International Business Chapter 11 Introduction Open Economy Macroeconomics Outline Introduction The Macroeconomy Global Setting Aggregate

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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

Macro Policies for Current Account Imbalances

The Adjustment Process

Case Study: The Adjustment Process in the United States

Macroeconomic Policy Coordination in Developed Countries

70 Gerber • International Economics, Seventh Edition

◼ Learning Objectives

After studying this chapter, students will be able to:

11.1 Diagram a shift in aggregate demand or supply and explain the impact on the

price level and GDP.

11.2 Diagram the effects on GDP and the price level of expansionary and contractionary

fiscal and monetary policies.

11.3 Analyze the effects of fiscal and monetary policies on the current account and

the exchange rate.

11.4 Explain how expenditure switching and expenditure reducing policies can be

used to reduce a current account deficit.

11.5 Draw a J-curve and use it to show how exchange rate depreciation does not

lead to an immediate reduction in the current account deficit.

◼ 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

study poses the question whether it is possible for small countries to use macroeconomic policies to

counteract a recession when financial markets are internationally integrated.

◼ 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?

Chapter 11 An Introduction to Open Economy Macroeconomics 71

• under a floating exchange rate system?

◼ 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

Answer: A and B both shift aggregate demand to the right, putting upward pressure on the price

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

policy is conducted by the central bank of a country—the Federal Reserve in the case

of the United States—and involves changes in the money supply to achieve desired

macroeconomic goals.

Expansionary fiscal policy involves either increases in government spending or decreases

in taxes, or a little of both. Both of these actions result in increases in disposable income,

then in consumption, repeating in turn until the last dollar or last penny is spent. The

effects of this expansionary fiscal policy dissipate over time due to leakage caused by

72 Gerber • International Economics, Seventh Edition

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

estimation of the size of the multiplier. Third, the effects of fiscal policy vary depending

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

rise in exchange rates causes domestic goods to be more expensive relative to foreign

goods and results in current account deficits. The increased value of the dollar enables

domestic consumers and firms to buy more foreign goods. This may result in the

deterioration of the current account deficit. Contractionary fiscal policy works in the

opposite direction.

exchange rate effect on expansionary monetary policy. The impact of expansionary

monetary policy on the current account is ambiguous since the income effect of monetary

policy on the current account is the opposite of the exchange rate effect. Contractionary

monetary policy involves the increase of interest rates which has the opposite effect of

expansionary monetary policy. Decreases in the money supply lead to the rise in interest

Chapter 11 An Introduction to Open Economy Macroeconomics 73

rates. The rise in interest rates causes an inflow of foreign capital, thereby increasing the

supply of foreign currency. The inflow of foreign currency in turn causes the domestic

currency to appreciate. As a result, foreign goods become relatively cheaper than the

domestic goods. The impact of contractionary monetary policy on the current account is

ambiguous since the income effect of monetary policy on the current account is the

opposite of the exchange rate effect. The increase in the supply of foreign capital raises

the value of the domestic currency. The increase in interest rates depresses the economy

by causing consumption and incomes to fall. This is the income effect of expansionary

monetary policy. These results are summarized in Table 11.2.

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

in the text, these changes in the exchange rate are generally due to fiscal and/or monetary

policy changes.

Unlike a floating rate system, a fixed exchange rate is either determined (by decree) by

the monetary authorities or pegged to a major currency or group of major currencies. A

fixed exchange rate system is either weak or unresponsive to market forces. One reason

for this is that economic conditions may force the government to change the value of a

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

need to be combined with expenditure-switching policies so that reduced demand for

output does not cause a recession. Expenditure-switching policies increase demand for

74 Gerber • International Economics, Seventh Edition

the exchange rate, and a rise in the domestic price of foreign goods. This turns domestic

expenditures away from foreign-produced goods and toward domestically produced

goods. Expansionary monetary policy is likely to lower interest rates and the exchange

rate, but may be inflationary.

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

employment in the short run. Lower interest rates and a depreciation of the currency may

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

previously may have had above-normal profit margins and may have chosen to accept

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

imposing a disproportionate burden to one or a single group of major world economies

(Europe in this case). Suppose, for example, world economic growth is unacceptably low,

Chapter 11 An Introduction to Open Economy Macroeconomics 75

a period in which nations find it in their own interest to pursue the same policies as their

leading partners.