1.Implementing the ERU curve to
the WS-PS model

The ERU curve represent the 
equilibrium rate of 
unemployment depending on WS
and PS curve. It slopes
downward

Horizontal axis = y (income)

Vertical axis = real exchange
rate (ø) øL, øH

øH to A (high), øL to B 
(low of the curve)

On the ERU curve, inflation 
is constant. home inflation
= world inflation (pi = pi*)

At points above the ERU curve,
the real wage is below the WS
curve so there is upward pressure
on inflation. Wages are too 
low to satisfy wage setters 
at this level of employment.
Home inflation > world inflation.
Real exchange rate (ø) is 
falling and real wages are
rising.

At points below the ERU curve,
the real wage is above the WS
curve so there is downward 
pressure on inflation. Wages
are too high for wage-setting
equilibrium given the low level 
of employment. Home inflation
is below world inflation. 
Hence 0 is rising and real 
wages are falling.


2.AD curve and IS-LM model

The AD curve shows the 
combinations of the real 
exchange rate, 0, and level 
of output, y, at which the 
goods market is in equilibrium
with the real interest rate 
equal to the world real
interest rate.

It is positively sloped because
of the assumption that the 
Marshall-Lerner condition 
holds: high competitiveness
(high 0) raises aggregate 
demand and output must 
therefore be high for goods
market equilibrium.

The move from A to B can be 
thought of as coming about in 
two different ways: either we
have a fixed exchange rate 
economy and the government 
devalues (i.e. it changes the
peg). This causes a rightward
shift in the IS curve first, 
which raises the interest rate
and induces a capital inflow, 
which in turn causes the IM to
shift to the right. The 
economy is then at point B. 
The alternative is to think 
of a flexible exchange rate
world in which the government
first loosens monetary policy:

LM shifts to the right, which
lowers the interest rate. This
causes a depreciation, which in
turn causes the ISM to shift to
the right taking the economy to
point B.

We can also easily show the 
trade balance condition in 
the ¤y-diagram.

The BT curve shows the 
combinations of the real 
exchange rate, , and the 
level of output, y,

at which trade is balanced: 
x = m.

An increased level of price
competitiveness (higher 0) 
raises exports (assuming the
Marshall-Lerner condition
holds) and requires a higher
level of output to drive up 
the demand for imports and 
deliver trade balance. Hence 
the BT curve is positively
sloped.

To the left of the BT curve 
there is a trade surplus 
and to the right there is
a trade deficit.


Short-run equilibrium at 
point A--the economy is on 
the aggregate demand curve

ADo but not on either 
the ERU or BT curves. 
At point A, the level of 
output is yo, the real 
exchange rate is equal 
to 0o and the economy 
is above the ERU curve. 
This means that the prevailing
real wage is below the real
wage that wage setters 
can expect at the relatively
low unemployment rate 
associated with Yo. Workers
are in a rather strong 
position in the labour market
and the money wage that is
set will rise relative to the
expected price level. Home
prices will rise relative to
foreign prices. Home inflation
is above world inflation. 
Assuming that the nominal 
exchange rate is constant, 
this depresses price 
competitiveness and the 
economy moves along the AD 
curve toward point B. Output
falls because of the lower 
export demand generated by 
the fall in competitiveness.



Medium-run equilibria such as
at points B and B'-the economy
is on ERU and AD and AD' 
respectively but not on BT. 
Inflation is constant at point
s B and B' because each is on
the ERU curve. There is a 
trade surplus at point B 
because it is to the left of 
the BT curve and a trade 
deficit at point B' because 
it is to the right of the BT
curve. The economy can remain
at points like B and B' with
stable inflation. However, in
the longer run, pressures 
may emerge as a consequence
of the external position that
tend to push the economy away
from B or B' toward point Z.



Long-run equilibrium at point
Z-on AD, ERU, and BT. At point
Z, labour market equilibrium 
coincides with the balanced 
trade level of output. This 
is likely to be a sustainable
long-run position for the 
economy.

Having put together the open 
economy model, we can now 
re-examine the situation,
recall that the government
used its two policy instruments
of a change in the nominal 
exchange rate (either as the
result of a discrete change in
the peg under fixed exchange
rates or due to a loosening of
monetary policy under flexible
rates) and an adjustment of 
fiscal policy to achieve its
two targets, the desired 
output level of y and trade 
balance.