Determinants of Aggregate Demand in an Open Economy Aggregate demand The amount of a country' s goods and services demanded by households and firms throughout the world a The aggregate demand for an open economy's output consists of four components Consumption demand(c) ° Investment demand( ° Government demand(G ° Current account(CA) Copyright C 2003 Pearson Education, Inc Slide 16-6
Copyright © 2003 Pearson Education, Inc. Slide 16-6 Determinants of Aggregate Demand in an Open Economy ▪ Aggregate demand • The amount of a country’s goods and services demanded by households and firms throughout the world. ▪ The aggregate demand for an open economy’s output consists of four components: • Consumption demand (C) • Investment demand (I) • Government demand (G) • Current account (CA)
Determinants of Aggregate Demand in an Open Economy Determinants of Consumption Demand Consumption demand increases as disposable income (i. e, national income less taxes) increases at the aggregate level The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved Copyright C 2003 Pearson Education, Inc Slide 16-7
Copyright © 2003 Pearson Education, Inc. Slide 16-7 ▪ Determinants of Consumption Demand • Consumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level. – The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved. Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy Determinants of the current account The Ca balance is viewed as the demand for a country's exports(EX) less that country's own demand for imports(IM) The Ca balance is determined by two main factors The domestic currency's real exchange rate against foreign currency(q=EP*/P) Domestic disposable income (yo Copyright C 2003 Pearson Education, Inc Slide 16-8
Copyright © 2003 Pearson Education, Inc. Slide 16-8 ▪ Determinants of the Current Account • The CA balance is viewed as the demand for a country’s exports (EX) less that country's own demand for imports (IM). • The CA balance is determined by two main factors: – The domestic currency’s real exchange rate against foreign currency (q = EP*/P) – Domestic disposable income (Y d ) Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy How Real Exchange Rate Changes Affect the Current Account An increase in g raises eX and improves the domestic country's Ca Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports An increase g can raise or lower IM and has an ambiguous effect on CA IM denotes the value of imports measured in terms of domestic output Copyright C 2003 Pearson Education, Inc Slide 16-9
Copyright © 2003 Pearson Education, Inc. Slide 16-9 ▪ How Real Exchange Rate Changes Affect the Current Account • An increase in q raises EX and improves the domestic country’s CA. – Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports. • An increase q can raise or lower IM and has an ambiguous effect on CA. – IM denotes the value of imports measured in terms of domestic output. Determinants of Aggregate Demand in an Open Economy
Determinants of Aggregate Demand in an Open Economy There are two effects of a real exchange rate Volume effect The effect of consumer spending shifts on export and Import quantities Value effect It changes the domestic output worth of a given volume of foreign imports a Whether the Ca improves or worsens depends on which effect of a real exchange rate change is dominant We assume that the volume effect of a real exchange rate change al ways outweighs the value effect Copyright C 2003 Pearson Education, Inc Slide 16-10
Copyright © 2003 Pearson Education, Inc. Slide 16-10 ▪ There are two effects of a real exchange rate: • Volume effect – The effect of consumer spending shifts on export and import quantities • Value effect – It changes the domestic output worth of a given volume of foreign imports. ▪ Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant. ▪ We assume that the volume effect of a real exchange rate change always outweighs the value effect. Determinants of Aggregate Demand in an Open Economy