Price and Output in the Open Economy

The aggregate demand curve shows the
relationship between the price level and
national income (or output).

Aggregate supply shows the nation’s output at different price levels. We need to distinguish between
aggregate supply in the long and short run. Like that of a sector or of one firm, and for the same reason, the
short-run aggregate supply curve, ASSR, has an increasing slope. The marginal product of labor declines
as output increases, so producers need higher prices to produce more. Prices have nothing to do with the
long-run aggregate supply, ASLR, since all prices are fully flexible in the long run.

The natural level of employment
is defined as the employment level
when the actual price level is the
same as the expected (by workers)
price level.

The natural level of output
(income) is defined as the level
of output (income) that would
prevail at the natural level of
employment.

Suppose the IS and LM curves intersect
above the BP curve. Then the interest rate that
brought equilibrium to goods and money markets
would be higher than the interest rate that would
achieve external balance, that is, capital inflows will
be greater than necessary. This will put pressure
on the exchange rate, and the central bank (CB)
will be compelled to purchase the excess foreign
exchange to defend its currency. This, in turn, will
increase the money supply, and the LM curve will
shift right. The IS and LM curves would intersect
on the BP curve. Conversely, suppose the IS and
LM curves intersect below the BP curve. Then
the interest rate that brings the goods and money
markets to equilibrium will be lower than required
for external balance causing capital flight out of the
country. This puts pressure on the exchange rate,
and the CB will have to supply foreign exchange
to the market to defend the currency. This would
reduce the money supply and lead to a leftward
shift of the LM curve until pressure on the exchange
rate is alleviated at a higher interest rate. Again, all
three curves intersect.

AD shifts right, No change in AD

AD shifts left, no change in AD

AD shifts left, AD shifts right

AD shifts right, AD shifts left

AD shifts right, Little or no change in AD

AD shifts left, little or no change in AD

AD shifts left, little or no change in AD

AD shifts right, little or no change in AD

AD shifts right, AD shifts left

AD shifts left, AD shifts right

The Asian crisis in 1997 could be treated as a monetary shock for the Turkish economy. In 1997, Türkiye still had control over the lira, therefore, we can treat the Asian crisis as a monetary shock in an open economy. We need to figure out whether, as a result of the Asian crisis, capital flow into the Turkish economy would increase or decrease. If foreign investors now shy away from Asian markets and look for alternative investments, capital inflow into Türkiye might increase. If, on the other hand, foreign investors return to “safe havens” and decrease investments in emerging economies, the Asian crisis could also trigger a capital outflow from Türkiye.

Shifts AD rightward, Ineffective (slight rightward shift of AD)

Shifts AD leftward, Ineffective (slight leftward shift of AD)

Ineffective, Shifts AD leftward

Ineffective, Shifts AD rightward

Real sector shocks are things like changes in tastes and preferences of consumers or firms that change
autonomous consumption or investment. However, we have focused mainly on shocks that affect exports
and imports. Tastes and preferences at home or abroad play a role, as well as increases in foreign prices
on changes to exports and imports under different exchange rate regimes. When exports increase and/or
imports decrease, this shifts the AD curve to the right under a fixed exchange rate regime but would not
have a permanent impact on the aggregate demand curve under a flexible exchange rate regime.