Saudi Vision 2030 economic objectives

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INTERNATIONAL ECONOMICS SEVENTEENTH EDITION

ROBERT J. CARBAUGH

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Chapter 15: Macroeconomic Policy in an Open Economy

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Chapter Outline

Economic Objectives of Nations

Policy Instruments

Aggregate Demand and Aggregate Supply: A Brief Review

Monetary and Fiscal Policy in a Closed Economy

Monetary and Fiscal Policy in an Open Economy

Macroeconomic Stability and the Current Account: Policy Agreement vs Policy Conflict

Inflation with Unemployment

International Economic Policy Coordination

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Economic Objectives of Nations (1 of 2)

Economic objectives of nations

Internal balance

External balance

Overall balance

Long-term economic growth

Reasonably equitable distribution of national income

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Economic Objectives of Nations (2 of 2)

Economic objectives of nations (cont’d)

Internal balance

Economic stability at full employment

A fully employed economy

No inflation

External balance

Neither deficits nor surpluses in current account

Overall balance

Combination of internal balance and external balance

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Policy Instruments (1 of 3)

Expenditure-changing policies

Alter level of total spending (aggregate demand) on goods and services either produced domestically or imported

Fiscal policy

Changes in government spending and taxes

Responsibility of president & Congress

Monetary policy

Changes in money supply and interest rates

Responsibility of central bank (Federal Reserve)

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Policy Instruments (2 of 3)

Expenditure-switching policies

Modify direction of demand

Use policies that shift demand between domestic output and imports

Under fixed exchange rate, nation with trade deficit could devalue currency to increase export competitiveness

Under managed floating exchange rate, nation with trade deficit could depreciate currency by using it to purchase other currencies

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Policy Instruments (3 of 3)

Direct controls (e.g., tariffs)

Government restrictions in a market economy

Control particular items in the current account

Restrain capital outflows

Stimulate capital inflows

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Aggregate Demand & Aggregate Supply: A Brief Review (1 of 4)

Aggregate demand curve (AD)

Level of real output (real GDP) purchased at various price levels during year

Spending by domestic consumers, businesses, government, and foreign buyers (net exports)

On aggregate demand curve, as price level falls, quantity of real output demanded increases

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Aggregate Demand & Aggregate Supply: A Brief Review (2 of 4)

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Aggregate Demand & Aggregate Supply: A Brief Review (3 of 4)

Aggregate demand–aggregate supply model

Aggregate supply curve (AS)

Relationship between price level and quantity of real output produced by economy during a given year

Upward sloping

Per-unit production costs and prices increase as real output increases

Macroeconomic Equilibrium: AD = AS

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Aggregate Demand & Aggregate Supply: A Brief Review (4 of 4)

Shifts of aggregate demand curve

Changes in determinants of AD

Consumption, investment, government purchases, or net exports

Shifts of aggregate supply curve

Changes in prices of resources, technology, business expectations

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Monetary and Fiscal Policy in a Closed Economy (1 of 3)

Monetary and fiscal policy are main tools by which government can influence economic performance

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Monetary and Fiscal Policy in a Closed Economy (2 of 3)

If aggregate output is low and unemployment high, government may increase aggregate demand through expansionary monetary and/or fiscal policies

Lead to increase in domestic consumption, investment, or government spending, resulting in increase in country’s real GDP

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Monetary and Fiscal Policy in a Closed Economy (3 of 3)

To control inflation, government will:

Reduce level of aggregate demand for real output by engaging through contractionary monetary or fiscal policies

Upward pressure on prices is softened and inflation moderates

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Monetary and Fiscal Policies in an Open Economy (1 of 13)

Expansionary monetary or fiscal policy

In closed economy, initial effect is increase in aggregate demand (domestic consumption, investment, or government spending)

In open economies, has secondary effects

May increase or decrease in aggregate demand by changing net exports and other determinants of aggregate demand

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Monetary and Fiscal Policy in an Open Economy (2 of 13)

If initial and secondary effects both result in increase in aggregate demand

Strengthens effect of expansionary policy

If initial and secondary effects have conflicting impacts

Expansionary effects are weakened

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Monetary and Fiscal Policy in an Open Economy (3 of 13)

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Monetary and Fiscal Policy in an Open Economy (4 of 13)

Effect of fiscal and monetary policy under fixed exchange rates

Expansionary fiscal policy more successful and expansionary monetary policy less successful in stimulating economy in open economy than in closed economy

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Monetary and Fiscal Policy in an Open Economy (5 of 13)

TABLE 15.1 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

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Monetary and Fiscal Policy in an Open Economy (6 of 13)

Fiscal policy is strengthened under fixed exchange rates

Initial effect: increase in aggregate demand

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Monetary and Fiscal Policy in an Open Economy (7 of 13)

Fiscal policy is strengthened under fixed exchange rates (cont’d)

Secondary effect: increase in aggregate demand

Budget deficit raises interest rate, leading to increased demand for domestic currency in foreign-currency market

To maintain fixed exchange rate, central bank buys foreign currency with domestic currency, increasing domestic money supply and supply of loanable funds, causing AD to rise further

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Monetary and Fiscal Policy in an Open Economy (8 of 13)

Monetary policy is weakened under fixed exchange rates

Initial effect: higher aggregate demand

Money supply increases, domestic interest rate falls, leading to increased consumption and investment

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Monetary and Fiscal Policy in an Open Economy (9 of 13)

Monetary policy is weakened under fixed exchange rates (cont’d)

Secondary effects: lower aggregate demand

Decreasing demand for domestic currency due to low interest rates

To maintain fixed exchange rate, authorities purchase domestic currency with foreign currency, causing decrease in money supply

Supply of loanable funds, causing AD to contract

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Monetary and Fiscal Policy in an Open Economy (10 of 13)

Effect of fiscal and monetary policy under floating exchange rates

Monetary policy is strengthened under floating exchange rates

Initial effect: increase in aggregate demand

Reduction in domestic interest rate

Increased consumption and investment

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Monetary and Fiscal Policy in an Open Economy (11 of 13)

Effect of fiscal and monetary policy under floating exchange rates

Monetary policy is strengthened under floating exchange rates (cont’d)

Secondary effects: increase in aggregate demand

Domestic currency depreciates; leads to increase in exports, decrease in imports, improvement in current account

Monetary policy – strengthened under floating exchange rates

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Monetary and Fiscal Policy in an Open Economy (12 of 13)

Effect of fiscal and monetary policy under floating exchange rates (cont.)

Fiscal policy is weakened under floating exchange rates

Initial effect: increase in aggregate demand

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Monetary and Fiscal Policy in an Open Economy (13 of 13)

Effect of fiscal and monetary policy under floating exchange rates (cont.)

Fiscal policy is weakened under floating exchange rates (cont’d)

Secondary effects: Decrease in aggregate demand

Budget deficit; higher interest rate and increased demand for domestic currency in foreign-exchange market

Domestic currency appreciates, leading to worsening of current account, causing AD to fall

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Macroeconomic Stability & Current Account: Policy Agreement vs Policy Conflict (1 of 2)

Can single policy restore overall balance?

Assume recession + current account deficit and floating exchange rate

Expansionary monetary policy to combat recession leads to currency depreciation

Rise in exports and fall in imports reduces current account deficit

Thus, single economic policy promotes overall balance

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Macroeconomic Stability & Current Account: Policy Agreement vs Policy Conflict (2 of 2)

Inflation + current account deficit

Contractionary monetary policy to combat inflation increases domestic interest rate and thus currency appreciation

Fall in exports and rise in imports increases current account deficit

Thus, there is policy conflict: monetary policy (or fiscal policy) alone will not restore both internal and external balance

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Inflation with Unemployment (1 of 3)

Assume that as economy advances to full employment, domestic prices unchanged until full employment reached

Demand-pull inflation – once nation’s production capacity achieved, further increases in aggregate demand pull prices upward

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Inflation with Unemployment (2 of 3)

When nation suffers both inflation and unemployment, internal balance cannot be achieved by manipulating aggregate demand

To decrease inflation, AD must be reduced

To decrease unemployment, AD must be increased

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Inflation with Unemployment (3 of 3)

Overall balance – three separate targets

Current-account equilibrium

Full employment

Price stability

Wage and price controls may be necessary to achieve all three

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International Economic Policy Coordination (1 of 9)

Economic relations among nations

Conflict — Independence — Integration

Policy cooperation

Officials from different nations meet to evaluate world economic conditions

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International Economic Policy Coordination (2 of 9)

International economic policy coordination

Attempt to significantly modify national policies—monetary policy, fiscal policy, and exchange-rate policy—in recognition of international economic interdependence

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International Economic Policy Coordination (3 of 9)

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International Economic Policy Coordination (4 of 9)

Policy coordination in theory

Some nations give higher priority to price stability, or to full employment, than others

Some nations have stronger legislatures or weaker trade unions than others

Party pendulums in different nations shift with elections occurring in different years

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International Economic Policy Coordination (5 of 9)

Policy coordination in theory (cont’d)

One nation may experience economic recession, while another may experience rapid inflation

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International Economic Policy Coordination (6 of 9)

Does policy coordination work?

Plaza Agreement of 1985, Group of Five (G-5) nations – United States, Japan, Germany, Great Britain, and France

Overvalued U.S. dollar

Twin U.S. deficits (trade & federal budget) were too large

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International Economic Policy Coordination (7 of 9)

Does policy coordination work? (cont’d)

Each country

Made specific pledges on macroeconomic policy

Agreed to initiate coordinated sales of dollars

By 1986, dollar had dramatically depreciated

But new concern: uncontrolled dollar plunge

Louvre Accord of 1987, Group of Five (G-5)

Intervention policies intended to curb pace of dollar’s depreciation

Other macroeconomic adjustments

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International Economic Policy Coordination (8 of 9)

Does policy coordination work? (cont’d)

By 2000s, more difficult to coordinate

Rise of independent central banks makes coordination more difficult

Additionally, huge growth of global financial markets has made currency intervention less effective

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International Economic Policy Coordination (9 of 9)

Does policy coordination work? (cont’d)

2000, Group of Seven (G-7) – U.S., Canada, Japan, U.K., Germany, France, and Italy

Coordinated purchases of euro to boost value; rose from $0.84 per euro to more than $0.88 per euro

Within 2 weeks of intervention, euro’s value at all-time low

Intervention is a failure

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