1. An Introduction to Open Economy Macroeconomics
Chapter 11
An Introduction to Open Economy Macroeconomics

2. Learning Objectives
Diagram a shift in aggregate demand or supply and explain the impact on the price level and GDP.
Diagram the effects on GDP and the price level of expansionary and contractionary fiscal and monetary policies.
Analyze the effects of fiscal and monetary policies on the current account and the exchange rate.

3. Learning Objectives (cont.)
Explain how expenditure switching and expenditure reducing policies can be used to reduce a current account deficit.
Draw a J-curve and use it to show how exchange rate depreciation does not lead to an immediate reduction in the current account deficit.

4. 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

5. Aggregate Demand and Aggregate Supply
Intermediate inputs: Goods purchased by one business from another for use in production
For example, a car manufacturer purchases glass, tires, steel, and so on. The payment for auto glass is not directly income to households because it is paid to another business; but if traced back it ultimately becomes income

6. TABLE 11.1 The Main Economic Agents in the Macroeconomy

7. 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

8. FIGURE 11.1 Aggregate Demand (AD) and Aggregate Supply (AS)

9. Aggregate Demand and Aggregate Supply (cont.)
On the horizontal part of the AS curve, the economy is operating below full employment
The middle, upward-sloping part of the AS curve symbolizes the range of GDP where inputs begin to become scarce
The vertical region of the AS curve, the economy is at full employment and no more output is possible until new workers enter the labor force or new factories and machines are built

10. 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

11. FIGURE 11.2 A Shift in the AD Curve

12. Aggregate Demand and Aggregate Supply (cont.)
Statistical analysis: a quantitative relationship between income received by households and household consumption; as income rises, so do expenditures
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

13. 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

14. Fiscal and Monetary Policies (cont.)
Institutions that enact fiscal and monetary policy vary across countries:
Legislative and executive branches are responsible for tax policy and for determining spending priorities
Central bank and the finance ministry set monetary policy, sometimes with direct input from the executive branch of government

15. Fiscal Policy
Expansionary fiscal policy: Increases in government spending and/or cuts in taxes; these result in an increase in output
- These have a positive multiplier effect
Contractionary fiscal policy: Cuts in government spending and/or increases in taxes
- These have a negative multiplier effect

16. Monetary Policy
Monetary policy works through a combination of change to the supply of money and change to interest rates
Open market operations: Most frequently used technique
- 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

17. FIGURE 11.3 Money Supply and Demand

18. 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

19. FIGURE 11.4 Real GDP Growth in United States, 1930-1941

20. 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?

21. FIGURE 11.5 An Increase in the Demand for Money

22. Fiscal and Monetary Policy and the Current Account
Once the exchange rate effects of monetary and fiscal policy have been identified, it is relatively easy to describe their effects on the current account
Effect of fiscal policy on the current account is definite, while the effect of monetary policy is ambiguous

23. Fiscal and Monetary Policy and the Current Account (cont.)
Expansionary monetary policy: increase in the money supply reduces interest rates causing a depreciation in the domestic currency
Exchange rate depreciation switches some consumer spending from foreign goods (imports) to domestic goods (foreign goods become relatively expensive)
A more robust expansion of the domestic economy results; expansionary monetary policy is reinforced by the changes in the exchange rate

24. Fiscal and Monetary Policy and the Current Account (cont.)
Contractionary monetary policy has the opposite effect: interest rates rise causing an appreciation of the domestic currency, which makes imports relatively cheaper
The reduction in demand for domestic goods reinforces the impact of contractionary monetary policy on income, consumption, and investment
Leads to a more vigorous decline in economic activity than would occur in a closed economy

25. TABLE 11.2 The Main Effects of Fiscal and Monetary Policies

26. 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

27. Macro Policies for Current Account Imbalances (cont.)
These two policies must be applied simultaneously:
Expenditure shifts without expenditure reductions are inflationary
Expenditure reductions without shifts toward domestic producers is recessionary

28. 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

29. FIGURE The J-Curve

30. FIGURE 11.7 The U.S. Trade Balance and the Exchange Rate, 1980–1988

31. 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

32. Macroeconomic Policy Coordination in Developed Countries (cont.)
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