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Chapter 11
An Introduction
to Open
Economy
Macroeconomics
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
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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TABLE 11.1 The Main Economic
Agents 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 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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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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TABLE 11.2 The Main Effects of
Fiscal and Monetary Policies
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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 U.S. Trade Balance
and the Exchange Rate, 1980–1988
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Macroeconomic Policy
Coordination
• Leading industrial economies discuss
macroeconomic issues, international relations,
and relations with developing countries at the G8 summit
– If global imbalances arise they discuss the potential
for policy coordination.
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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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Chapter 11
Additional
Chapter Art
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FIGURE 11.4 Real GDP Growth,
United States
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FIGURE 11.5 An Increase in
the Demand for Money
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FIGURE 11.6 The J-Curve
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