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Chapter 11
An Introduction
to Open
Economy
Macroeconomics
Learning Objectives
• Diagram a shift in aggregate demand or
supply and explain the impact on the price
level and GDP.
• Diagram the effects on GDP and the price
level of expansionary and contractionary
fiscal and monetary policies.
• Analyze the effects of fiscal and monetary
policies on the current account and the
exchange rate.
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Learning Objectives
(cont.)
• Explain how expenditure switching and
expenditure reducing policies can be used to
reduce a current account deficit.
• Draw a J-curve and use it to show how
exchange rate depreciation does not lead to
an immediate reduction in the current
account deficit.
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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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Aggregate Demand and
Aggregate Supply
• Intermediate inputs: Goods
purchased by one business from
another for use in production
• For example, a car manufacturer purchases
glass, tires, steel, and so on. The payment
for auto glass is not directly income to
households because it is paid to another
business; but if traced back it ultimately
becomes income
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TABLE 11.1 The Main Economic
Agents in the Macroeconomy
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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.)
• On the horizontal part of the AS curve, the
economy is operating below full employment
• The middle, upward-sloping part of the AS
curve symbolizes the range of GDP where
inputs begin to become scarce
• The vertical region of the AS curve, the
economy is at full employment and no more
output is possible until new workers enter the
labor force or new factories and machines are
built
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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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Aggregate Demand and
Aggregate Supply (cont.)
• Statistical analysis: a quantitative
relationship between income received by
households and household consumption; as
income rises, so do expenditures
• 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
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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
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Fiscal and Monetary Policies
(cont.)
• Institutions that enact fiscal and monetary
policy vary across countries:
• Legislative and executive branches are
responsible for tax policy and for
determining spending priorities
• Central bank and the finance ministry set
monetary policy, sometimes with direct
input from the executive branch of
government
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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
- These have a positive multiplier effect
• 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: Most frequently
used technique
- 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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FIGURE 11.3 Money Supply and
Demand
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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 11.4 Real GDP Growth in United
States, 1930-1941
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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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FIGURE 11.5 An Increase in the
Demand for Money
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Fiscal and Monetary Policy and
the Current Account
• Once the exchange rate effects of monetary
and fiscal policy have been identified, it is
relatively easy to describe their effects on
the current account
• Effect of fiscal policy on the current account
is definite, while the effect of monetary
policy is ambiguous
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Fiscal and Monetary Policy and
the Current Account (cont.)
Expansionary monetary policy: increase in the money
supply reduces interest rates causing a depreciation in
the domestic currency
•Exchange rate depreciation switches some consumer
spending from foreign goods (imports) to domestic
goods (foreign goods become relatively expensive)
•A more robust expansion of the domestic economy
results; expansionary monetary policy is reinforced by
the changes in the exchange rate
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Fiscal and Monetary Policy and the
Current Account (cont.)
Contractionary monetary policy has the opposite
effect: interest rates rise causing an appreciation of
the domestic currency, which makes imports relatively
cheaper
• The reduction in demand for domestic goods
reinforces the impact of contractionary monetary
policy on income, consumption, and investment
• Leads to a more vigorous decline in economic
activity than would occur in a closed economy
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TABLE 11.2 The Main Effects of
Fiscal and Monetary Policies
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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
•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 11.6 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.)
• 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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