International Economics Tenth Edition CHAPTER N I N E T E E N 19 International Economics Tenth Edition Prices and Output in an Open Economy: Aggregate Demand and Aggregate Supply Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand how short- and long-run equilibrium are reached under fixed and flexible exchange rates with aggregate demand and aggregate supply. Understand how real and monetary shocks and monetary and fiscal policies affect the nation’s aggregate demand and equilibrium Explain how monetary and fiscal policies can be used to adjust to supply shocks and stimulate growth in an open economy Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction In the real world, prices rise and fall as the economy expands and contracts during business cycles. In this chapter, we relax the assumption of constant prices and examine the relationship between price and output in an open economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy Aggregate demand (AD) shows the relationship between total quantity demanded of goods and services and the general price level, holding the money supply, government spending and taxes constant. Aggregate supply (AS) shows the relationship between total quantity supplied of goods and services and the general price level. This relationship depends on time horizon, so there are long-run and short-run aggregate supply curves. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-1 Derivation of the AD Curve from the IS-LM Curves. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed Economy Long-run aggregate supply (LRAS) does not depend on prices, but on quantity of labor, capital, natural resources and technology. The quantity of inputs available to an economy determines the natural level of output (YN) in the long run. LRAS is vertical at YN when plotted against price. Short-run aggregate supply (LRAS) does depend on prices, sloping upward because of imperfect information and market imperfections. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-2 The Long-Run and Short-Run Aggregate Supply Curves. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-3 Equilibrium in a Closed Economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Under fixed exchange rates: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates Opening an economy to trade primarily affects aggregate demand in short and medium run. Under fixed exchange rates: The aggregate demand curve is more elastic than for the closed economy. The more responsive exports and imports are to the change in domestic prices, the more elastic aggregate demand will be relative to the closed economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-5 Derivation of a Nation’s Aggregate Demand Curve Under Fixed Exchange Rates. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Under flexible exchange rates: Aggregate Demand in an Open Economy under Fixed and Flexible Exchange Rates Under flexible exchange rates: The aggregate demand curve is more elastic than for the closed economy and for the open economy with fixed exchange rates. With flexible exchange rates, instead of the money supply increasing when prices increase, the currency will appreciate, bringing nation back into equilibrium. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-6 Derivation of the Nation’s Aggregate Demand Curve Under Flexible Exchange Rates. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Effect of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices Suppose there is an increase in exports and/or reduction in imports with unchanged domestic prices. Under fixed exchange rates, a balance of payments surplus will lead to an increase in aggregate demand. Under flexible exchange rates, the potential balance of payments surplus will appreciate the nation’s currency, correcting trade balance. Aggregate demand does not change. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-7 Changes in the Nation’s Trade Balance and Aggregate Demand. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-8 Short-Term Capital Flows and Aggregate Demand. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Effect of Economic Shocks and Macroeconomic Policies on Aggregate Demand in Open Economies with Flexible Prices Summary Any shock that affects the real sector of the economy affects aggregate demand under fixed exchange rates, but not flexible exchange rates. Any monetary shock affects aggregate demand under both fixed and flexible exchange rates – but in opposite directions. Fiscal policy is effective under fixed exchange rates but not under flexible exchange rates. The opposite is true for monetary policy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Effect of Fiscal and Monetary Policies in Open Economies with Flexible Prices Under fixed exchange rates and highly elastic short-term international capital flows, fiscal policy is effective, but monetary policy is not. Under flexible exchange rates, monetary policy is effective, but fiscal policy is not. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-9 Expansionary Fiscal Policy from the Natural Level of Output and Recession Under Fixed Exchange Rates. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Macroeconomic Policies to Stimulate Growth and Adjustment to Supply Shocks Though fiscal and monetary policies are used primarily to affect aggregate demand, they can also be used to stimulate long-run economic growth. If successful in the long run, growth policies can lead to: Increased employment Higher incomes Lower prices Currency appreciation Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-11 Macroeconomic Policies for Long-Run Growth. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Macroeconomic Policies to Stimulate Growth and Adjustment to Supply Shocks The supply shocks from increases in petroleum prices in the 1970s caused aggregate supply curves in importing nations to shift left, leading to recession and stagflation. The impact on aggregate demand is less clear. Nations that used expansionary monetary policies to combat stagflation generally faced even more inflation than those that did not. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-12 Macroeconomics Policies to Adjust to Supply Shocks. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 19-1 Deviations of Short-Run Outputs from the Natural Level in the United States FIGURE 19-4 Short-Run Output Deviations from the Natural Level in the United States. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 19-11 Index of Central Bank Independence and Average Inflation Case Study 19-2 Central Bank Independence and Inflation in Industrial Countries FIGURE 19-11 Index of Central Bank Independence and Average Inflation Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 19-3 Inflation Targeting—A New Approach to Monetary Policy Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 19-4 Petroleum Shocks and Stagflation in the United States FIGURE 19-13 Stagflation in the United States, 1970-2011. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 19-5 Impact of an Increase in the Price of Petroleum Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 19-6 Actual and Natural Unemployment Rates and Inflation in the United States Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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