Suppose that in a particular year there is a both an increase in the long-run equilibrium real exchange rate (increase in q) and a decrease in the long-run equilibrium nominal exchange rate (decrease in E).Within the context of the general model of long run exchange rate determination developed in section 6.5 of Lesson 6, this combination of events could be explained by an ______________(increase /decrease) in the level of domestic absorption (A), accompanied by a large ___________ (increase/decrease) in the domestic money supply (M), assuming no changes in any other determinants of q and E.

LESSON 6.5

6.5.1 The Determination of the Long-run Equilibrium Real Exchange Rate

Let's begin by accepting the fact that the real exchange rate (q) isnotalways equal to 1.0, as absolute PPP predicts,or even necessarily constant, as relative PPP predicts, but is an endogenous variable whose value we need to explain.

The model we will use to explain the real exchange rate is a variant of our previously-developed long-run model of the open economy in which output/national income is equal to a fixed full-employment level:Y^f= F(K^f,L^f).

As before, planned aggregate demand for domestic output (D) is equal to the sum of planned consumption expenditure (C), planned investment spending (I), planned government purchases (G), and the current account balance, which we assume equal to net exports (CA=NX):

D = C + I + G + CA

We continue to assume that planned consumption spending (C) is an increasing function of aggregate real disposable income (YT), while planned investment spending (I) is an exogenous variable, as are the levels of planned government purchases (G) and net taxes (T).

We now make one innovation: we assume that the current account balance (CA= NX) is anincreasing function of the real exchange rate (q), or the relative price of foreign goods and services:

CA = CA(q),q = E P*/P

An increase in the real exchange rate, or the relative price of foreign goods, increases foreign demand for domestic exports and reduces domestic demand for imports, both of which lead to an increase in net exports, or the current account balance:

q EX& IM CA

In Figure 6-4 the current account function is depicted by the upward-sloping line indicating that an increase in the real exchange rate (q) causes a rise in the value of the current account balance (CA).

Figure 6-4 The Current Account Function

When the real exchange rate equalsq⁰the current account balance is zero; when the real exchange rate isless thanq⁰there is a current accountdeficit(CA< 0), and when the real exchange rate isgreater thanq⁰there is a current accountsurplus(CA> 0).

Aggregate demand for domestic output is therefore a function as follows:

D=C(Y-T)+I+G+CA(q)Consumption

spending as

a function of

disposable

income

Investment and

government

purchases both

exogenous

Current account

balance as an

increasing function

of the real

exchange rate

Long-runoutput market equilibriumoccurs when aggregate demand for output equals full-employment supply of output:

D=C(Y^f-T) +I+G+CA(q)= Y^f

Equivalently, long-run output market equilibrium occurs when the current account balance equals the difference between full-employment national income and total planned spending by domestic buyers (C + I + G), or absorption (A):

CA(q)=Y^f-A,A=C(Y^f-T) +I+G

The variable which adjusts to produce that long-run output market equilibrium (for given values ofY^f, T, I,andG) is thereal exchange rate(q).Thelong-run equilibrium real exchange rateis the value ofqfor which the current account balance equals the difference between national income and absorption, orCA(q)=Y^f-A, and, hence, the output market is in equilibrium at full-employment (D=Y^f).

In Figure 6-5 the long-run equilibrium real exchange rate corresponds to the point of intersection of the upward-sloping current account function and the vertical line showing the difference between full-employment national income (Y^f) and total domestic absorption (A).Figure 6-5 shows the case in which the difference between domestic output and domestic absorption (Y^fA) is positive and, hence, there is a current account surplus in equilibrium. But Figure 6-5 can easily be redrawn by repositioning the vertical (Y^fA) line to show either an equilibrium current account deficit or an equilibrium current account balance of zero.

Figure 6-5 Determination of the Long-run Equilibrium Real Exchange Rate

We have now developed a model to understand how the long-run equilibrium level of the real exchange rate is determined. In the next section we will use our model to explain changes in the real exchange rate.

6.5.2Explaining Long-run Changes in the Real Exchange Rate

In this section we separately analyse the effects on the equilibrium real exchange rate of two changes: an increase in domestic demand for goods and services, or absorption; and an exogenous increase in foreign demand for domestic output.

Suppose that the level of domestic absorption is initiallyA¹and the output market is initially in long-run equilibrium at point 1 in Figure 6-6 with real exchange rate ofq¹where:

CA(q¹) =(Y^fA¹)

There is then anincrease in domestic absorptiondue to an exogenous rise in any ofC, IorG. As absorption rises fromA¹toA², the gap between domestic output and domestic absorption is reduced from (Y^fA¹) to (Y^fA²), as shown in Figure 6-6 by the leftward shift of the (Y^fA) line. To restore output market equilibrium the real exchange rate must fall fromq¹toq²leading to a decrease in the equilibrium current account balance to match the decline in the output-absorption gap. Long-run output market equilibrium now occurs at point 2 where:

CA(q²) =(Y^fA²)

In summary, other things equal an increase in domestic absorption will lower the long-run equilibrium real exchange rate. Conversely, a decrease in absorption, with a given level of full-employment output, will increase the long-run equilibrium real exchange rate.

Figure 6-6The Effects on the Real Exchange Rate of an Increase in Absorption

As an activity, construct a diagram to show the effects of anexogenous increase in foreign demandfor domestic exportswhich increases the value of the current account balanceCA(q)at each value of the real exchange rate (q), shifting theCA(q) line. Assume no change in either domestic national income or domestic absorption. Does the equilibrium level of the real exchange rate rise or fall?Check your answer against the answer key provided byclicking here

In the next section we integrate our theory of the real exchange rate with purchasing power parity theory to form a general theory of the long-run determinants of the real and nominal exchange rate.

6.5.3 Combining Real and Monetary Determinants of the Exchange Rate

By re-arranging the formula for the real exchange rate (q) we see that the nominal exchange rate (E) is the product of the real exchange rate (q) and the ratio of the domestic and foreign price levels (P/P*):

q = E P*/PE=qP/P*

Thus, in our general model of long-run exchange rates, the nominal exchange rate (E) is determined in the long-run by bothrealfactors, which determineq,andmonetaryfactors, which determine the ratioP/P*.

Specifically, our model predicts that, other things equal:

1. A one-time permanentincreasein thelevelof thedomesticmoney supply (M^S) will cause a proportionate increase in the domestic price level (P) and a proportionateincreasein thenominalexchange rate (E), withno changein therealexchange rate (q):
2. M^S P E(=q P/P*)
3. A one-time permanentincreasein thelevelof theforeignmoney supply (M^S*) will cause a proportionate increase in the foreign price level (P*) and a proportionatedecreasein thenominalexchange rate (E), withno changein therealexchange rate (q):
4. M^S* P* E(=q P/P*)
5. A permanentincreasein thegrowth rateof thedomesticmoney supply (M^S/M^S) will cause an equalincreasein the rate of domestic price inflation () and in therate ofdepreciationof the domestic currency, withno changein therealexchange rate (q):
6. M^S/M^S E/E(=*)
7. A permanentincreasein thegrowth rateof theforeignmoney supply (M^S*/M^S*) will cause an equal increase in the rate of foreign price inflation (*) and an equal increase in therate of appreciationof the domestic currency, withno changein therealexchange rate (q):
8. M^S*/M^S* * E/E(=*)
9. An (exogenous)increasein real demand for domestic output (D) from either domestic or foreign buyers willdecreasethe long-run equilibriumrealexchange rate (q) - arealappreciation. There will be no impact on price levels or their ratio (P/P*)and, hence, thenominalexchange rate (E) will decrease in direct proportion to the decrease in therealexchange rate (real appreciation will lead to nominal appreciation):
10. D q E(=q P/P*)