Chapter 22
How Does the Open Macroeconomy Work?
Overview
This chapter provides a framework and model for analyzing international macroeconomics. We
judge the performance of a national economy against two objectives. Internal balance involves
both full employment and price stability or an acceptable rate of inflation. External balance
involves a reasonable and sustainable makeup of the country’s international payments, taken to
be approximately an official settlements balance that is zero. The framework generally assumes
that the domestic price level is sticky or sluggish in the short run, although it does respond to
supply and demand conditions beyond the short run.
In the short run (and within the economy’s supply capabilities), domestic production is
determined by aggregate demand: Y = AD = C + Id + G + (X – M) = E + (X – M), where Y is both
domestic production and national income, and E is national expenditure on goods and services.
Consumption C is a positive function of Y (inclusive of the effects of taxes T), and real domestic
investment Id is a negative function of the interest rate i. Imports M are a positive function of Y,
according to the marginal propensity to import m.
If the interest rate and price level are constant, then the equilibrium is the level of real GDP (and
income) that equals desired aggregate demand at that level of income, or, equivalently, the level
of real GDP for which desired national saving S equals desired domestic and foreign investment
Id + If, given that X – M is (approximately) equal to If. The spending multiplier shows how
equilibrium GDP responds to exogenous changes in any component of aggregate demand. The
spending multiplier in a small open economy is 1/(s + m), where s is the marginal propensity to
save (including any “forced saving” causes by the tax system). The multiplier is smaller than in a
comparable closed economy (in which m is zero).
For a large country the change in its imports has spillover effects on foreign GDP. A change in
this large country’s income changes its imports, which changes foreign exports by enough to alter
foreign production and income. In turn, the change in foreign income changes foreign imports,
which changes the first country’s exports, leading to a further change in this country’s production
and income.Foreign income repercussions increase the size of the spending multiplier for a large
country.
The IS-LM-FE model provides a more complete framework for analyzing the open
macroeconomy. It shows the determination of the short-run equilibrium levels of the country’s
real GDP and interest rate while also indicating the state of the country’s official settlements
balance (or, equivalently, the pressure on the exchange rate value of the country’s currency). We
are relaxing the assumption that the interest rate is steady.
The downward-sloping IS curve shows all combinations of Y and i that represent equilibrium in
the domestic product market. A change in an influence on aggregate demand other than Y or i
results in a shift in the IS curve. The upward-sloping LM curve shows all combinations of Y and
i that represent equilibrium in the money market. A change in the money supply or a change in
an influence on money demand other than Y or i results in a shift in the LM curve. The
intersection of the IS and LM curves shows the short-run equilibrium values for real GDP and
the interest rate.
The FE curve shows all combinations of Y and i that result in a zero official settlements balance.
If the country’s current account balance CA is a negative function of Y (because of import
demand), and the country’s (nonofficial) financial account FA is a positive function of i (because
of the incentive for international capital flows), the FE curve generally slopes upward. A point
above or to the left of the FE curve indicates that the country’s official settlements balance is in
surplus; a point below or to the right indicates a payments deficit. Given the marginal propensity
to import, how flat or steep the FE curve is depends on how responsive international capital
flows are to interest rate changes. The more responsive, the flatter the FE curve. In the extreme,
with perfect capital mobility the FE curve is a horizontal line. A change in an influence on the
current or financial accounts other than Y or i causes a shift in the FE curve. The text also notes
that the ability of a higher domestic interest rate to attract inflows of capital probably falls off
beyond a short time period.
As the economy moves beyond the short run, the product price level does change, for three basic
reasons. First, most countries have some amount of ongoing inflation. Second, strong or weak
aggregate demand (relative to the economy’s supply capabilities) puts pressure on the price level
—strong demand causes overheating and weak demand causes a “discipline” effect. Third, price
shocks, including oil price shocks and large, abrupt changes in the exchange rate value of the
country’s currency, can change the price level.(Appendix G describes a model using aggregate
demand and aggregate supply that can be used to analyze more formally pressures that change
the price level.)
The final piece of the framework that we develop in the text is that the country’s exports and
imports depend on international price competitiveness, in addition to depending on national
incomes. The price of foreign-produced traded products relative to the price of home-produced
substitute products is Pfe/P, where e is measured as units of domestic currency per unit of
foreign currency. This ratio is the real exchange rate introduced in Chapter 19. The country’s
demand for imports is a negative function of this price ratio, while demand for the country’s
exports is a positive function. A change in price competitiveness causes a change in net exports,
so that both the IS and the FE curves shift.
Tips
We present a framework that can be used to analyze both fixed (Chapter 23) and floating
(Chapter 24) exchange rates. Clearly, any one framework is not perfect, but we believe that this
framework (the Mundell-Fleming model) is a good framework that includes a large number of
relationships that must be juggled in analyzing the open macroeconomy. Footnote 3 presents
some shortcomings of this approach. The aggregate demand-aggregate supply model of
Appendix G is one way to address some of these shortcomings.
We have chosen to focus more on the complete model, and to reduce the treatment of spending
multipliers by presenting the explicit formula for only the small, open-economy multiplier.
Foreign income repercussions are covered intuitively and with examples. An instructor who
wants to cover more on multipliers may want to prepare a class handout of a few pages that
works through multipliers with foreign income repercussions.