[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

New ADI curve after cut in
European interest rate
Net Exports and Shifts in the ADI Curve Net exports depend on the real
exchange rate, but they also can be affected by other factors. For instance, U.S.
exports will be affected by the level of income in other countries. If incomes in Mexico
rise, Mexicans will buy more goods and services, including more U.S.-produced
goods. So U.S. exports to Mexico will rise when incomes in Mexico rise. And similarly,
if Mexico suffers a recession, U.S. exports to Mexico will fall.
Shifts in net exports at a given real exchange rate cause the ADI curve to shift,
just as shifts in government purchases do. A case in point occurred in the late 1990s.
Financial crises in several Asian and Latin American economies led to severe recessions
in many of these countries. As incomes fell, households and firms cut back
spending. As a consequence, the demand for U.S.-produced goods fell, lowering U.S.
exports. At the same time, the financial crises reduced the value of many Asian currencies
relative to the dollar. This rise in the value of the dollar also acted to reduce
U.S. net exports. At a given rate of inflation, total demand for U.S. goods fell,
shifting the ADI curve to the left.
If this shift in net exports had been the only factor affecting the U.S. economy
at the time, the impact would have been to push the United States into a recession.
But in fact, the 1990s was one of the strongest periods of U.S. growth in the twentieth
century. So what happened? Is our model wrong? Two things prevented
the Asian financial crisis from creating a recession in the United States. First,
domestic consumption and investment spending remained very strong in the United
States. The growth in these components of demand served to offset the drop in
net exports. The second factor was the Fed’s response. As problems in Asia developed
during 1995, the Fed cut the federal funds rate. The Fed’s target
for the funds rate fell from 6 percent in 1995 to 5.25 percent in February
1996. This action is a good example of the type of stabilization policy
discussed in Chapter 33. To offset a potential leftward shift in the
ADI curve due to a drop in net exports, the Fed cut the interest rate
to boost investment spending.
INFLATION (π)
π 0
Y 0
Y 1
OUTPUT (Y )
Figure 35.1
THE EFFECTS OF A RISE IN EUROPEAN
INTEREST RATES ON U.S. OUTPUT
Initial ADI
curve
If European interest rates rise, the dollar will depreciate.
This depreciation increases U.S. exports, and the
increased demand leads to a rise in U.S. output.
Foreign Interest Rates and Shifts in the ADI Curve Policy
actions by foreign governments also have the potential to affect interest
rates and exchange rates. If the European Central Bank, for example,
decides to raise interest rates in Europe, euro assets become more
attractive and the euro appreciates in value relative to the dollar. This
appreciation makes European goods more expensive for Americans
to buy, and it makes American goods cheaper for Europeans to buy.
The appreciating euro increases U.S. net exports as our exports
rise and our imports fall. For a given inflation rate in the United States,
this increase in demand for U.S. output means the ADI curve has shifted
to the right. In the short run, U.S. output rises. The effect of a rise in
European interest rates on U.S. output is illustrated in Figure 35.1.
This discussion can be summarized in two points. First, the ADI
curve is downward sloping in the open economy, just as it was for the
closed economy. There is a new channel from inflation to spending,
however, and this affects the slope of the ADI curve—as inflation rises,
and the real interest rate rises, the value of the domestic currency
782 ∂ CHAPTER 35 POLICY IN THE OPEN ECONOMY