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international economics 5th by gerber ch11

Chapter 11
An Introduction
to Open
Economy
Macroeconomics

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TABLE 11.1
The Main Economic Agents
in the Macroeconomy

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Aggregate Demand and Aggregate
Supply
• Economy’s income equals the value of

its output
• Intermediate inputs: Goods
purchased by one business from
another for use in production

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Aggregate Demand and
Aggregate Supply
• Shows the relationship between output (GDP) and
price levels in the economy at a given point in time

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Aggregate Demand and Aggregate
Supply (cont.)
• Changes in aggregate supply or demand lead to
new levels of GDP and prices
• Increase in consumption expenditure (C),
business investment (I), net exports (XN) or
government spending (G) increase aggregate
demand
• When GDP or price levels are not at their desired
levels, macroeconomic monetary or fiscal policy
may be prescribed

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11-5


Fiscal Policy
• Fiscal policy: Government taxation and expenditures
formulated by legislative and executive branches.


• Expansionary fiscal policy: Increases in government
spending and/or cuts in taxes; these result in an increase in
output
– Multiplier effect: An increase in demand ultimately results
in an even larger increase in GDP
• Contractionary fiscal policy: Cuts in government spending
and/or increases in taxes
– These have a negative multiplier effect

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Fiscal Policy
• Problems with fiscal policy

– Expansionary policies tend to cause inflation so
GDP doesn’t rise as much
– Large margin of error in estimating the multiplier
– Politics often hinders effectiveness of fiscal
policy
– As a result, fiscal policy is used less for
managing the economy

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Monetary Policy
• Monetary policy is a combination of changes to the
money supply and changes to interest rates by the
central bank.
• More easily implemented than fiscal policy
– Expansionary monetary policy: An increase in the money
supply and decrease in interest rates, investment rises, AD
increases
– Contractionary monetary policy: A decrease in the money
supply and a rise in interest rates, investment falls, AD falls

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Figure 11.4 Real GDP Growth, United States

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11-9


Case Study – The Great
Depression
• Fiscal policy was contractionary
• Monetary policy was contractionary
• Central banks responded correctly based on gold standard

– When supply of gold is low, increase interest
rates to increase demand for domestic currency
– First countries to leave gold standard were the
first to experience recovery

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11-10


Current Account Balances Revisited
• Recall: S + (T – G) = I + CA
• How does a change in income caused by a change in
monetary or fiscal policy affect the current account?

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Fiscal and Monetary Policy and the
Current Account
• Expenditure Switching: Some consumer spending
switches from domestic goods to foreign goods and vice
versa.
– Partially or completely offsets increase in M from rising
incomes when using monetary policy.

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TABLE 11.2
The Main Effects of
Fiscal and Monetary Policies

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Fiscal and Monetary Policy and the
Current Account
• Fiscal policy effects on CA are definite
• Expansionary fiscal policy increases income,
consumption, and interest rates
– Increase in incomes will increase imports
– Domestic currency appreciates and leads to an
increase in imports as people switch
expenditures from domestic to foreign goods
– CA falls
• Opposite for contractionary fiscal policy
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The Long Run
• Change in monetary and fiscal policy do not have any long
run impacts
• In long run, output in an economy tends to fluctuate around
the full-employment levels
• There are automatic changes in the labor market to move
economy towards full-employment
• Most controversial is amount of time for adjustments to
occur

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11-15


Macro Policies for
Current Account Imbalances
• Use Expenditure switching polices and
expenditure reducing policies
– A combination of fiscal, monetary, and exchange rate
policies for addressing current account deficits

– Expenditure switching policies include exchange
rate depreciation and trade barriers
– Expenditure reducing policies are contractionary
monetary or fiscal policies

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11-16


Macro Policies for
Current Account Imbalances (cont.)
• Expenditure shifts without expenditure reductions are
inflationary
• Expenditure reductions without shifts toward domestic
producers is recessionary

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The Adjustment Process
• Adjustment process: Describes changes in the
trade deficit that are caused by a change in the
exchange rate
– For example, depreciation raises the real price of
foreign goods, making domestic substitutes more
attractive
– Depreciation has, however, a time lag
– Moreover, the first impact of depreciation may be a Jcurve: A deterioration of the current account

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Figure 11.6 The J-Curve

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FIGURE 11.7
The U.S. Trade Balance and the
Exchange Rate, 1980–1988

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Macroeconomic Policy Coordination
in Developed Countries
• Leading industrial economies discuss macroeconomic
issues, international relations, and relations with
developing countries at the G-8 summit

-If global imbalances arise they discuss the
potential for policy coordination

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11-21


Macroeconomic Policy Coordination
in Developed Countries (cont.)
• However, policy coordination among all
countries of the world is difficult
– Nations want to guard sovereignty
– Nations are reluctant to pursue same
policies as trading partners

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