international economics 5th by gerber 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 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 full-employment • 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 ... 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... 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... • 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: