Transcript Ch11

Chapter 11
An Introduction
to Open
Economy
Macroeconomics
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
TABLE 11.1
The Main Economic Agents
in the Macroeconomy
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-2
Aggregate Demand and Aggregate
Supply
• Economy’s income equals the value of
its output
• Intermediate inputs: Goods
purchased by one business from
another for use in production
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-3
Aggregate Demand and
Aggregate Supply
• Shows the relationship between output
(GDP) and price levels in the economy at
a given point in time
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-4
Aggregate Demand and Aggregate
Supply (cont.)
• Changes in aggregate supply or demand lead to
new levels of GDP and prices
• Increase in consumption expenditure (C),
business investment (I), net exports (XN) or
government spending (G) increase aggregate
demand
• When GDP or price levels are not at their desired
levels, macroeconomic monetary or fiscal policy
may be prescribed
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-5
Fiscal Policy
• Fiscal policy: Government taxation and expenditures
formulated by legislative and executive branches.
• 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 GDP
• Contractionary fiscal policy: Cuts in government spending
and/or increases in taxes
– These have a negative multiplier effect
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-6
Fiscal Policy
• Problems with fiscal policy
– Expansionary policies tend to cause inflation
so GDP doesn’t rise as much
– Large margin of error in estimating the
multiplier
– Politics often hinders effectiveness of fiscal
policy
– As a result, fiscal policy is used less for
managing the economy
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-7
Monetary Policy
• Monetary policy is a combination of changes to
the money supply and changes to interest rates by
the central bank.
• More easily implemented than fiscal policy
– Expansionary monetary policy: An increase in the
money supply and decrease in interest rates,
investment rises, AD increases
– Contractionary monetary policy: A decrease in the
money supply and a rise in interest rates, investment
falls, AD falls
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-8
Figure 11.4 Real GDP Growth, United States
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-9
Case Study – The Great
Depression
• Fiscal policy was contractionary
• Monetary policy was contractionary
• Central banks responded correctly based on
gold standard
– When supply of gold is low, increase interest
rates to increase demand for domestic currency
– First countries to leave gold standard were the
first to experience recovery
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-10
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?
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-11
Fiscal and Monetary Policy and the
Current Account
• Expenditure Switching: Some consumer spending
switches from domestic goods to foreign goods and vice
versa.
– Partially or completely offsets increase in M from rising
incomes when using monetary policy.
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-12
TABLE 11.2
The Main Effects of
Fiscal and Monetary Policies
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-13
Fiscal and Monetary Policy and the
Current Account
• Fiscal policy effects on CA are definite
• Expansionary fiscal policy increases income,
consumption, and interest rates
– Increase in incomes will increase imports
– Domestic currency appreciates and leads to an
increase in imports as people switch
expenditures from domestic to foreign goods
– CA falls
• Opposite for contractionary fiscal policy
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-14
The Long Run
• Change in monetary and fiscal policy do not
have any long run impacts
• In long run, output in an economy tends to
fluctuate around the full-employment levels
• There are automatic changes in the labor
market to move economy towards fullemployment
• Most controversial is amount of time for
adjustments to occur
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-15
Macro Policies for
Current Account Imbalances
• Use Expenditure switching polices and
expenditure reducing policies
– A combination of fiscal, monetary, and exchange rate
policies for addressing current account deficits
– Expenditure switching policies include exchange
rate depreciation and trade barriers
– Expenditure reducing policies are contractionary
monetary or fiscal policies
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-16
Macro Policies for
Current Account Imbalances (cont.)
• Expenditure shifts without expenditure
reductions are inflationary
• Expenditure reductions without shifts toward
domestic producers is recessionary
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-17
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
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-18
Figure 11.6 The J-Curve
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-19
FIGURE 11.7
The U.S. Trade Balance and the
Exchange Rate, 1980–1988
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-20
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
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-21
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
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-22
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
11-23