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Prof. Gustavo Indart
Department of Economics
University of Toronto
ECO209
MACROECONOMIC THEORY
Chapter 9
International Adjustment: Aggregate
Demand and Supply in an Open Economy
Discussion Questions:
1.a. A loss of export markets leads not only to an external deficit but also to a decrease in the
level of output. Since a policy dilemma between an external and an internal balance exists,
a combination of expenditure-switching and expenditure-raising policies is required. The
levying of tariffs helps to achieve an external balance, while an increase in government
spending helps to achieve an internal balance.
1.b. A reduction in saving and an increase in the demand for domestic goods will lead to an
increase in national income. As a result, imports will increase, leading to a balance of
payments deficit. This is not a dilemma situation and an expenditure-reducing policy (a cut
in spending) will remedy the situation.
1.c. An increase in government spending will lead to an increase in national income and the
level of imports. This will cause a balance of payments deficit. This is not a dilemma
situation and an expenditure-reducing policy (a cut in spending) will suffice to reestablish an
internal and external balance.
1.d. A shift in the demand from imports to domestic goods will increase output and lead to a
trade surplus. This is a dilemma situation and a combination of expenditure-switching and
expenditure-reducing policies should be employed. Lowering tariffs combined with a cut in
government spending will help to achieve an external and internal balance.
1.e. A reduction in imports with a corresponding increase in saving will not affect the level of
national income but it will lead to a trade surplus. An appropriate response is a reduction in
income taxes combined with lower tariffs. This will help to reduce the trade surplus without
affecting national income.
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2. Temporary trade imbalances can be easily financed, since the central bank is not likely to
run out of foreign currency reserves rapidly. A country that has a temporary payments
imbalance may even borrow foreign currency from abroad as long as the level of domestic
investment spending is sufficient to increase the level of output, some of which will
eventually be exported. A temporary disturbance in trade patterns can come from a change
in exchange rates caused by unstable exchange rate expectations.
If a country suffers a permanent imbalance, however, the central bank will eventually run
out of foreign currency reserves. A permanent imbalance may be caused by a loss in foreign
market share. The adjustment can happen through the automatic adjustment process, but
that could involve long periods of high unemployment. Therefore, domestic policy changes
are required to move the economy more rapidly toward balance.
3. The answer to this question is student specific. Government intervention can help smooth
out temporary fluctuations in exchange rates. However, this is often problematic since at the
time a currency appreciation occurs, the government can never be sure whether a
disturbance is transitory and soon likely to reverse itself or more persistent and fundamental
in nature. If unstable exchange rate expectations lead to capital flows that cause exchange
rate movements and undesired changes in domestic output, central bank intervention
seems justified. But central banks also often intervene to try to reduce inflation by preventing
import prices from rising. The cost of reducing inflation in this way is a steady loss in
competitiveness, which may even result in a foreign exchange crisis. Ultimately, inflation has
to be stopped by restrictive monetary policy. Central banks may also intervene to affect
trade flows and to bring about desired changes in domestic output. In the long run, however,
governments are better off not opposing strong market forces by intervening in the foreign
exchange market. If a government really wants to bring about change, it should employ
domestic policies. It may supplement its policy by intervening in the foreign exchange
market as well to emphasize its intent.
Government intervention is more effective if it is backed up by credible policies. There is
evidence that non-sterilized intervention affects exchange rates more successfully, since
there is a change in money supply equal to the amount of the intervention. But if the
intervention is sterilized, domestic money supply will remain unchanged and even a massive
intervention may not affect the exchange rate to the desired degree.
4. This is basically a discussion of the points presented in Box 9-3.
5. In a system of freely floating exchange rates, domestic monetary policy can be used
effectively, whereas in a system of fixed exchange rates, monetary policy is
completely ineffective. A freely floating exchange rate system is less crisis-prone
since exchange rates are determined solely by market forces. It therefore provides a
better framework for macroeconomic stability. However, spillover effects make
macroeconomic stabilization policy more difficult in a system of freely floating
exchange rates. These spillover (or interdependence) effects can lead to a loss of
competitiveness among other problems. There is therefore good reason for
countries to coordinate their policies.
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6. Central banks often intervene to affect exchange rates in the belief that they can affect trade
flows and prevent import prices from rising. They may also believe that exchange rate
fluctuations have occurred simply due to erratic changes in expectations. However, it is
often unclear whether exchange rate movements are transitory or the beginning of a new
trend with strong market forces at work. This makes intervention problematic. While nonsterilized intervention will affect exchange rates because it will affect the domestic money
supply, it is not clear that sterilized intervention will have the desired effects.
7.
It appears that spillover (or interdependence) effects are much stronger under a system of
floating exchange rates. Therefore, it can be argued that macroeconomic stabilization policy
can be just as difficult under a system of freely floating exchange rates as under a system of
fixed exchange rates.
Application Questions:
1.
The imposition of a tariff raises the relative price of imports and increases the demand for
domestic goods. This increases the level of domestic output, causing interest rates to rise.
Higher domestic interest rates will lead to an inflow of funds and the domestic currency will
begin to appreciate. The higher value of the domestic currency will lower the relative price of
imports again. With perfect capital mobility, the currency appreciation will progress to the
point where the overall change in net exports is zero. In the end, the levels of output and the
interest rate will be back at their original levels.
2. (You are not responsible for answering this question since we haven’t yet covered this
material in class. We need first to cover the material in Lectures 15-16 to be able to answer
this question.)
Assume a $10 billion balance of payments deficit occurs:
The central bank's balance sheet before sterilization:
Assets
foreign exchange - 10
other reserves
0
Liabilities
member bank deposits - 10
currency
0
monetary base
monetary base
- 10
- 10
The central bank's balance sheet after sterilization:
Assets
foreign exchange - 10
govt. securities
+ 10
Liabilities
member bank deposits
currency
0
0
monetary base
monetary base
0
0
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3. A country experiencing a permanent increase in its exports will develop a trade surplus.
Under the assumption that the central bank does not undertake sterilization operations, the
increase in net exports combined with the increase in money supply will lead to an increase
in aggregate demand. This will result in an increase in domestic prices, making import goods
relatively less expensive and export goods relatively more expensive. Eventually, this will
lead to a decrease in net exports. As long as the surplus exists, domestic prices will
continue to rise until an internal and external balance is reestablished. In the long run, overemployment will also cause upward pressure on wages and prices, causing the upwardsloping aggregate supply curve to shift to the left.
4. After a currency depreciation, exports should rise and imports should decline, both in the
short run and in the long run. However, empirical evidence suggests that in the short run the
volume effects are too small to overcome the price effect. Only in the long run, when
consumers and producers have had time to adjust to the change in relative prices, will the
volume effects be large enough to overcome the price effect.
5. Assume the economy is initially in long-run equilibrium. An increase in money supply will,
drive the domestic interest rate below the foreign interest rate. A capital outflow will occur
and the domestic currency will start to depreciate. As a result, exports will rise, imports will
decline. The level of output demanded and the domestic interest rate will rise until they
reach the level of the foreign interest rate. However, the new level of output demanded will
be above the full-employment level and this will cause upward pressure on prices. The rising
price level will reduce real money balances. Since the domestic interest rate will be above
the foreign interest rate, funds will flow in and the domestic currency will appreciate. As a
result, imports will rise and exports will decline. The level of output demanded will decline
again, and the domestic interest rate will decrease until it reaches the level of the foreign
interest rate. In the end, the level of output demanded will again be at the full-employment
level.