1. Macroeconomic Policy in an Open Economy © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 1 PowerPoint slides prepared by: Andreea Chiritescu Eastern Illinois University

2. Economic Objectives of Nations Objectives of macroeconomic policy Internal balance External balance Long-term economic growth Reasonably equitable distribution of national income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 2

3. Economic Objectives of Nations Internal balance Economic stability at full employment A fully employed economy No inflation External balance When it realizes neither deficits nor surpluses in its current account Overall balance Internal balance and external balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 3

4. Policy Instruments Expenditure-changing policies Alter the level of total spending (aggregate demand) for goods and services Produced domestically and imported Fiscal policy Changes in government spending and taxes Monetary policy Changes in the money supply and interest rates Central bank © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 4

5. Policy Instruments Expenditure-switching policies Modify the direction of demand Shifting it between domestic output and imports Under fixed exchange rates and trade deficit Devalue its currency Under managed floating exchange-rate and to increase its competitiveness Depreciate its currency © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 5

6. Policy Instruments Direct controls Government restrictions on the market economy To control particular items in the current account To restrain capital outflows To stimulate capital inflows © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 6

7. Aggregate Demand and Aggregate Supply Aggregate demand-aggregate supply model Aggregate demand curve (AD) Level of real output (real GDP) purchased at alternative price levels during a given year Spending by domestic consumers, by businesses, by government, and by foreign buyers (net exports) As the price level falls The quantity of real output demanded increases © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 7

8. Aggregate Demand and Aggregate Supply Aggregate demand-aggregate supply model Aggregate supply curve (AS) Relation between the level of prices and amount of real output that will be produced by the economy during a given year Upward sloping Per-unit production costs and prices increase as real output increases Equilibrium: AD = AS © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 8

9. Aggregate Demand and Aggregate Supply Shifts in aggregate demand curve Changes in the determinants of AD Consumption, investment, government purchases, or net exports Shifts in the aggregate supply curve Changes in the price of resources, technology, business expectations © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 9

10. The economy is in equilibrium where the aggregate demand curve intersects the aggregate supply curve. This intersection determines the equilibrium price level and output for the economy. Increases (decreases) in aggregate demand or aggregate supply result in rightward (leftward) shifts in these curves. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 10 Macroeconomic equilibrium: the aggregate demand-aggregate supply model FIGURE 16.1

11. TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy 2008-2009 recession Federal Reserve Lowering the federal funds rate target to virtually zero Expanded its role as lender of last resort Credit to banks and other financial institutions as well as businesses © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 11

12. TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy 2008-2009 recession U.S. government – Economic Stimulus Act of 2008 $113 billion (0.8% of GDP) – one-time tax rebates to lower- and middle-income individuals and households To be spent immediately Hoping to increase the aggregate demand Only 10-20% of the tax rebate dollars were spent The rest: household saving or for paying down past debt © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 12

13. TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy 2009, Barack Obama Fiscal stimulus program of $789 billion $507 billion in spending programs $282 billion in tax relief Designed to increase the aggregate demand © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 13

14. Monetary and Fiscal Policy in a Closed Economy If aggregate output is too low and unemployment is too high Government - increase aggregate demand for real output Expansionary monetary or fiscal policies Increase in the country’s real GDP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 14

15. Monetary and Fiscal Policy in a Closed Economy If inflation is troublesome Government - reduce the level of aggregate demand for real output Contractionary monetary or fiscal policy Upward pressure on prices is softened and inflation moderates Expansionary monetary or fiscal policy Increase in aggregate demand Increase in domestic consumption, investment, or government spending © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 15

16. (a) Expansionary monetary or fiscal policy in a closed economy. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 16 Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (a) FIGURE 16.2

17. Monetary and Fiscal Policy in an Open Economy Expansionary monetary or fiscal policy Initial effect: Increase in aggregate demand Increase in domestic consumption, investment, or government spending Secondary effect: Increase or decrease in aggregate demand Changing net exports and other determinants of aggregate demand © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 17

18. Monetary and Fiscal Policy in an Open Economy If the initial and secondary effects - increases in aggregate demand Strengthened effect of expansionary policy If the initial and secondary effects - conflicting impacts Weakened effect © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 18

19. Monetary and Fiscal Policy in an Open Economy Expansionary fiscal policy; fixed exchange rates Initial effect: Increase aggregate demand Secondary effect: Increase aggregate demand Budget deficit; Higher interest rate Increased demand for domestic currency in foreign- currency market Purchase foreign currency with domestic currency Increase in the domestic money supply Increase the amount of loanable funds Fiscal policy - strengthened under fixed exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 19

20. Monetary and Fiscal Policy in an Open Economy Expansionary monetary policy; fixed exchange rates Initial effect: Increase aggregate demand Reduce the domestic interest rate Increased consumption and investment Secondary effect: Reduce aggregate demand Decreasing demand for currency Purchase domestic currency with foreign currency Decrease in money supply and loanable funds Monetary policy - weakened under fixed exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 20

21. Monetary and Fiscal Policy in an Open Economy Expansionary monetary policy; floating exchange rates Initial effect: Increase aggregate demand Reduce the domestic interest rate Increased consumption and investment Secondary effect: Increase aggregate demand Domestic currency depreciates Increase in exports, decrease in imports, improvement in current account Monetary policy – strengthened under floating exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 21

22. Monetary and Fiscal Policy in an Open Economy Expansionary fiscal policy; floating exchange rates Initial effect: Increase aggregate demand Secondary effect: Decrease aggregate demand Budget deficit; Higher interest rate Increased demand for domestic currency in the foreign-exchange market Domestic currency appreciates; Falling exports Rising imports, Deteriorating current account Fiscal policy – weakened, floating exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 22

23. (b) Expansionary monetary policy or fiscal policy in an open economy. (1) The policy’s initial and secondary effects reinforce each other. (2) The policy’s initial and secondary effects conflict with each other. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 23 Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (b) FIGURE 16.2

24. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 24 The effectiveness of monetary and fiscal policy in promoting internal balance for an economy with a high degree of capital mobility TABLE 16.1 Exchange-Rate RegimeMonetary PolicyFiscal Policy Floating exchange ratesStrengthenedWeakened Fixed exchange ratesWeakenedStrengthened

25. TRADE CONFLICTS Does crowding occur in an open economy? Crowding out Increased government expenditures and the subsequent budget deficits Private consumption or investment spending decreasing Higher interest rates caused by budget deficits Government deficits Don’t necessarily squeeze out private spending © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 25

26. TRADE CONFLICTS Does crowding occur in an open economy? Recessions People are not spending all of the available funds Consumers are saving more than businesses intend to invest Deficit-financed government spending doesn’t crowd out private spending Extent of crowding out Lessened in an open economy with capital flows Inflows of capital from abroad keep interest rates lower © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 26

27. Macroeconomic Stability and the Current Account: Policy Agreement vs. Policy Conflict Recession + current account deficit Floating exchange rates Expansionary monetary policy to combat recession Currency depreciation Rise in exports and fall in imports Reduce the current account deficit A single economic policy promotes overall balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 27

28. Macroeconomic Stability and the Current Account: Policy Agreement vs. Policy Conflict Inflation + current account deficit Contractionary monetary policy to combat inflation Increase in domestic interest rate Currency appreciation Fall in exports and rise in imports Larger current-account deficit Policy conflict: monetary policy (or fiscal policy) alone will not restore both internal and external balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 28

29. Inflation With Unemployment Inflation with unemployment Internal balance cannot be achieved just by manipulating aggregate demand Reduce AD to decrease inflation Increase AD to decrease unemployment Overall balance - three separate targets Current-account equilibrium Full employment Price stability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 29

30. International Economic-Policy Coordination Economic relations among nations Conflict Independence Integration Policy cooperation Officials from different nations meet to evaluate world economic conditions Policy coordination Formal agreement among nations to initiate particular policies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 30

31. Relations among national governments can be visualized along a spectrum ranging from policy conflict to policy interdependence. Between these extremes are a variety of forms of cooperation and coordination. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 31 Relations among national governments FIGURE 16.3

32. TRADE CONFLICTS G-20 agrees to cooperate on global economic policy: international policy coordination World economy - out of balance with the U.S. U.S. – most of the global current-account deficit China, Japan, and Germany – most of the global surplus United States Consumed more than it produced Invested more than it saved Borrowed from trading partners © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 32

33. TRADE CONFLICTS G-20 agrees to cooperate on global economic policy: international policy coordination 2009, Group of 20 nations - The G-20 plan: Coordinate macroeconomic policies Foster balanced economic growth China and Japan - rely less on exports and more on domestic consumption The U.S. - curtail its budget deficit Europe - difficult structural reforms to increase business investment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 33

34. TRADE CONFLICTS G-20 agrees to cooperate on global economic policy: international policy coordination G-20 Members will need periodically to review each nation’s policies Act by moral suasion, not sanctions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 34

35. International Economic-Policy Coordination Obstacles to successful policy coordination Some nations give higher priority to price stability, or to full employment, than others Some nations have a stronger legislature Or weaker trade unions, than others The party pendulums in different nations Shift with elections occurring in different years One nation may experience economic recession While another nation experiences rapid inflation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 35

36. International Economic-Policy Coordination Plaza Agreement of 1985, G-5 The United States, Japan, Germany, Great Britain, and France Overvalued U.S. dollar Twin U.S. deficits (trade and federal budget) were too large © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 36

37. International Economic-Policy Coordination Plaza Agreement of 1985, G-5 Each country Specific pledges on macroeconomic policy Agreed to initiate coordinated sales of the dollar By 1986, dollar had dramatically depreciated Louvre Accord of 1987, G-5 New concern: uncontrolled dollar plunge Intervention policies – curbing the pace of the dollar’s depreciation Other macroeconomic adjustments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 37

38. International Economic-Policy Coordination 2000, G-7 The United States, Canada, Japan, the United Kingdom, Germany, France, and Italy Coordinated purchases of the euro to boost its value From $0.84 per euro to more than $0.88 per euro Within two weeks following the intervention, the euro’s value slid to an all-time low © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 38