Penn State Writing Sample --- Tutorial Class Paper

Ye Chen BSc University of Bristol Application: Ph.D in Economics State University of Pennsylvania Supplementary Material: Writing Sample

International Economics

Tutorial Class Paper

(October, 2009) Question: In early 2009 the US initiated a sharp expansion of fiscal policy. Explain the likely effects on US aggregate demand, the value of the US dollar, and the size of its current account deficit of such a fiscal expansion.

In February 2009, the US congress passed the $787 billion worth economic stimulus package --- ‘American Recovery and Reinvestment Act of 2009’. By building necessary models, this essay is to discuss the likely effects of the large fiscal expansion has on several key factors of the US economy including aggregate demand, the value of the US dollar, and the size of the current account deficit.

Aggregate demand (D) is the amount of a country’s goods and services demanded by households and firms throughout the world. A country’s overall short-run output level depends on the aggregate demand for its products. For an open economy’s, the aggregate demand is the sum of consumption demand (C), investment demand (I), government demand (G), and the net export demand, that is, the current account (CA). The relationship is expressed as:

D = C + I + G + CA

To determine how aggregate demand (D) changes when other factors of the economy increase or decrease, we need to look into elements which influence the four types of demand, or correspondingly, the four types of expenditure.

Consumption expenditure depends on disposable income, Yd (which equals national income less taxes, Y-T). It can be written as: C = C(Y-T). The impact of increase in Yd on consumption (C) is positive, as we know that more disposable income lead people to spend more.

We assume that investment (I) and government expenditure (G) are given.

The exchange rate (E) between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency.

The current account balance (CA), viewed as the demand for a country’s exports less that country’s own demand for imports, is determined by two main factors: the domestic disposable income (Yd=Y-T) and the real exchange rate(EP ＊ /P), where E is the nominal exchange rate, P＊ is the foreign price level, and P is the home price level. So, CA = CA(EP＊/P, Yd)

An increase in real exchange rate (EP ＊ /P) means an depreciation of domestic currency. It makes domestic goods and services cheaper relative to foreign goods and services, which shifts both domestic and foreign spending from foreign goods to domestic goods. As a result, exports (EX) rises and imports (IM) decreases. Therefore the domestic country’s current account (CA) will rise. An appreciation of domestic currency, on the other hand, will worsen the current account.

An increase in Yd causes domestic consumers to spend more on all goods, including imports from abroad. But Yd has no influence on exports because it does not affect foreign consumers. So a rise in Yd worsens the current account (CA).

Combining the four components, we can write the aggregate demand equation as:

D = C(Y-T) +I + G + CA(EP＊/P, Y-T)

From this expression, we can see that a rise in the government spend G will increase the aggregate demand (D). So, the expansionary fiscal policy of the US government at the beginning of the year (the Stimulus Package) which includes huge amount of tax relief, investment in infrastructure, etc, will boost the aggregate demand of the US economy in the process of the gradual recovery from the recession.

Too analyze the impact of the Stimulus Package on the US dollar exchange rate and furthermore, the current account balance, it is convenient and important for us to establish the diagrammatic model of “AA-DD schedules”.

The graph below shows the relationship between aggregate demand (D) and real ○ Y1 D1 45 Output Aggregate Y demand Demand 1

D

income Y for fixed values of the real exchange rate, taxes, investment demand, and

government spending. As Y rises, consumption rises by a fraction of the increase in income, which explains that the slope of the aggregate demand curve is smaller than 1.

Equilibrium in output market requires domestic output Y to be equal to the aggregate demand D. This is indicated by point 1, where the aggregate demand curve intersects the 45 degree line.

Now we can look at how the exchange rate and output are simultaneously determined. Aggregate demand D D=Y

Aggregate (E2)

Demand

Rise in exchange rate, E1 to E2

Aggregate (E1)

Demand

45○ Y1

Y2

Output Y

Exchange Rate E

DD

2 E2

1

E1

Y1

Y2

Output Y

The above two graphs illustrate the relationship between the exchange rate and output implied by output market equilibrium. With fixed price levels at home and abroad, the rise in the nominal exchange rate (E1 to E2) makes domestic goods and services cheaper relative to foreign goods and services. So the demand for domestic products is now higher and the export will increase. However, although the amount of foreign goods demanded by domestic consumers will decrease (volume effect), each amount of foreign goods becomes dearer so it will cost more in terms of domestic currency (value effect). Here we assume the volume effect is greater than the value effect and the import decreases (Marshall Lerner Condition). The change in the exchange rate (E1 to E2) shifts the aggregate demand curve upward. And the equilibrium output level rises from Y1 to Y2. This explains the upward-sloping DD curve.

If we assume P and P ＊ are fixed in the short run, a depreciation of the domestic currency (a rise in E, or E1 to E2) is associated with a rise in domestic output (Y1 to

Y2), while an appreciation (a fall in E) is associated with a fall in domestic output. This is the “DD schedule” shown in the lower graph (previous page).

We have derived DD schedule using the analysis of equilibrium in output market. Now let us look at the equilibrium in the asset market.

The interest parity condition tells us that the foreign exchange market is in equilibrium when assets or deposits of all currencies offer the same expected rate of return when measured in terms of a common currency. This is captured in the equation : R = R＊ + (Ee – E)/E where R is the interest rate on domestic currency deposits and R ＊ is the interest rate on foreign currency deposits. E is the spot exchange rate and Ee is the expected future exchange rate.

The interest parity condition indicates a downward-sloping curve in the foreign exchange market, i.e. a negative relationship between R and E, given R ＊ and Ee are constant. The intuition behind this is that when the domestic interest rate (R) rises, the demand for the domestic currency will increase because it offers a higher interest. This higher demand will drive the “price” of the domestic currency up and the exchange rate (E) down.

In the domestic money market, the condition for equilibrium is that the supply of money equals the demand of money, i.e. Md = MS. This is captured in the equation:

Md/P = L(R, Y)

Where Md/P is the real money supply and L(R, Y) is the real money demand. The impact of R on the value of L(R, Y) is negative because a rise in the interest rate R makes interest-bearing non-money assets more attractive and thus lowers real money demand L(R, Y). A rise in output Y, increases real money demand L(R, Y) by raising the volume of monetary transactions people need.

Now if we combine our analysis of foreign exchange market and the domestic money E1 Money E 0 Foreign Domestic Domestic-currency Real 1 R1 xchange domestic Demand Ratemoney Curve,holdings MSP L(R, Y)onRate, E Exchange Interest return Money foreignMarket deposits R currency Supply

market, we can picture the asset market equilibrium in the diagram below (next page).

The graph above captures the analysis of domestic money market and the foreign exchange market. The upper part of the graph indicates the relationship between domestic interest rate R and the exchange rate E. The lower part of the graph indicates the relationship between the domestic interest rate R and the real domestic money holdings. The equilibrium of domestic money market (Md = MS) leads to point 1

where the money demand curve intersects the real money supply line. The interest rate R1 clears the domestic money market while the exchange rate E1 clears the foreign exchange market.

In the graph below (on the next page), a rise in output from Y1 to Y2 raises aggregate real money demand from L(R, Y1) to L(R, Y2). For each level of interest rate people now demand more money holdings and this shifts the money demand curve rightwards to a new position. This new equilibrium in the domestic money market gives a higher domestic interest rate, R2. And as the domestic interest rate rises to R2, the foreign exchange market will correspondingly see the change in exchange rate from E1 to E2, which indicates an appreciation of the domestic currency.

RMS 2 E 0 Foreign Domestic Domestic-currency Real O 1 R1 E1 L(R, E2 R2 xchange utput eal Y2) Y1) domestic risesRatemoney holdings EP Exchange Interest return Money onRate, foreignMarket deposits R currency Supply

Therefore, for given values of MS, P, R ＊ and Ee, equilibrium in asset market requires that a rise in domestic output (Y) must be accompanied by an appreciation of the domestic currency. This relationship between output (Y) and exchange rate (E) is the “AA schedule”. AA schedule can be captured by a downward sloping curve on the following graph.

E1utput, Y Exchange O 2 1 AA Y2 Y1 E2 rate, E

Now that we have derived DD schedule based on equilibrium in the output market and AA schedule based on equilibrium in the asset market, we can look at the shortrun equilibrium of the economy as a whole by combining the two equilibria.

Assuming again the domestic output prices are fixed in the short run, we can put AADD schedules on the same graph below, where the intersection (point 1) indicates the AA Exchange Output, Y1 E1 DD Y rate, E 1

output market equilibrium and asset market equilibrium simultaneously.

Going back to our initial discussion of the effects of the US government expansionary fiscal policy, we can use the established AA-DD schedules model to analyze them.

The two graphs below (on the next page) illustrate how change in government spending G can shift the DD schedule. An increase in G causes the aggregate demand curve to shift upward. For a given exchange rate E0, the level of output equating aggregate demand and supply is higher (Y1 to Y2). This implies that an increase in G causes DD schedule to shift to the right (DD1 to DD2).

Applying our model to the real world, we can predict that the US government’s stimulus package which includes huge amounts of government spending and tax cuts, will boost the US domestic consumption and the domestic aggregate demand. This will then drive the US domestic output up to a higher level (Y1 to Y2), for a given exchange rate (E0).

D=Y E 1 DD1 Y1 DD2 Y2 Government 0 spending Exchange Output Aggregate Y Rate demand ( US Stimulus rises E D

Package )

This fiscal expansion shifts the DD schedule to the right (DD1 to DD2).

In the short run, people’s expectation on the exchange rate (Ee) does not change, and in our discussion we mainly focus on fiscal expansion so we assume there is no monetary policy movement (MS does not change). AA schedule therefore does not move in the short run following the fiscal expansion. The graph below shows the shift of DD schedule from DD1 to DD2. The exchange rate then falls from E1 to E2, which means the US dollar will appreciate.

DD1 US AA Exchange Output, Y2 E2 DD2 Y1 E1 Stimulus Y rate, E Package

Based on the model, in the short run, as a result of the fiscal expansion the US dollar should appreciate in value, which makes foreign goods and services cheaper, and this, along with an income rise (Y1 to Y2), should increase imports. Exports on the other hand, will suffer a decrease as the US goods become more expensive following a dollar appreciation. The two effects will worsen the US current account. The expansionary fiscal policy will therefore, reduce the US current account balance in the short run.

In the long run, people observe the drop in the exchange rate and their expectation (Ee) changes as well. As the expected exchange rate goes down, AA schedule will shift downward. At the same time, the output will be adjusted to the long run natural

level (Yn), which is the level of output that can be sustained over the long term due to natural and institutional constraints. The economy reaches its new long run equilibrium at point 3 in the graph on the next page.

n DD2 Exchange Output, E1 DD1 AA1 3 2 1 E3 E2 AA2 Y rate, E Y

In the long run, the US dollar will appreciate even more than the short run (E1 to E3). This will further worsen the US current account deficit. But the aggregate demand comes back to the long run natural level (Yn). This can be explained as that in the long run, the effect of the fiscal expansion on the output level is completely offset by the worsened current account caused by the US dollar appreciation.

Whether this US stimulus package is a long run fiscal expansion is arguable. Some say it is only a temporary policy because of the financial crisis while others believe it has permanent effects to the US economy. The fact that the US dollar has actually depreciated since the Congress passed the stimulus package might suggest that our model does not quite fit the current real world situation. It is therefore important to point out that although the discussion in our model focuses on the theoretical analysis of the fiscal expansion, there are other factors in the current situation which can also seriously influence the US aggregate demand, the value of the US dollar and the size of the US current account deficit, e.g. monetary policies such as cutting interest rates, US domestic inflation, etc.

However, the essay question indicates that the discussion should be in the direction of fiscal expansion.

References:

[International Economics] Theory and Policy, Seventh Edition. Paul R. Krugman & Maurice Obstfeld, 2006. Pearson Addison Wesley.

“Flexible Exchange Rates in the Short Run”, Rudiger Dornbusch & Paul Krugman. [Brookings Papers on Economic Activity 1976] Arthur M.Okun and George L.Perry, Editors. The Brookings Institution, Washington DC.