© The McGraw-Hill Companies, 2008 Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill,

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© The McGraw-Hill Companies, 2008 Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Open economy macroeconomics … is the study of economies in which international transactions play a significant role –international considerations are especially important for open economies like the UK, Germany or the Netherlands Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world –especially via the exchange rate.

© The McGraw-Hill Companies, Floating Exchange Rate and Monetary Policy Y P M İnterest rate AD 2 MS 1 MD P1P1 Y2Y2 r2r2 MS 2 r1r1 AD 1 Y1Y1 Central bank increases money supply and decreases the interest rate. A decrease in interest rate increases the demand and output.

© The McGraw-Hill Companies, 2008 Floating Exchange Rate and Monetary Policy Monetary Policy is Effective under Floating Exchange rate. Increase in MS → Decrease in r. –C and I increases –NX increases because the devaluation of the exchange rate. Increases in demad and output. 4

© The McGraw-Hill Companies, Fixed Exchange Rate and Fiscal Policy The government can use an expansionary fiscal policy to increase the demand and the output. Y P AD 1 P1P1 AD 2 AD 3 Y1Y1 Y3Y3 Y2Y2 İncrease in G

© The McGraw-Hill Companies, 2008 Fixed Exchange Rate and Fiscal Policy When (G) increases, –National output increases. –Interest rate will also increase, –There will be capital inflow –The central bank increases the money supply to keep the exchange rate constant. –The interest rate will return to the original value. In the meantime the output will increase and a short-term economic boom will be experienced. 6

© The McGraw-Hill Companies, 2008 Crises in Greece Greece cannot apply its monetary policy because it is in the Euro area. Greece cannot apply its fiscal policy because the budget deficit is already very high and the country is likely to default. The only policy left is to decrease prices. They will be more competitive this way and will be able to export. To decrease the price level, the labor costs should decrease. 7