1. Chapter 11 An Introduction to Open Economy Macroeconomics

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-2 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

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-3 Introduction 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

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-4 Key Players in the Macroeconomy

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-5 Aggregate Supply and Demand Analysis Aggregate supply and demand shows the relationship between economic output (GDP) and price levels in the macroeconomy at a given point in time 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

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-6 FIGURE 11.1 Aggregate Demand (AD) and Aggregate Supply (AS)

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-7 Aggregate Supply and Demand (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 expendature (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

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-8 FIGURE 11.2 A Shift in the AD Curve

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-9 Two Categories of Macroeconomic Policies Fiscal policy: government taxation and expenditures; usually formulated by the legislative and executive branches Monetary policy: money supply and interest rates; usually formulated by the central bank and the finance ministry Let’s analyze fiscal and monetary policies in detail…

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-10 Fiscal Policy Expansionary fiscal policy: increase in government spending and/or cuts in taxes; result in an increase in output – Multiplier effect: 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 – Have a negative multiplier effect

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-11 Monetary Policy Works through a combination of change to the supply of money and change to interest rates Open market operations: 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

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-12 Monetary Policy (cont.) Central bank’s increasing the supply of money in he 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

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-13 FIGURE 11.3 Money Supply and Demand

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-14 Fiscal and Monetary Policies in Sum Both fiscal and monetary policy influence exchange rates and the current account balance – In both cases, the effect is through a change in interest rates – Neither policy is likely to have long-run effects on income

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-15 Implementation of Fiscal and Monetary Polices Compared Implementation of monetary policy is relatively simple: conducted by the U.S. central bank, the Federal Reserve Implementation of fiscal policy is more difficult: requires Congress to pass legislation that must be signed by the president

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-16 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?

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-17 Impact of Fiscal and Monetary Policies on the Current Account

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-18 FIGURE 11.6 U.S. Current Account Balance, 1980–2002 (Billions of $U.S.)

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-19 Marco 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

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-20 Marco Policies for Current Account Imbalances (cont.) The two policies must be applied simultaneously: expenditure shifts without expenditure reductions are inflationary, while expenditure reductions without shifts toward domestic producers is recessionary

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-21 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

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-22 FIGURE 11.7 The J-Curve

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-23 Macroeconomic Policy Coordination Leading industrial economies coordinate macroeconomic policies in the annual G-5 and G-7 summits – If they jointly decide to expand monetary and fiscal policies, growth in incomes increases the demand for imports, thus raising incomes around the world

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11-24 Macroeconomic Policy Coordination (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