INTERNATIONAL ECONOMICS, 15E Robert Carbaugh © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Policy in an Open Economy Chapter 16 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter Outline Economic Objectives of Nations Policy Instruments Aggregate Demand and Aggregate Supply: A Brief Review Monetary and Fiscal Policy in a Closed Economy Monetary and Fiscal Policy in an Open Economy Macroeconomic Stability and the Current Account: Policy Agreement vs Policy Conflict Inflation with Unemployment International Economic Policy Coordination © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Objectives of Nations (1 of 2) Objectives of macroeconomic policy ◦ Internal balance ◦ External balance ◦ Overall balance ◦ Long-term economic growth ◦ Reasonably equitable distribution of national income © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Objectives of Nations (2 of 2) Objectives of macroeconomic policy (cont.) ◦ Internal balance  Economic stability at full employment  A fully employed economy  No inflation ◦ External balance  When it realizes neither deficits nor surpluses in its current account ◦ Overall balance  The combination of internal balance and external balance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Policy Instruments (1 of 3) Expenditure changing policies ◦ Alter the level of total spending (aggregate demand) for goods and services which are either produced domestically or imported ◦ Fiscal policy  Changes in government spending and taxes  Responsibility of President & the U.S. Congress ◦ Monetary policy  Changes in the money supply and interest rates  Responsibility of the Central bank (Federal Reserve) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Policy Instruments (2 of 3) Expenditure-switching policies ◦ Modify the direction of demand  Use policies that shift between domestic output and imports ◦ Under fixed exchange rates and trade deficit  Devalue currency ◦ Under managed floating exchange-rate and to increase its competitiveness  Depreciate currency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Policy Instruments (3 of 3) Direct controls (such as tariffs) ◦ Government restrictions in a market economy ◦ Control particular items in the current account ◦ Restrain capital outflows ◦ Stimulate capital inflows © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Demand & Aggregate Supply: A Brief Review (1 of 3) Aggregate demand-Aggregate supply model ◦ Aggregate demand curve (AD)  Level of real output (real GDP) purchased at various price levels during a given year  Spending by domestic consumers, businesses, government, and foreign buyers (net exports)  On an Aggregate Demand curve, as the price level falls  The quantity of real output demanded increases © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure Macro Equilibrium: Aggregate Demand… Supply © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Demand & Aggregate Supply: A Brief Review (2 of 3) Aggregate demand-aggregate supply model ◦ Aggregate supply curve (AS)  Relation between the level of prices and amount of real output that will be produced by the economy during a given year  Upward sloping  Per-unit production costs and prices increase as real output increases ◦ Macroeconomic Equilibrium: AD = AS © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Demand & Aggregate Supply: A Brief Review (3 of 3) Shifts in aggregate demand curve ◦ Changes in the determinants of AD  Consumption, investment, government purchases, or net exports Shifts in aggregate supply curve ◦ Changes in the price of resources, technology, business expectations © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in a Closed Economy (1 of 2) Monetary & Fiscal Policies Tools to Influence Performance of Economy If aggregate output is too low & if the unemployment is high, then the government ◦ Increases aggregate demand which may result in higher output by engaging in:  Expansionary monetary and/or fiscal policies  Increase in domestic consumption, investment, or government spending resulting in an increase in the country’s real GDP © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in a Closed Economy (2 of 2) To control inflation, the government will: ◦ Reduce the level of aggregate demand for real output by engaging in  Contractionary monetary and/or fiscal policies  Upward pressure on prices is softened and inflation moderates © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure Effect of Expansionary Monetary or Fiscal Policy…GDP © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (1 of 7) Expansionary monetary or fiscal policy ◦ Initial effect (only effect in closed economy)  Increase in aggregate demand  Increase in domestic consumption, investment, or government spending ◦ Secondary effects in open economies ◦ Conflicting impacts: increase or decrease in aggregate demand by  Changing net exports and other determinants of aggregate demand © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (2 of 7) If the initial and secondary effects both result in increases in aggregate demand, then it ◦ Strengthens the effect of expansionary policy If the initial and secondary effects have conflicting impacts ◦ Expansionary effects are weakened © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (3 of 7) Effect of Fiscal & Monetary Policy under Fixed Exchange Rates ◦ Expansionary fiscal policy more successful and an expansionary monetary policy is less successful in open economy than in closed economy at stimulating the economy © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table Effectiveness of Monetary & Fiscal Policy…Mobility © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (4 of 7) Fiscal Policy is Strengthened Under Fixed Exchange Rates ◦ Initial effect: Increase aggregate demand ◦ Secondary effect: Increase aggregate demand  Budget deficit; Higher interest rate  Increased demand for domestic currency in foreign- currency market  Purchase foreign currency with domestic currency  Increase in the domestic money supply  Increase the amount of loanable funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (5 of 7) Monetary Policy is Weakened Under Fixed Exchange Rates ◦ Initial effect: Increase aggregate demand  Money Supply increases, domestic interest rate reduces  Increased consumption and investment ◦ Secondary effects: Reduced aggregate demand  Decreasing demand for domestic currency due to low interest rates  To maintain fixed exchange rate, authorities purchase domestic currency with foreign currency which result in  Decrease in money supply and loanable funds © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (6 of 7) Effect of Fiscal & Monetary Policy Under Floating Exchange Rates ◦ Initial effect: Increase aggregate demand  Reduce the domestic interest rate  Increased consumption and investment ◦ Secondary effect: Increase aggregate demand  Domestic currency depreciates  Increase in exports, decrease in imports, improvement in current account ◦ Monetary policy – strengthened under floating exchange rates © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Monetary and Fiscal Policy in an Open Economy (7 of 7) Effect of Fiscal & Monetary Policy Under Floating Exchange Rates (cont.) ◦ Fiscal policy is weakened under floating exchange rates  Initial effect: Increase aggregate demand  Secondary effect: Decrease aggregate demand  Budget deficit; Higher interest rate  Increased demand for domestic currency in the foreign-exchange market  Domestic currency appreciates; Falling exports  Rising imports, Deteriorating current account © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Stability & Current Account: Policy Agreement vs Conflict (1 of 2) Recession + current account deficit ◦ Floating exchange rates ◦ Expansionary monetary policy to combat recession  Currency depreciation  Rise in exports and fall in imports ◦ Reduce the current account deficit A single economic policy promotes overall balance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Stability & Current Account: Policy Agreement vs Conflict (2 of 2) Inflation + current account deficit ◦ Contractionary monetary policy to combat inflation  Increase in domestic interest rate  Currency appreciation  Fall in exports and rise in imports ◦ Larger current-account deficit Policy conflict: monetary policy (or fiscal policy) alone will not restore both internal and external balance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflation with Unemployment (1 of 2) Assumed that as economy advances to full employment, domestic prices unchanged until full employment reached Once nation’s production capacity achieved, further increases in aggregate demand pull prices upward This is demand-pull inflation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Inflation with Unemployment (2 of 2) Inflation with unemployment ◦ Internal balance cannot be achieved just by manipulating aggregate demand  Reduce AD to decrease inflation  Increase AD to decrease unemployment Overall balance - three separate targets ◦ Current-account equilibrium ◦ Full employment ◦ Price stability (Wage & Price controls) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Economic Policy Coordination (1 of 5) Economic relations among nations ◦ Conflict -- Independence -- Integration Policy cooperation ◦ Officials from different nations meet to evaluate world economic conditions International economic policy coordination ◦ Formal agreement among nations to initiate particular policies to modify national monetary, fiscal & exchange rate policies © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure Relations among National Governments © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Economic Policy Coordination (2 of 5) Policy Coordination in Theory ◦ Some nations give higher priority to price stability, or to full employment, than others ◦ Some nations have a stronger legislature  Or weaker trade unions, than others ◦ The party pendulums in different nations  Shift with elections occurring in different years ◦ One nation may experience economic recession  While another nation experiences rapid inflation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Economic Policy Coordination (3 of 5) Does Policy Coordination Work? ◦ Plaza Agreement of 1985, Group of Five (G-5) nations - The United States, Japan, Germany, Great Britain, and France  Overvalued U.S. dollar  Twin U.S. deficits (trade & federal budget) were too large ◦ Each country  Specific pledges on macroeconomic policy  Agreed to initiate coordinated sales of the dollar ◦ By 1986, dollar had dramatically depreciated © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Economic Policy Coordination (4 of 5) Does Policy Coordination Work? (cont.) ◦ But New concern: uncontrolled dollar plunge ◦ Louvre Accord of 1987, Group of Five (G-5)  Intervention policies – curbing the pace of the dollar’s depreciation  Other macroeconomic adjustments ◦ By 2000s, more difficult to coordinate  Rise of independent central banks  Makes coordination more difficult © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Economic Policy Coordination (5 of 5) Does Policy Coordination Work? (cont.) 2000, Group of Seven (G-7) ◦ The United States, Canada, Japan, the United Kingdom, Germany, France, and Italy ◦ Coordinated purchases of the euro to boost its value ◦ From $0.84 per euro to more than $0.88 per euro ◦ Within two weeks following the intervention, the euro’s value slid to an all-time low ◦ Economists considered intervention a failure © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.