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Chapter 21
Open Economy
Macroeconomic
Policy and
Adjustment
Topics to be Covered
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Internal Balance vs. External Balance
Macroeconomic Equilibrium
The IS Curve
The LM Curve
The BP Curve
Monetary Policy and Fiscal Policy under Fixed
Exchange Rates
• Monetary Policy and Fiscal Policy under
Floating Exchange Rates
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Topics to be Covered (cont.)
• The New Open Economy Macroeconomics
• International Policy Coordination
• The Open Economy Multiplier
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Open Economy Goals:
Internal and External Balance
• Internal Balance—a steady growth of
the domestic economy consistent with a
low unemployment rate.
• External Balance—the achievement of
a desired trade balance or desired
international capital flows.
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Tools of Macroeconomic Policy
• Fiscal Policy—government spending
and taxation.
• Monetary Policy—central bank control
of the money supply and credit.
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Macroeconomic Equilibrium
• Macroeconomic Equilibrium requires
equilibrium in three major markets:

Goods Market Equilibrium: the quantity of
goods and services supplied is equal to the
quantity demanded.

Money Market Equilibrium: the quantity of money
supplied is equal to the quantity demanded.

Balance of Payments Equilibrium: the current
account deficit (surplus) is equal to the capital
account surplus (deficit), so that the official
settlements balance equals zero.
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IS–LM–BP Model
• The IS curve represents the goods
market equilibrium.
• The LM curve represents the money
market equilibrium.
• The BP curve represents the balance of
payments equilibrium.
• Macroeconomic equilibrium is achieved at
the point where all the curves intersect.
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The IS Curve
• The IS curve shows combinations of the
interest rate (i) and output (Y) that provide
equilibrium in the goods market, holding other
things (e.g., the price level) constant.
• Equilibrium occurs when leakages (saving,
taxes, and imports) equal injections
(investment, government spending, and
exports), that is:
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Deriving the IS Curve
• Refer to Figure 21.2 IS curve derivation
• Assumptions:



S and IM depend positively on income
T, I, G, and EX are independent of income
I depends negatively on interest rate
• S + T + IM line is upward-sloping because as
domestic income rises, S and IM increase.
• I + G + EX line is horizontal since I, G, and
EX are independent of income.
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Why is the
IS Curve Downward-sloping?
• When the interest rate falls, more
potential investment projects become
profitable, and thus investment increases
(I + G + EX line shifts upwards). As
investment rises, equilibrium income
also rises.
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21-12
The LM Curve
• The LM curve shows combinations of
i and Y that provide equilibrium in the
money market.
• Graphically, money market equilibrium
occurs at the intersection of the money
supply curve and the money demand
curve (refer to Figure 21.3).
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21-14
Deriving the LM Curve
• Refer to Figure 21.3
• Assumptions:


Money supply is determined by the central
bank and thus exogenous.
Money demand is negatively related to i.
• Money supply curve is vertical.
• Money demand curve is
downward-sloping.
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Why is the
LM Curve Upward-sloping?
• As income increases, demand for
money would increase (money demand
curve shifts upward). Given a fixed
money supply, there will be an excess
demand for money at the original
interest rate. The desire to hold more
money than is available will cause
the interest rate to rise to a new
equilibrium level.
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The BP Curve
• The BP Curve shows combinations of
i and Y that provide equilibrium in the
balance of payments, holding the
price level, exchange rate, and foreign
debt constant.
• Graphically, equilibrium occurs at the
intersection of the current account
surplus line and the capital account
deficit line (refer to Figure 21.4).
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Deriving the BP Curve
• Refer to Figure 21.4
• The current account line is downwardsloping because as income increases,
imports rise and the current account
surplus falls.
• The capital account line is horizontal
since the capital account is determined
by i, not Y.
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Why is the
BP Curve Upward-sloping?
• If the interest rate increases, domestic
financial assets become more attractive
to foreign buyers, and the capital
account deficit falls. At the old income
level, the current account surplus
will exceed the capital account deficit,
so income must rise to a new
equilibrium level.
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Macroeconomic Equilibrium
• Equilibrium for the economy requires
that all three markets (goods,
money, and balance of payments) be
in equilibrium.
• This occurs at the intersection point of
the IS, LM, and BP curves.
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IS–LM–BP Model with
Fixed Exchange Rates
• Effects of Expansionary Monetary Policy
• Effects of Expansionary Fiscal Policy
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Monetary Policy
Under Fixed Exchange Rates
• With fixed exchange rates, the central
bank is not free to conduct monetary
policy independent of the rest of
the world.
• Given perfect asset substitutability and
perfect capital mobility, the domestic
interest rate and foreign interest rate are
equal, and the BP line is horizontal at
i = iF. (refer to Figure 21.5)
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Monetary Policy
under Fixed XR (cont.)
• If the central bank increases the money supply, then
the LM curves shifts to the right, resulting in a higher
Y and lower i.
• The lower i causes a capital outflow and pressure on
the domestic currency to depreciate.
• To maintain the fixed exchange rate, the central bank
sells foreign exchange to buy domestic currency, thus
reducing money supply and shifting the LM curve
back to restore the initial equilibrium.
• Summary: Monetary policy is ineffective in
changing Y under fixed exchange rates and perfect
capital mobility.
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Fiscal Policy
Under Fixed Exchange Rates
• BP curve is horizontal at initial equilibrium interest
rate (refer to Figure 21.6).
• An increase in government spending shifts the IS
curve to the right, resulting in both higher i and Y.
• Higher i causes a capital inflow and pressure on the
domestic currency to appreciate. The central bank
must buy foreign exchange with domestic currency,
thus increasing the money supply and shifting LM
curve to the right. The new equilibrium is at the
original interest rate but at a higher income level.
• Summary: Under fixed exchange rates, fiscal policy
can increase income.
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IS–LM–BP Model
With Floating Exchange Rates
• The IS–LM–BP model with flexible
exchange rates and perfect
capital mobility is also called the
Mundell-Fleming model.
• Effects of Expansionary Monetary Policy
• Effects of Expansionary Fiscal Policy
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Monetary Policy
Under Floating Exchange Rates
• With floating exchange rates, the domestic monetary
policy is independent.
• Refer to Figure 21.7 An increase in money supply
shifts LM to the right, resulting in a lower i and
higher Y.
• The lower i causes a capital outflow and a depreciation
of the domestic currency. The depreciation makes
domestic goods relatively cheaper and stimulates net
exports, thus shifting the IS curve to the right. The
new equilibrium settles at the original i but at a
higher income.
• Summary: Monetary policy can change income under
floating exchange rates.
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Fiscal Policy
Under Floating Exchange Rates
• Refer to Figure 21.8
• Expansionary fiscal policy shifts the IS curve
to the right resulting in both higher income
and interest rate.
• The higher i attracts capital inflow, and the
domestic currency appreciates. The
appreciation shifts IS back to the original
equilibrium i and Y.
• Summary: Fiscal policy is ineffective and
there is complete crowding out, that is, the
increase in government spending is offset by
a decline in private spending.
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The New Open Economy
Macroeconomics
• The new macroeconomic models of open
economies:
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
Looks at households and firms and how their
actions aggregate to macroeconomic phenomena
Examines two countries (or, one country and the
rest of the world) and the determination of macro
variables such as income, prices, and the
exchange rate
Assumes price level is fixed in short run but
flexible in the long run
Allows for pricing to market behavior in which firms
practice price discrimination across countries
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International Policy Coordination
• If all countries coordinated their domestic policies:




Crowding out could be minimized
Exchange rates would be stabilized (although others
argue that exchange rates are determined by real
economic shocks)
Beggar-thy-neighbor policies such as competitive
devaluations could be avoided
A locomotive effect whereby a large country pulls other
countries behind it may be produced
• The practical problem of policy coordination is the fact
that different governments have different objectives.
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The Open Economy Multiplier
• Assuming that saving and imports are each
proportional to income and that interest rate is
fixed, the equilibrium national income can be
expressed as:
where s is the marginal propensity to save
and m is the marginal propensity to import.
• The term 1/(s+m) is the open
economy multiplier.
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Open Economy Multiplier (cont.)
• Since s and m are fractions less than 1, then the
multiplier is expected to be greater than 1. Thus,
an increase in I, G, or EX would cause the
equilibrium income level to rise by more than the
change in spending.
• Refer to Figure 21.9 for example
• If exports increase, then the incomes of factors
employed in the export industry will rise. These
resource-owners (e.g., workers) will increase their
spending on goods and services, thereby stimulating
production, and further increases in income and
spending (the multiplier effect).
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