Price and Output and Macroeconomic Policies in an Open Economy

The Effectiveness of Macroeconomic Policies in an Open Economy How do different monetary policies affect the output and price level in an open economy in the medium and long run? How do adjustments in the price level, interest rates, and the exchange rate would lead the economy toward a long-run equilibrium?

Aggregate Demand An economy’s aggregate demand represents the relationship between the economy’s total total demand for its output of goods and services and its price level. The aggregate demand is a downward-sloping curve representing a negative relationship between the price level and the quantity demand of goods and services produced in the economy. Although the aggregate demand looks like a market demand it represents a quite different type of relationship.

The Aggregate Demand Curve M/P M/P’ P’>P i i’ Q ii P P’ L(Q,i) IS IS’ LM LM’ AD Q o o o L(Q’,i) i’’ O’ Q Changes in G, T, M, e, P*, and X will cause shifts in AD M/P

The Aggregate Supply Curve (Short-Run, Medium-Run and Long-Run) o P Q SRAS LRAS MRAS

The Medium-Run Aggregate Supply Curve What makes the m-r aggregate supply curve upward-sloping? Imperfect information Institutional and contractual barriers to price adjustments Long-run price adjustments do not take place in all sectors at the same time An increase in the general price level may be construed as a relative price change What causes the m-r aggregate supply curve to shift?

Macroeconomic Policy under a Fixed Rate Regime The long-run automatic adjustment mechanism Monetary policy is generally not effective under a fixed exchange rate regime Fiscal policy could be effective in the medium run in moving the economy toward higher output and price levels: ΔG => shift of AD to the right => Δi => capital inflow=> surplus=> purchase of FX by the central bank => ΔM => further shifts of AD. Furthermore, given e, ΔP => ΔR => changes in exports and imports. Long-run price adjustments would shift the MRAS curve to the left, if the economy moves beyond the full-employment output, bringing the output level back to the full-employment level while pushing the price further up.

Exchange Rate Policy under Fixed Exchange Rates A devaluation would shift AD to the right: Δe => ΔR=> ΔIM &ΔX=> surplus => purchase of FX by the central bank=> ΔM => further shit of AD to the right In the long-run, if the economy moves above the L-R full employment output, price adjustments will bring it back to the long-run Q and higher prices.

Monetary Policy Under a Flexible Exchange Rate Regime Automatic adjustments under flexible exchange rates Fiscal policy not very effective under flexible FX regime Monetary policy: ΔM => shift of SD to the right: ΔQ, ΔP, Δe => ΔR (lower relative price) Exchange Rate overshooting.