International Business Chapter 27 Prices And Output In The Open Economy: Aggregate Supply And Demand

Unlock access to all the studying documents.

View Full Document

CHAPTER 27

PRICES AND OUTPUT IN THE OPEN ECONOMY:

Aggregate Supply and Demand

Learning Objectives:

■ Explain the concepts and interaction of aggregate demand and aggregate supply in the

closed economy.

I. Outline

Introduction

– Crisis in Argentina

Aggregate Demand and Supply in the Closed Economy

– Aggregate Demand in the Closed Economy

– Aggregate Supply in the Closed Economy

– Equilibrium in the Closed Economy

Aggregate Demand and Supply in the Open Economy

– Aggregate Demand in the Open Economy under Fixed Rates

– Economic Policy and Supply Considerations

External Shocks and the Open Economy

Summary

II Special Chapter Features

In the Real World: U.S. Actual and Natural Income and Unemployment

293

III. Purpose of Chapter

The purpose of the chapter is to examine the manner in which trade and international

IV. Teaching Tips

A. Changes in international capital flows and trade flows exert pressure not only on income

and employment but also upon prices. The less adaptable the economy is to changing economic

B. We have attempted to provide a more rigorous background in aggregate demand and

supply than is found in many international economics texts at this level. For those who have had

C. It is useful to emphasize that the principal difference in deriving the aggregate demand

D. The key to students grasping the AD framework is for them to realize that any factor that

leads to an increase (decrease) in equilibrium income in the IS/LM/BP framework will lead to a

rightward (leftward) shift in the AD curve.

E. The AD/AS model provides a useful framework for contrasting the difference between

F. We have found that students are very interested in problems such as foreign price shocks

that affect both the AD and the AS curves as, for example, in the case of petroleum price

changes.

294

G. Although we have not focused on the issue directly in this chapter, this is a useful place

IV. Answers to End-of-Chapter Questions and Problems

1. The natural level of employment is the level of employment at which the demand for

labor equals the supply of labor and actual prices and real wages equal expected prices and real

2. The short-run aggregate supply curve indicates the change in output produced because of

a change in the price level, but with no change in the expected real wage. As indicated in the

answer to Question #1 above, the long run is a period that is sufficiently long to allow workers to

3. The aggregate supply curves are shifted by underlying factors such as changes in

technology, scale economies, changes in the level of capital stock, improved management

techniques, and improved marketing arrangements. An increase in international transactions and

4. Other things equal, the restrictive monetary policy in Germany would push German

interest rates higher and stimulate an inflow into Germany of foreign short-term financial capital.

In terms of the IS/LM/BP apparatus, such a policy would shift the U.S. BP curve upward (to the

295

5. If imported inputs are important, the appreciation of the currency would have the effect

of reducing the price of those imported inputs and hence reducing costs of production. This

6. If discretionary policy is to have more than a short-run impact on income and

employment, it must result in changes in one or more of the structural factors that underlie the

7. Expansionary monetary policy will increase aggregate demand, giving an even greater

boost to prices. The stagflation has resulted from a leftward shift in the aggregate supply curves,

8. If the home country’s currency is expected to depreciate, other things equal, there would

be an increased demand for foreign currency. Under a flexible-rate system, this causes a

9. Under the flexible exchange rate scenario of Figure 10, expansionary monetary policy

would have the impact of shifting the aggregate demand curve to the right, leading to an

expansion of income and accompanying increases in prices. With the appropriate level of money

296

VI. Sample Exam Questions

1. What effect does opening the economy have on the aggregate demand curve? The

aggregate supply curve? Is it possible that the long-run supply curve will shift to the right more

rapidly in the open economy than in the closed economy? Why or why not?

2. Suppose that the government attempts to stimulate income and employment by using

monetary policy. Explain how this will affect the economy in the short run and the long run.

What must occur for this policy action to have a permanent impact on income and employment?

How might this occur?

3. Suppose that attractive investment opportunities open up outside the United States.

Explain the effects that such opportunities might have on U.S. financial markets and economic

4. Suppose that there is an exogenous increase in foreign prices. Using the AD/AS

framework, explain how this would affect the domestic economy under fixed exchange rates and

under flexible exchange rates. Would your answer be different if there were no imported inputs

into the production process? Why or why not?