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Chapter 11
An Introduction
to Open
Economy
Macroeconomics
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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
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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
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TABLE 11.1
The Main Economic Agents
in the Macroeconomy
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Aggregate Demand and Aggregate
Supply
• Intermediate inputs: Goods
purchased by one business from
another for use in production
• Aggregate supply and demand show
the relationship between economic
output (GDP) and price levels in the
macroeconomy at a given point in time
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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
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FIGURE 11.1
Aggregate Demand (AD) and
Aggregate Supply (AS)
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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
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FIGURE 11.2
A Shift in the AD Curve
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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
• Let’s analyze fiscal and monetary policies in
detail…
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Fiscal Policy
• Expansionary fiscal policy: Increases in government
spending and/or cuts in taxes; these result in an increase in
output
– 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
• Contractionary fiscal policy: Cuts in government spending
and/or increases in taxes
– These have a negative multiplier effect
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Monetary Policy
• Monetary policy works through a combination of
change to the supply of money and change to
interest rates
• Open market operations: 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
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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
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FIGURE 11.3
Money Supply and Demand
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Figure 11.4 Real GDP Growth, United States
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Implementation of Fiscal and
Monetary Polices Compared
• Implementation of monetary policy is
relatively simple: It is conducted by the U.S.
central bank, the Federal Reserve
• Implementation of fiscal policy is more
difficult: It requires Congress to pass
legislation that must be signed by the
President
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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?
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TABLE 11.2
The Main Effects of
Fiscal and Monetary Policies
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Figure 11.5 An Increase in the Demand for Money
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Fiscal and Monetary Policy and the
Current Account
• While the effect of fiscal policy on the current account is
definite, the effect of monetary policy is ambiguous
• In the case of monetary policy, changes in the exchange
rate and income have offsetting effects on the current
account, but with fiscal policy changes in the exchange
rate and income have reinforcing effects on the current
account
-As a result, the impact of monetary policy on the current account is
indeterminate, while the impact of fiscal policy is definite
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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
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Macro Policies for
Current Account Imbalances (cont.)
• These two policies must be applied
simultaneously: Expenditure shifts without
expenditure reductions are inflationary, while
expenditure reductions without shifts toward
domestic producers is recessionary
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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 Jcurve: A deterioration of the current account
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Figure 11.6 The J-Curve
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FIGURE 11.7
The U.S. Trade Balance and the
Exchange Rate, 1980–1988
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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
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Macroeconomic Policy Coordination
in Developed Countries (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
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