LECTURE 22. The Open Economy

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1 LECTURE 22 The Open Economy

2 MACROECONOMY Open economy Trades with other nations Goods and services Financial assets Floating exchange rate Model large open economy Substantial capital flows

3 INTERNATIONAL TRADE, EXCHANGE RATES, AD Increase in net exports (X-IM) Increase X; decrease IM Multiplier effect on economy Aggregate demand shifts outward-right Increase real GDP Increase price level Determinants of net exports Foreign incomes Relative prices of foreign & domestic goods

4 The effects of higher net exports D0 D1 B S Price Level A S D0 Real GDP D1

5 INTERNATIONAL TRADE, EXCHANGE RATES, AD Relative prices of a country s exports Fall Net exports increase Net exports decrease Real GDP decrease Real GDP increase Rise

6 INTERNATIONAL TRADE, EXCHANGE RATES, AD Price of foreign products Rise Net exports increase Real GDP increase Fall Real GDP decrease Currency appreciations or depreciations Change international relative prices Net exports decrease

7 INTERNATIONAL TRADE, EXCHANGE RATES, AD Currency depreciation Raise net exports Increase aggregate demand Currency appreciation Reduce net exports Decrease aggregate demand

8 Exchange rates and home currency prices 30,000 TV Japanese Set 1,000 U.S. Home Computer Exchange Rate Price in Japan Price in the U.S. Price in the U.S. Price in Japan 1=120 yen 1=100 yen 30,000 30, ,000 1, , ,000

9 Effects of exchange rate changes on aggregate demand Price Level D2 D0 D1 E1 (depreciation) E2 E0 S S (appreciation) D2 D0 D1 Real GDP 9

10 INTERNATIONAL TRADE, EXCHANGE RATES, AD Late 1990s & early 2000s U.S. trade deficit grew enormously 1995 dollar appreciation Boost U.S. imports (40% growth) Damage U.S. exports (7% growth) 1997: 105 billion real net export deficit 2002: 471 billion deficit

11 AGGREGATE SUPPLY IN AN OPEN ECONOMY Depreciation of U.S. dollar Prices of imported inputs rise U.S. aggregate supply curve Shifts inward Increase Additional inflationary effects On consumer prices Prices of domestic goods & services

12 AGGREGATE SUPPLY IN AN OPEN ECONOMY Appreciation of U.S. dollar Imported inputs cheaper U.S. aggregate supply curve Shifts outward Prices of domestic goods Decrease

13 Effects of exchange rate changes on aggregate supply Price Level D (depreciation) E1 E0 E2 S1 S0 S2 (appreciation) S1 S0 S2 D Real GDP

14 MACROECONOMIC EFFECTS OF EXCHANGE RATES Dollar depreciation Aggregate demand shift outward Aggregate supply shift inward U.S. price level increase GDP rise or fall Shifts in demand larger GDP rises Currency depreciation Inflationary Probably expansionary

15 The effects of a currency depreciation D0 D1 A S1 S0 Price Level E S1 S0 D0 D1 Real GDP

16 MACROECONOMIC EFFECTS OF EXCHANGE RATES Dollar appreciation Aggregate demand shift inward Aggregate supply shift outward U.S. price level falls GDP rise or fall Shifts in demand larger GDP falls Currency appreciation Disinflationary Probably contractionary

17 The effects of a currency appreciation D2 D0 S0 S2 Price Level E S0 S2 B D2 D0 Real GDP

18 MACROECONOMIC EFFECTS OF EXCHANGE RATES International capital flows Purchases & sales of financial assets Across national borders Rise in interest rates International capital inflows Currency appreciates Net exports decrease Contract the economy

19 MACROECONOMIC EFFECTS OF EXCHANGE RATES Drop in interest rates Expand the economy International capital outflows Currency depreciates Net exports increase

20 FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Closed economy Aggregate demand increase Closed economy Does not trade with other nations Goods Assets

21 FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Open economy Interest rates increase Exchange rate appreciate Attract foreign capital Capital account surplus increase Net exports decrease Current account deficit increase Capital account surplus + Current account deficit = 0

22 FISCAL & MONETARY POLICIES - OPEN ECONOMY Fiscal expansion - Open economy Aggregate demand outward shift Aggregate supply outward shift Aggregate demand inward shift Fiscal multiplier reduced

23 A fiscal expansion in an open economy Price Level D0 D2 D1 A B C S0 S2 S0 S2 D0 D2 D1 Real GDP

24 Percentage shares of real GDP in U.S.; 1981 & 1986 Year C I G X-IM Change 64.5% % % %

25 FISCAL & MONETARY POLICIES - OPEN ECONOMY Contractionary monetary policy Decrease aggregate demand Interest rates increase Exchange rates appreciate Aggregate supply outward shift Capital inflow Strengthen monetary policy

26 A monetary contraction in an open economy D0 Price Level D2 D1 B A S0 S2 S0 S2 C D2 D1 D0 Real GDP

27 INTERNATIONAL ASPECTS: DEFICIT REDUCTION Policy mix Fiscal contraction & Monetary expansion Reduce interest rates strongly Push down the value of the dollar Strongly stimulate our foreign trade Net effects on output and inflation Uncertain

28 INTERNATIONAL ASPECTS: DEFICIT REDUCTION Trade deficit Excess of imports over exports Trade surplus Excess of exports over imports Accounting relationship Trade deficit can arise Government budget deficit G > T Excess investment over saving I > S X IM = (S I) (G T)

29 Expected effects of policy (1) (2) (3) Variable Fiscal Contraction Monetary Expansion Combination Real interest rate Exchange rate Net exports Real GDP Inflation ??

30 SHOULD WE WORRY ABOUT THE TRADE DEFICIT? U.S. trade deficits The nation Consumes more then it produces Mirror image: required capital inflows Economic weakness Mortgage our futures To finance higher consumer spending Economic strength Foreigners eager to lend capital

31 ON CURING THE TRADE DEFICIT X-IM = (S-I) (G-T) Reduce trade deficit Decrease budget deficit G-T Tightening fiscal policy Loosening monetary policy More rapid economic growth abroad Raise domestic saving Reduce domestic investment Protectionism

32 STOP. Write down 2 things you remember.

33 LECTURE 23: THIS MODULE

34 MICROECONOMICS Individuals, Firms, The Market, Market Demand and Supply Elasticity Monopoly, Perfect Competition, Oligopoly, Monopolistic Competition Game Theory

35 MACROECONOMICS Growth and Development Aggregate Demand & Supply Fiscal Policy Monetary Policy Open Economy Considerations.

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