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103
CHAPTER OUTLINE
I. Although most development policies relate to the long- term outcomes,
short- run stabilization problems often dominate the policy agenda. Serious
macroeconomic imbalances can arise from external or internal shocks or
from the cumulative effects of prior mismanagement. Stabilization prob-
lems were especially widespread during the 1970s, 1980s, the late 1990s,
and in Eu rope in 2010– 2012 because of world market conditions and many
countries’ macroeconomic mismanagement.
II. The basic model for analyzing stabilization policies in developing countries
is the Australian model, which starts from the presumption that most devel-
oping countries are small, open economies. They are small in the sense
ofbeing price takers in world markets for tradable goods (including both
importables and exportables). They are open in that the domestic economy
is heavily affected by international trade and nance. Nontradables, includ-
ing most ser vices, also account for a substantial share of output. The domes-
tic price of tradables is determined by the world price and the of cial
exchange rate, while the price of nontradables is a function of domestic
supply and demand conditions. The relative price of tradable to nontradable
goods mea sures the real exchange rate (P) in this model.
III. External balance is de ned as equality between the supply and demand for
tradables. With zero net foreign nancing, this is equivalent to a zero bal-
ance of trade; with a net in ow of foreign savings, a corresponding balance-
of- trade de cit is consistent with external balance. External imbalance can
take the form of an unsustainable trade de cit or, less critically, an exces-
sive trade surplus. In like fashion, internal balance is de ned as equality
between supply and demand for nontradables. Internal imbalance can take
Managing Short- Run Crises
in an Open Economy
CHAPTER 15
104 | Chapter 15
the form of in ationary excess demand or contractionary excess supply
that idles factors of production and leads to excessive unemployment. These
concepts are easy to depict using supply- and- demand analysis for tradables
and nontradables, with P as the price variable.
IV. Two key variables determining the macroeconomic outcome are aggregate
expenditure (absorption and the real exchange rate). A rise in absorption
increases demand for both tradables and nontradables. A rise in the real
exchange rate, by altering relative prices, induces a shift in consumption
toward nontradables and a shift in production toward tradables. Although
the markets possess self- correcting tendencies, structural rigidities can ren-
der the adjustments too slow to solve short- run crises; in addition, the auto-
matic adjustments can be counteracted by inappropriate policy responses.
V. The model reveals which combination of changes in absorption (A) and the
real exchange rate (P) is needed to restore microeconomic balance, starting
from any initial situation of external or internal imbalance. To simplify the
analysis, the model is presented in the form of a phase diagram with A and
P on the axes. In this diagram, the external balance line (EB) delineates
combinations of A and P for which the tradables market has a balance, a
surplus, or a de cit. Similarly, the internal balance line (IB) shows the com-
binations of A and P for which the market for nontradables has a balance,
asurplus of capacity (unemployment), or excess demand (in ation).
VI. Two main instruments are available to the government to help move the sys-
tem toward overall balance. First, monetary and scal policies directly affect
absorption; second, of cial exchange rate policy affects the real exchangerate.
VII. The Australian model is used to analyze the nature of macroeconomic
imbalances and the mix of policies needed to achieve stabilization. In gen-
eral, both policy instruments must be used in coordinated fashion to reach
the equilibrium. The essence of stabilization policy is to identify the disequi-
librium condition and then determine the warranted policy adjustments. For
countries suffering large external de cits and high domestic in ation, the
indicated response is austerity plus a real depreciation. This is standard IMF
prescription. One important detail is that the aid in ows ease the adjustment
pro cess by reducing the necessary dose of austerity and devaluation. The
model also provides a basis for analyzing the “Dutch disease,” the nature of
the debt repayment problem, and the macroeconomic effects of drought.
Boxed Examples
Box 15–1: Real versus Nominal Exchange Rates
Box 15–2: Pioneering Stabilization: Chile, 1973– 84
Box 15–4: The Greek Debt Crisis of 2010– 12
Chapter 15 has four case studies. The rst case study examines how nominal and
real exchange rates are linked together by the requirement that the relative prices
of tradable and nontradable goods in the real exchange rate (RER) be expressed
in dollars. It follows with a discussion of the real effective exchange rate (REER),
application of the Austrian model.
In the New Edition
This chapter has been expanded to include the section on macroeconomic policies
for developing countries. Pre sen ta tion of the Australian Model of short- run macro-
economic management has been clari ed and illustrated with updated examples.
This chapter also features a new appendix for this edition, providing a review of
national income and balance of payments accounting.
Class Notes
Chapter 15 is more formulaic in its approach to addressing crisis management in
open economies. It develops and applies a single model, the Australian model of
external and internal balance in a small, open economy. The introductory analysis
uses the production frontier to establish some basic concepts. This leads to a more
complete pre sen ta tion of the model in terms of supply and demand for tradables
and nontradables. Then the model is recast into a phase diagram focusing on the
instrument variables A and P.
The phase diagram provides a con ve nient map for examining various cases of
comparative statics and identifying the appropriate policy adjustments to cure any
combination of imbalances. But there are several more subtle details that students
might not grasp without your help. First, be sure to clarify the difference between
shifts in EB and IB versus movement along these curves to a change in A or P.
enough to resolve short-run stabilization crises.
QUESTION BANK
Concept Map
Managing Short- Run Crises in an Open Economy
Equilibrium in a Small, Open Economy
Internal and External Balance
Real Versus Nominal Exchange Rates
The Phase Diagram
Equilibrium and Disequilibrium
Pioneering Stabilization: Chile, 1973– 1984
Stabilization Prices
Dutch Disease
Multiple- Choice Questions
1. During the 1970s, 1980s, and 1990s, many economies became unbalanced
because of:
a. the expansion of the WTO.
b. the emergence of NAFTA and the EU as powerful reenergized economic
forces.
c. world market conditions and macroeconomic mismanagement.
d. China’s emergence as a new global economic power.
2. The two main policy approaches for correcting macroeconomic imbalances
are:
a. changes in aggregate expenditure and adjustments to the exchange rate.
b. changes in expenditure and price controls.
c. adjustments to the exchange rate and price controls.
d. price controls and trade restrictions.
3. For purposes of macroeconomic analysis, a country is small when:
a. its population is less than 20 million.
b. it is a price taker in world markets for its exports and imports.
c. its macroeconomic imbalances have no signi cant effect on other
countries.
d. its domestic economy is not signi cantly in uenced by international
trade and nancial ows.
4. Which of the following should be classi ed as a nontradable?
a. rural road construction ser vices
b. wheat production wholly consumed within the country
c. computer equipment that cannot be produced locally
d. all of the above
5. The domestic price of a tradable good is determined by which equation?
a. Pt = e/P*
t
b. Pt = P*
t/e
c. Pt = eP*
t
d. Pt = e − P*
t
6. If the world price of cotton is $.75 per pound and Mexico’s exchange rate is
14 pesos per dollar, then the peso price of cotton in Mexico (in the absence of
distortionary policies) is:
a. P.08 per pound.
b. P.125 per pound.
c. P10.5 per pound.
d. P8 per pound.
7. The de ning characteristic of equilibrium in the Australian model is that:
a. the economy is operating on its production frontier.
b. the market for nontradables is in equilibrium.
c. the market for tradables is in equilibrium.
d. both the market for nontradables and the market for tradables are in
equilibrium.
8. In terms of national income accounting concepts, absorption is de ned as
GNP:
a. plus imports minus exports.
b. plus exports minus imports.
c. plus imports plus exports.
d. minus investment expenditures minus exports.
9. A depreciation of the real exchange rate (as de ned in the Australian model)
means that the:
a. price of tradables rises relative to the price of nontradables.
b. price of tradables fall relative to the price of nontradables.
c. of cial exchange rate (de ned as local currency per unit of foreign
currency) falls.
d. of cial exchange rate rises more slowly than the average price of
nontradables.
10. At any point to the left of the EB line in the phase diagram:
a. there is in ationary pressure.
b. there is an external surplus.
c. scal and monetary policies are too loose.
d. all of the above.
11. Starting from disequilibrium in both markets, an increase in absorption will
cause:
a. the supply curve to shift to the left for both tradables (T) and
nontradables (N).
b. the demand curve to shift to the right for both T and N.
c. the demand curve to shift to the right for N and to the left for T.
d. no shifts in the curves, but the economy moves to a position of in ation
and external de cit.
12. Starting from an equilibrium in both markets, an increase in absorption will
cause:
a. the supply curve to shift to the left for both tradables (T) and nontrad-
ables (N).
b. the demand curve to shift to the right for both T and N.
c. the demand curve to shift to the right for N and to the left for T.
d. no shift in the curves, but the economy moves to a position of in ation
and external surplus.
13. Which of the following events will cause the external- balance line in the
phase diagram to shift to the left?
a. an appreciation of the exchange rate
b. a decline in the interest rate on foreign debt
c. a decline in the absorption
d. a decline in export earnings
14. Which of the following is a self- correcting tendency in the market when an
economy is in the in ation- and- de cit zone?
a. The loss of foreign exchange reserves compels the government to impose
price controls and trade controls.
b. The macroeconomic imbalances cause international lenders to increase
the interest rate on the country’s external debt.
c. Domestic in ation reduces the real exchange rate.
d. All of the above.
15. Using the exchange rate as an anchor for an adjustment program means:
a. letting the market set the nominal exchange rate.
b. maintaining a crawling peg such that the real exchange rate remains xed.
c. xing the of cial, nominal exchange rate.
d. imposing strict controls over foreign exchange transactions.
16. An unexpected feature of Chile’s stabilization program in the 1970s was
that:
a. export growth was weak after the real exchange rate appreciated.
b. the economy stabilized without requiring scal austerity.
c. the market’s self- correcting mechanisms worked smoothly and quickly
to eliminate the imbalances.
d. in ation stayed high despite tight monetary policy and a big drop in the
scal de cit.
17. For an economy suffering from high in ation and a large external de cit, the
standard prescription for stabilization entails scal:
a. austerity to reduce demand and an appreciation of the exchange rate.
b. austerity to reduce demand and a real appreciation.
c. stimulus to expand supply and a real devaluation.
d. stimulus to expand supply and a real appreciation.
18. For an economy that is experiencing internal balance with a large de cit,
which package of stabilization mea sures is warranted?
a. a real devaluation, with no changes in absorption
b. a real appreciation, with no change in absorption
c. a real devaluation, with scal austerity
d. a real appreciation, with scal austerity
19. If the world price of tradables remains unchanged while the of cial exchange
rate rises by 20 percent and domestic prices for nontradables rise by 50 per-
cent, then the real exchange rate (as de ned in the Australian model):
a. rises by 30 percent.
b. falls by 30 percent.
c. falls by 20 percent.
d. rises by 70 percent.
20. The onset of the Dutch disease in represented in the Australian model as a
shift of the external- balance (EB) line to the:
a. left.
b. right.
c. left combined with a shift of the internal- balance (IB) line to the left.
d. right combined with a shift of the IB line to the left.
IDs and Paired- Concept Questions
These terms can be used individually as short- answer identi cation questions, or
they can be used in pairs. In the latter case, ask students to explain (1) the meaning
and signi cance of each of the two terms and (2) the relationship between them.
1. Tradable goods, real exchange rate
3. Of cial exchange rate, devaluation
5. Internal balance, external balance
7. International Monetary Fund, balance of trade
9. Phase diagram, self- correcting tendencies
