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.

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Macroeconomic Policyin 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‐

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


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Economic Objectives of Nations• Objectives of macroeconomic policy• Internal balance • External balance• Long-term economic growth• Reasonably equitable distribution of national

income


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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


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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


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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


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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


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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


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• 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


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• 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


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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.

Macroeconomic equilibrium: the aggregate demand-aggregate supply model

FIGURE 16.1


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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


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TRADE CONFLICTS


• 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


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TRADE CONFLICTS


• 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


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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


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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


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(a) Expansionary monetary or fiscal policy in a closed economy.

Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (a)

FIGURE 16.2


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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


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• 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


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• 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


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• 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


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• 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


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• 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


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(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.

Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (b)

FIGURE 16.2


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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 Regime Monetary Policy Fiscal PolicyFloating exchange rates Strengthened Weakened Fixed exchange rates Weakened Strengthened


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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


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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


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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


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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


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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


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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


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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.

Relations among national governmentsFIGURE 16.3


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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


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TRADE CONFLICTS


• 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


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TRADE CONFLICTS


• G-20• Members will need periodically to review each

nation’s policies• Act by moral suasion, not sanctions


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• 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


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• 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


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• 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


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• 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

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.

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