Macroeconomic Policy in an Open Economy Power Point

Macroeconomic Policy in an Open Economy Power. Point slides prepared by: Andreea Chiritescu Eastern Illinois University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 1

Economic Objectives of Nations • Objectives of macroeconomic policy • • Internal balance External balance Long‐term economic growth Reasonably equitable distribution of national income © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 2

Economic Objectives of Nations • Internal balance • Economic stability at full employment • A fully employed economy • No inflation • External balance • When it realizes neither deficits nor surpluses in its current account • Overall balance • Internal balance and external balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 3

Policy Instruments • Expenditure‐changing policies • Alter the level of total spending (aggregate demand) for goods and services • Produced domestically and imported • Fiscal policy • Changes in government spending and taxes • Monetary policy • Changes in the money supply and interest rates • Central bank © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 4

Policy Instruments • Expenditure‐switching policies • Modify the direction of demand • Shifting it between domestic output and imports • Under fixed exchange rates and trade deficit • Devalue its currency • Under managed floating exchange‐rate and to increase its competitiveness • Depreciate its currency © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 5

Policy Instruments • Direct controls • Government restrictions on the market economy • To control particular items in the current account • To restrain capital outflows • To stimulate capital inflows © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 6

Aggregate Demand Aggregate Supply • Aggregate demand‐aggregate supply model • Aggregate demand curve (AD) • Level of real output (real GDP) purchased at alternative price levels during a given year • Spending by domestic consumers, by businesses, by government, and by foreign buyers (net exports) • As the price level falls • The quantity of real output demanded increases © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 7

Aggregate Demand Aggregate Supply • Aggregate demand‐aggregate supply model • Aggregate supply curve (AS) • Relation between the level of prices and amount of real output that will be produced by the economy during a given year • Upward sloping • Per‐unit production costs and prices increase as real output increases • Equilibrium: AD = AS © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 8

Aggregate Demand Aggregate Supply • Shifts in aggregate demand curve • Changes in the determinants of AD • Consumption, investment, government purchases, or net exports • Shifts in the aggregate supply curve • Changes in the price of resources, technology, business expectations © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 9

FIGURE 16. 1 Macroeconomic equilibrium: the aggregate demand‐aggregate supply model The economy is in equilibrium where the aggregate demand curve intersects the aggregate supply curve. This intersection determines the equilibrium price level and output for the economy. Increases (decreases) in aggregate demand or aggregate supply result in rightward (leftward) shifts in these curves. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 10

TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy • 2008‐ 2009 recession • Federal Reserve • Lowering the federal funds rate target to virtually zero • Expanded its role as lender of last resort • Credit to banks and other financial institutions as well as businesses © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 11

TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy • 2008‐ 2009 recession • U. S. government – Economic Stimulus Act of 2008 • $113 billion (0. 8% of GDP) – one‐time tax rebates to lower‐ and middle‐income individuals and households • To be spent immediately • Hoping to increase the aggregate demand • Only 10‐ 20% of the tax rebate dollars were spent • The rest: household saving or for paying down past debt © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 12

TRADE CONFLICTS Monetary and fiscal policy respond to financial turmoil in the economy • 2009, Barack Obama • Fiscal stimulus program of $789 billion • $507 billion in spending programs • $282 billion in tax relief • Designed to increase the aggregate demand © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 13

Monetary and Fiscal Policy in a Closed Economy • If aggregate output is too low and unemployment is too high • Government ‐ increase aggregate demand for real output • Expansionary monetary or fiscal policies • Increase in the country’s real GDP © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 14

Monetary and Fiscal Policy in a Closed Economy • If inflation is troublesome • Government ‐ reduce the level of aggregate demand for real output • Contractionary monetary or fiscal policy • Upward pressure on prices is softened and inflation moderates • Expansionary monetary or fiscal policy • Increase in aggregate demand • Increase in domestic consumption, investment, or government spending © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 15

FIGURE 16. 2 Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (a) Expansionary monetary or fiscal policy in a closed economy. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 16

Monetary and Fiscal Policy in an Open Economy • Expansionary monetary or fiscal policy • Initial effect: Increase in aggregate demand • Increase in domestic consumption, investment, or government spending • Secondary effect: Increase or decrease in aggregate demand • Changing net exports and other determinants of aggregate demand © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 17

Monetary and Fiscal Policy in an Open Economy • If the initial and secondary effects ‐ increases in aggregate demand • Strengthened effect of expansionary policy • If the initial and secondary effects ‐ conflicting impacts • Weakened effect © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 18

Monetary and Fiscal Policy in an Open Economy • Expansionary fiscal policy; fixed exchange rates • Initial effect: Increase aggregate demand • Secondary effect: Increase aggregate demand • Budget deficit; Higher interest rate • Increased demand for domestic currency in foreign‐ currency market • Purchase foreign currency with domestic currency • Increase in the domestic money supply • Increase the amount of loanable funds • Fiscal policy ‐ strengthened under fixed exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 19

Monetary and Fiscal Policy in an Open Economy • Expansionary monetary policy; fixed exchange rates • Initial effect: Increase aggregate demand • Reduce the domestic interest rate • Increased consumption and investment • Secondary effect: Reduce aggregate demand • Decreasing demand for currency • Purchase domestic currency with foreign currency • Decrease in money supply and loanable funds • Monetary policy ‐ weakened under fixed exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 20

Monetary and Fiscal Policy in an Open Economy • Expansionary monetary policy; floating exchange rates • Initial effect: Increase aggregate demand • Reduce the domestic interest rate • Increased consumption and investment • Secondary effect: Increase aggregate demand • Domestic currency depreciates • Increase in exports, decrease in imports, improvement in current account • Monetary policy – strengthened under floating exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 21

Monetary and Fiscal Policy in an Open Economy • Expansionary fiscal policy; floating exchange rates • Initial effect: Increase aggregate demand • Secondary effect: Decrease aggregate demand • Budget deficit; Higher interest rate • Increased demand for domestic currency in the foreign‐exchange market • Domestic currency appreciates; Falling exports • Rising imports, Deteriorating current account • Fiscal policy – weakened, floating exchange rates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 22

FIGURE 16. 2 Effect of an expansionary monetary or fiscal policy on equilibrium real GDP (b) Expansionary monetary policy or fiscal policy in an open economy. (1) The policy’s initial and secondary effects reinforce each other. (2) The policy’s initial and secondary effects conflict with each other. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 23

TABLE 16. 1 The effectiveness of monetary and fiscal policy in promoting internal balance for an economy with a high degree of capital mobility Exchange-Rate Regime Monetary Policy Fiscal Policy Floating exchange rates Strengthened Weakened Fixed exchange rates Weakened Strengthened © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 24

TRADE CONFLICTS Does crowding occur in an open economy? • Crowding out • Increased government expenditures and the subsequent budget deficits • Private consumption or investment spending decreasing • Higher interest rates caused by budget deficits • Government deficits • Don’t necessarily squeeze out private spending © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 25

TRADE CONFLICTS Does crowding occur in an open economy? • Recessions • People are not spending all of the available funds • Consumers are saving more than businesses intend to invest • Deficit‐financed government spending doesn’t crowd out private spending • Extent of crowding out • Lessened in an open economy with capital flows • Inflows of capital from abroad keep interest rates lower © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 26

Macroeconomic Stability and the Current Account: Policy Agreement vs. Policy Conflict • Recession + current account deficit • Floating exchange rates • Expansionary monetary policy to combat recession • Currency depreciation • Rise in exports and fall in imports • Reduce the current account deficit • A single economic policy promotes overall balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 27

Macroeconomic Stability and the Current Account: Policy Agreement vs. Policy Conflict • Inflation + current account deficit • Contractionary monetary policy to combat inflation • Increase in domestic interest rate • Currency appreciation • Fall in exports and rise in imports • Larger current‐account deficit • Policy conflict: monetary policy (or fiscal policy) alone will not restore both internal and external balance © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 28

Inflation With Unemployment • Inflation with unemployment • Internal balance cannot be achieved just by manipulating aggregate demand • Reduce AD to decrease inflation • Increase AD to decrease unemployment • Overall balance ‐ three separate targets • Current‐account equilibrium • Full employment • Price stability © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 29

International Economic‐Policy Coordination • Economic relations among nations • Conflict • Independence • Integration • Policy cooperation • Officials from different nations meet to evaluate world economic conditions • Policy coordination • Formal agreement among nations to initiate particular policies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 30

FIGURE 16. 3 Relations among national governments can be visualized along a spectrum ranging from policy conflict to policy interdependence. Between these extremes are a variety of forms of cooperation and coordination. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 31

TRADE CONFLICTS G‐ 20 agrees to cooperate on global economic policy: international policy coordination • World economy ‐ out of balance with the U. S. • U. S. – most of the global current‐account deficit • China, Japan, and Germany – most of the global surplus • United States • Consumed more than it produced • Invested more than it saved • Borrowed from trading partners © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 32

TRADE CONFLICTS G‐ 20 agrees to cooperate on global economic policy: international policy coordination • 2009, Group of 20 nations ‐ The G‐ 20 plan: • Coordinate macroeconomic policies • Foster balanced economic growth • China and Japan ‐ rely less on exports and more on domestic consumption • The U. S. ‐ curtail its budget deficit • Europe ‐ difficult structural reforms to increase business investment © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 33

TRADE CONFLICTS G‐ 20 agrees to cooperate on global economic policy: international policy coordination • G‐ 20 • Members will need periodically to review each nation’s policies • Act by moral suasion, not sanctions © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 34

International Economic‐Policy Coordination • Obstacles to successful policy coordination • Some nations give higher priority to price stability, or to full employment, than others • Some nations have a stronger legislature • Or weaker trade unions, than others • The party pendulums in different nations • Shift with elections occurring in different years • One nation may experience economic recession • While another nation experiences rapid inflation © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 35

International Economic‐Policy Coordination • Plaza Agreement of 1985, G‐ 5 • The United States, Japan, Germany, Great Britain, and France • Overvalued U. S. dollar • Twin U. S. deficits (trade and federal budget) were too large © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 36

International Economic‐Policy Coordination • Plaza Agreement of 1985, G‐ 5 • Each country • Specific pledges on macroeconomic policy • Agreed to initiate coordinated sales of the dollar • By 1986, dollar had dramatically depreciated • Louvre Accord of 1987, G‐ 5 • New concern: uncontrolled dollar plunge • Intervention policies – curbing the pace of the dollar’s depreciation • Other macroeconomic adjustments © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 37

International Economic‐Policy Coordination • 2000, G‐ 7 • The United States, Canada, Japan, the United Kingdom, Germany, France, and Italy • Coordinated purchases of the euro to boost its value • From $0. 84 per euro to more than $0. 88 per euro • Within two weeks following the intervention, the euro’s value slid to an all‐time low © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use 38