Chapter 11
An Introduction to Open
Economy Macroeconomics
◼ Outline
Introduction: The Macroeconomy in a Global Setting
Aggregate Demand and Aggregate Supply
Fiscal and Monetary Policies
Fiscal Policy
Monetary Policy
Case Study: Fiscal and Monetary Policy during the Great Depression
Current Account Balances Revisited
Fiscal and Monetary Policies, Interest Rates, and Exchange Rates
Fiscal and Monetary Policy and the Current Account
The Long Run
Case Study: Argentina and the Limits to Macroeconomic Policy
Macroeconomic Policies for Current Account Imbalances
The Adjustment Process
Case Study: The Adjustment Process in the United States
Macroeconomic Policy Coordination in Developed Countries
◼ What Students Should Know after Reading Chapter 11
The chapter begins with a review of open economy macroeconomics at the principles level, relying mainly
on the aggregate demand/aggregate supply model. The primary purpose of this review is for students to
understand the role of fiscal and monetary policies and the impact those policies have on interest rates,
exchange rates, current accounts, and business and consumer decision making. The first case study
examines fiscal and monetary policies in the Great Depression in the United States, while the second case
62 Gerber • International Economics, Sixth Edition
◼ Suggested Writing Assignment
The most important and interesting topic that students need to understand in Chapter 11 is the relationship
between current account imbalances, particularly deficits, and fiscal and monetary policies. The instructor
may want to ask students for a written explanation of the main policy effects summarized in Table 11.2.
For example, the student might suppose that a country is facing a current account deficit. What kind of
monetary and/or fiscal policy is called for:
• under a fixed exchange rate system?
• under a floating exchange rate system?
Alternatively, students might be asked to summarize the pros and cons of fixed and floating exchange rate
◼ Answers to End-of–Chapter Questions
1. Using aggregate demand and aggregate supply, graph the effects on the price level and GDP of each
of the following.
a. A cut in income taxes
b. An increase in military spending
c. A drop in export demand by foreign purchasers
d. An increase in imports
e. A decline in business investment spending
2. Explain the concepts of fiscal and monetary policy. Who conducts them and how do they work their
way through the economy?
Answer: Fiscal policy is the deliberate manipulation of government spending and taxes in order
to affect aggregate economic activity. Congress and the president conduct it. Monetary
3. What are the some of the problems in trying to use fiscal and monetary policies? Why can’t
economists and politicians make precise predictions about the effects of a policy change on income
and output?
Answer: It is hard to predict the effects of fiscal policy because of its inherent problems. First,
expansionary fiscal policy tends to cause the inflation rate to rise, thereby offsetting some
of the increased consumer spending. Second, there is a substantial margin of error in the
4. Describe the mechanism that leads from a change in fiscal policy to changes in interest rates,
exchange rates, and the current account balance. Do the same for monetary policy.
Answer: Expansionary fiscal policy raises incomes and consumption. These raises in turn lead to
an increase in the demand for money. The increase in the demand for money puts an
64 Gerber • International Economics, Sixth Edition
5. Some countries have fixed exchange rate systems instead of flexible exchange rate systems. How
does the exchange rate system limit their ability to use monetary policy?
Answer: There is a market-determined equilibrium exchange rate that equates the demand for and
supply of a currency in a flexible exchange rate system. Consequently, changes in the
exchange rate affect exports and imports and thereby correct any imbalances. As shown
6. The United States is currently running a large current account deficit. If Congress and the White
House decided to enact policies to reduce or to eliminate the deficit, what actions should they take?
Describe the set of policy options that would be available to them.
Answer: Generally, expenditure-reducing policies such as contractionary fiscal or monetary
policies would be used to cut the overall level of demand in the economy. This would
7. Describe the larger economic effects of the policies in the previous question. That is, what would be
the effects on income, consumption, employment, interest rates, and real exchange rates of policies
designed to reduce or eliminate the current account deficit?
Answer: Contractionary fiscal policy is likely to lead to less spending, consumption, income, and
8. During the second half of the 1980s, the United States depreciated the dollar in hopes that it would
reduce the current account deficit. After a year, the deficit was actually larger and newspaper
editorialists were writing columns claiming that there is no link between the exchange rate and the
current account. Explain why they got this wrong.
Answer: They got it wrong because the current account improved, but with a longer than expected
lag of almost two years. The lag could have been due to several factors. Foreign firms
9. Suppose the United States, Japan, and many other places around the world go into recession, but
growth remains strong in Europe. Why would macroeconomic policy coordination help, who should
coordinate, and what are some of the obstacles to coordination?
Answer: The usual goal for policy coordination is to achieve a desirable level of world economic
growth, but there are other objectives as well. Policy coordination may help avoid