.

The aggregate demand for an open economy’s output consists of four components corresponding to the four components of GNP: consumption demand, investment demand, government demand, and the current account (net export demand). An important determinant of the current account is the real exchange rate, the ratio of the foreign price level (measured in domestic currency) to the domestic price level.

Output is determined in the short run by the equality of aggregate demand and aggregate supply. When aggregate demand is greater than output, firms increase production to avoid unintended inventory depletion. When aggregate demand is less than output, firms cut back production to avoid unintended accumulation of inventories.

The economy’s short-run equilibrium occurs at the exchange rate and output level where—given the price level, the expected future exchange rate, and foreign economic conditions—aggregate demand equals aggregate supply and the asset markets are in equilibrium. In a diagram with the exchange rate and real output on its axes, the short run equilibrium can be visualized as the intersection of an upward-sloping DD schedule, along which the output market clear, and a downward-sloping AA schedule, along which the asset markets clear. AA: Y up ->E down (to maintain asset mkt eq)
DD: E up -> Y up (to maintain asset mkt eq)

A temporary increase in the money supply, which does not alter the long-run expected exchange rate, causes a depreciation of the currency and a rise in output, therefore increase…...

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