Chapter 11 An Introduction to Open Economy Macroeconomics

Chapter Objectives Analyze the relationship of balance of payments and the exchange rate to each other and to the national economy Focus particularly on the interactions of the current account, exchange rates, consumption, investment, and government spending Explore the role of national governments in the economy: especially the impact of macroeconomic policies on the exchange rate and the current account Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Introduction: The Macroeconomy in a Global Setting Since the Great depression of the 1930s, national governments have held a central role in guaranteeing economic growth, employment, and price stability However, besides policies, the day-to-day operations of governments, consumers, and businesses alike have a major impact on the current account and exchange rates 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 Intermediate inputs: Goods purchased by one business from another for use in production Aggregate supply and demand show the relationship between economic output (GDP) and price levels in the macroeconomy at a given point in time Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Aggregate Demand and Aggregate Supply (cont.) The aggregate supply curve calls attention to three regions of GDP: under, nearing, and at or beyond full employment equilibrium The aggregate demand curve shows expenditure by consumers (C), business (I), the government (G), and foreign purchases of exports – domestic purchases of imports (X–M) at various price levels Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

FIGURE 11.1 Aggregate Demand (AD) and Aggregate Supply (AS) Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Aggregate Demand and Aggregate Supply (cont.) Changes in aggregate supply or demand, which can occur for numerous reasons, lead to new levels of GDP and prices An increase in consumption expenditure (C), business investment (I), or government spending (G), for example, would 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.

FIGURE 11.2 A Shift in the AD Curve Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Fiscal and Monetary Policies Fiscal policy: Covers government taxation and expenditures; usually formulated by the legislative and executive branches Monetary policy: Covers money supply and interest rates; usually formulated by the central bank and the finance ministry Let’s analyze fiscal and monetary policies in detail… Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Fiscal Policy 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 production and income as effects of the demand hike run through the economy 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.

Monetary Policy Monetary policy works through a combination of change to the supply of money and change to interest rates Open market operations: The central bank's buying and selling of bonds in the open market -Selling bonds leads the nation’s financial institutions to give up some of their cash, with cash reserves shrinking throughout the economy Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Monetary Policy (cont.) The central bank’s increasing the supply of money in the economy reduces the interest rate Expansionary monetary policy: An increase in the money supply and decrease in interest rates Contractionary monetary policy: A decrease in the money supply and a rise in interest rates Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

FIGURE 11.3 Money Supply and Demand Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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

Implementation of Fiscal and Monetary Polices Compared Implementation of monetary policy is relatively simple: It is conducted by the U.S. central bank, the Federal Reserve Implementation of fiscal policy is more difficult: It requires Congress to pass legislation that must be signed by the President 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? Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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

Figure 11.5 An Increase in the Demand for Money Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Fiscal and Monetary Policy and the Current Account While the effect of fiscal policy on the current account is definite, the effect of monetary policy is ambiguous In the case of monetary policy, changes in the exchange rate and income have offsetting effects on the current account, but with fiscal policy changes in the exchange rate and income have reinforcing effects on the current account -As a result, the impact of monetary policy on the current account is indeterminate, while the impact of fiscal policy is definite Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

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

Macro Policies for Current Account Imbalances (cont.) These two policies must be applied simultaneously: Expenditure shifts without expenditure reductions are inflationary, while 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Figure 11.6 The J-Curve 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.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.