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Chapter 11
An Introduction to
Open Economy
Macroeconomics
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
• 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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Key Players in the Macroeconomy
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Aggregate Supply
and Demand Analysis
• Aggregate supply and demand shows the
relationship between economic output (GDP) and
price levels in the macroeconomy at a given point
in time
• 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 Supply
and Demand (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 expendature (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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Two Categories
of Macroeconomic Policies
• Fiscal policy: government taxation and
expenditures; usually formulated by the
legislative and executive branches
• Monetary policy: 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: increase in government
spending and/or cuts in taxes; result in an increase
in output
– Multiplier effect: 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
– Have a negative multiplier effect
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Monetary Policy
• Works through a combination of change to
the supply of money and change to
interest rates
• Open market operations: 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.)
• Central bank’s increasing the supply
of money in he 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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Fiscal and Monetary Policies in Sum
• Both fiscal and monetary policy
influence exchange rates and the
current account balance
– In both cases, the effect is through a
change in interest rates
– Neither policy is likely to have long-run
effects on income
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Implementation of Fiscal and
Monetary Polices Compared
• Implementation of monetary policy is
relatively simple: conducted by the U.S.
central bank, the Federal Reserve
• Implementation of fiscal policy is more
difficult: 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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Impact of Fiscal and Monetary
Policies on the Current Account
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FIGURE 11.6 U.S. Current Account
Balance, 1980–2002 (Billions of $U.S.)
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Marco 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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Marco Policies for Current
Account Imbalances (cont.)
• The 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 J-curve: a deterioration of the current account
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FIGURE 11.7 The J-Curve
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Macroeconomic Policy Coordination
• Leading industrial economies
coordinate macroeconomic policies in
the annual G-5 and G-7 summits
– If they jointly decide to expand monetary
and fiscal policies, growth in incomes
increases the demand for imports, thus
raising incomes around the world
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Macroeconomic
Policy Coordination (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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