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LECTURE 22 The Open Economy MACROECONOMY Open economy Trades with other nations Goods and services Financial assets Model – large open economy Substantial capital flows Floating exchange rate INTERNATIONAL TRADE, EXCHANGE RATES, AD Increase in net exports (X-IM) Increase X; decrease IM Multiplier effect on economy Aggregate demand – shifts outward-right Increase real GDP Increase price level Determinants of net exports Foreign incomes Relative prices of foreign & domestic goods The effects of higher net exports D1 Price Level D0 S B A S D0 Real GDP D1 INTERNATIONAL TRADE, EXCHANGE RATES, AD Relative prices of a country’s exports Fall Net exports – increase Real GDP – increase Rise Net exports – decrease Real GDP – decrease INTERNATIONAL TRADE, EXCHANGE RATES, AD Price of foreign products Rise Real GDP – decrease Net exports – increase Currency appreciations or depreciations Real GDP – increase Fall Net exports – decrease Change international relative prices INTERNATIONAL TRADE, EXCHANGE RATES, AD Currency depreciation Raise net exports Increase aggregate demand Currency appreciation Reduce net exports Decrease aggregate demand Exchange rates and home currency prices ¥30,000 Japanese TV Set Exchange Rate €1=120 yen €1=100 yen €1,000 U.S. Home Computer Price in Japan Price in the U.S. Price in the U.S. Price in Japan ¥30,000 ¥30,000 €250 €300 €1,000 €1,000 ¥120,000 ¥100,000 Effects of exchange rate changes on aggregate demand D1 Price Level D0 D2 E1 (depreciation) E2 S E0 (appreciation) S D2 Real GDP D1 D0 9 INTERNATIONAL TRADE, EXCHANGE RATES, AD Late 1990s & early 2000s U.S. trade deficit – grew enormously 1995 – dollar appreciation Boost U.S. imports (40% growth) Damage U.S. exports (7% growth) 1997: €105 billion real net export deficit 2002: €471 billion deficit AGGREGATE SUPPLY IN AN OPEN ECONOMY Depreciation of U.S. dollar Prices of imported inputs – rise U.S. aggregate supply curve Shifts inward Prices of domestic goods & services Increase Additional inflationary effects On consumer prices AGGREGATE SUPPLY IN AN OPEN ECONOMY Appreciation of U.S. dollar Imported inputs – cheaper U.S. aggregate supply curve Shifts outward Prices of domestic goods Decrease Effects of exchange rate changes on aggregate supply D (depreciation) Price Level E1 S0 S2 (appreciation) E0 S1 S0 S1 E2 D S2 Real GDP MACROECONOMIC EFFECTS OF EXCHANGE RATES Dollar depreciation Aggregate demand – shift outward Aggregate supply – shift inward U.S. price level – increase GDP – rise or fall Shifts in demand – larger GDP – rises Currency depreciation Inflationary Probably expansionary The effects of a currency depreciation Price Level D0 S1 D1 S0 A E S1 D1 S0 D0 Real GDP MACROECONOMIC EFFECTS OF EXCHANGE RATES Dollar appreciation Aggregate demand – shift inward Aggregate supply – shift outward U.S. price level – falls GDP – rise or fall Shifts in demand – larger GDP – falls Currency appreciation Disinflationary Probably contractionary The effects of a currency appreciation D0 Price Level D2 S0 S2 E S0 S2 B D2 Real GDP D0 MACROECONOMIC EFFECTS OF EXCHANGE RATES International capital flows Purchases & sales of financial assets Across national borders Rise in interest rates Contract the economy International capital inflows Currency – appreciates Net exports – decrease MACROECONOMIC EFFECTS OF EXCHANGE RATES Drop in interest rates Expand the economy International capital outflows Currency – depreciates Net exports – increase FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Closed economy Aggregate demand – increase Closed economy Does not trade with other nations Goods Assets FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Open economy Interest rates – increase Exchange rate – appreciate Attract foreign capital Capital account surplus – increase Net exports – decrease Current account deficit – increase Capital account surplus + Current account deficit = 0 FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Open economy Aggregate demand – outward shift Aggregate supply – outward shift Aggregate demand – inward shift Fiscal multiplier – reduced A fiscal expansion in an open economy Price Level D0 D2 D1 S0 B S2 A C S0 S2 D0 Real GDP D2 D1 Percentage shares of real GDP in U.S.; 1981 & 1986 Year C I G X-IM 1981 1986 Change 64.5% 67.3 +2.8 14.3% 14.5 +0.2 20.5% 21.2 +0.7 0.2% -2.8 -3.0 FISCAL & MONETARY POLICIES - OPEN ECONOMY Contractionary monetary policy Decrease aggregate demand Interest rates – increase Exchange rates – appreciate Capital inflow Strengthen monetary policy Aggregate supply – outward shift A monetary contraction in an open economy D0 Price Level D1 S0 D2 S2 A B C S0 S2 D0 D2 Real GDP D1 INTERNATIONAL ASPECTS: DEFICIT REDUCTION Policy mix Fiscal contraction & Monetary expansion Reduce interest rates strongly Push down the value of the dollar Strongly stimulate our foreign trade Net effects on output and inflation Uncertain INTERNATIONAL ASPECTS: DEFICIT REDUCTION Trade deficit Excess of imports over exports Trade deficit – can arise Trade surplus Government budget deficit G > T Excess of exports over imports Accounting relationship X – IM = (S – I) – (G – T) Excess investment over saving I >S Expected effects of policy Variable Real interest rate Exchange rate Net exports Real GDP Inflation (1) (2) (3) Fiscal Contraction Monetary Expansion Combination + - + + + + ? ? SHOULD WE WORRY ABOUT THE TRADE DEFICIT? U.S. trade deficits The nation Consumes more then it produces Mirror image: required capital inflows Economic weakness Mortgage our futures To finance higher consumer spending Economic strength Foreigners – eager to lend capital ON CURING THE TRADE DEFICIT X-IM = (S-I) – (G-T) Reduce trade deficit Decrease budget deficit G-T Tightening fiscal policy Loosening monetary policy More rapid economic growth abroad Raise domestic saving Reduce domestic investment Protectionism STOP. Write down 2 things you remember. LECTURE 23: THIS MODULE MICROECONOMICS Individuals, Firms, The Market, Market Demand and Supply Elasticity Monopoly, Perfect Competition, Oligopoly, Monopolistic Competition Game Theory MACROECONOMICS Growth and Development Aggregate Demand & Supply Fiscal Policy Monetary Policy Open Economy Considerations.
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