Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 11 An Introduction to Open Economy Macroeconomics

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 11.1 The Main Economic Agents in the Macroeconomy

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Aggregate Demand and Aggregate Supply Economy’s income equals the value of its output Intermediate inputs: Goods purchased by one business from another for use in production

Aggregate Demand and Aggregate Supply Shows the relationship between output (GDP) and price levels in the economy at a given point in time Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 11-4

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Aggregate Demand and Aggregate Supply (cont.) Changes in aggregate supply or demand lead to new levels of GDP and prices Increase in consumption expenditure (C), business investment (I), net exports (XN) or government spending (G) increase aggregate demand When GDP or price levels are not at their desired levels, macroeconomic monetary or fiscal policy may be prescribed

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Fiscal Policy Fiscal policy: Government taxation and expenditures formulated by legislative and executive branches. Expansionary fiscal policy: Increases in government spending and/or cuts in taxes; these result in an increase in output –Multiplier effect: An increase in demand ultimately results in an even larger increase in GDP Contractionary fiscal policy: Cuts in government spending and/or increases in taxes –These have a negative multiplier effect

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Fiscal Policy Problems with fiscal policy –Expansionary policies tend to cause inflation so GDP doesn’t rise as much –Large margin of error in estimating the multiplier –Politics often hinders effectiveness of fiscal policy –As a result, fiscal policy is used less for managing the economy

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Monetary Policy Monetary policy is a combination of changes to the money supply and changes to interest rates by the central bank. More easily implemented than fiscal policy –Expansionary monetary policy: An increase in the money supply and decrease in interest rates, investment rises, AD increases –Contractionary monetary policy: A decrease in the money supply and a rise in interest rates, investment falls, AD falls

Figure 11.4 Real GDP Growth, United States Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 11-9

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Case Study – The Great Depression Fiscal policy was contractionary Monetary policy was contractionary Central banks responded correctly based on gold standard –When supply of gold is low, increase interest rates to increase demand for domestic currency –First countries to leave gold standard were the first to experience recovery

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Current Account Balances Revisited Recall: S + (T – G) = I + CA How does a change in income caused by a change in monetary or fiscal policy affect the current account?

Fiscal and Monetary Policy and the Current Account Expenditure Switching: Some consumer spending switches from domestic goods to foreign goods and vice versa. –Partially or completely offsets increase in M from rising incomes when using monetary policy. Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 11.2 The Main Effects of Fiscal and Monetary Policies

Fiscal and Monetary Policy and the Current Account Fiscal policy effects on CA are definite Expansionary fiscal policy increases income, consumption, and interest rates –Increase in incomes will increase imports –Domestic currency appreciates and leads to an increase in imports as people switch expenditures from domestic to foreign goods –CA falls Opposite for contractionary fiscal policy Copyright © 2011 Pearson Addison-Wesley. All rights reserved

The Long Run Change in monetary and fiscal policy do not have any long run impacts In long run, output in an economy tends to fluctuate around the full-employment levels There are automatic changes in the labor market to move economy towards full- employment Most controversial is amount of time for adjustments to occur Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Macro Policies for Current Account Imbalances Use Expenditure switching polices and expenditure reducing policies –A combination of fiscal, monetary, and exchange rate policies for addressing current account deficits –Expenditure switching policies include exchange rate depreciation and trade barriers –Expenditure reducing policies are contractionary monetary or fiscal policies

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Macro Policies for Current Account Imbalances (cont.) Expenditure shifts without expenditure reductions are inflationary Expenditure reductions without shifts toward domestic producers is recessionary

Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Adjustment Process Adjustment process: Describes changes in the trade deficit that are caused by a change in the exchange rate –For example, depreciation raises the real price of foreign goods, making domestic substitutes more attractive –Depreciation has, however, a time lag –Moreover, the first impact of depreciation may be a J- curve: A deterioration of the current account

Figure 11.6 The J-Curve Copyright © 2011 Pearson Addison-Wesley. All rights reserved

Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 11.7 The U.S. Trade Balance and the Exchange Rate, 1980–1988

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Macroeconomic Policy Coordination in Developed Countries Leading industrial economies discuss macroeconomic issues, international relations, and relations with developing countries at the G-8 summit -If global imbalances arise they discuss the potential for policy coordination

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Macroeconomic Policy Coordination in Developed Countries (cont.) However, policy coordination among all countries of the world is difficult –Nations want to guard sovereignty –Nations are reluctant to pursue same policies as trading partners

Copyright © 2011 Pearson Addison-Wesley. All rights reserved