THE OPEN ECONOMY - SLIDEBLAST.COM
THE OPEN ECONOMY ‘Macroeconomics’ Carlin & Soskice (Ch 9 -11) CHAPTER 12 • Spillover of policy actions: o Positive AD spillover – ‘locomotive effect’ – of a home expansionary fiscal policy under flexible ER’s Unlike with small open economy in which Home’s output returns to initial level, ER appreciation is less in the interdependence case so Home’s output is higher • The reason Foreign’s output also rises is due to the depreciation of its ER when Home’s appreciates – boosts Foreign’s NX and output rises Home expansionary MP under fixed ER has a locomotive effect too – increases world money supply, decreases world IR so output expands in Home and Foreign o Negative spillover – ‘beggar-thy-neighbour effect’ – of a Home expansionary MP under flexible ER’s Home’s monetary expansion produces a depreciation for it and an appreciation for Foreign which depresses NX and output Also, Home fiscal expansion under fixed ER’s is contractionary for Foreign – world IR pushed up and output abroad reduced o In MR, after wages and prices in Home and Foreign have adjusted: SR MP effects disappear – both return to original output In MR, effects of a Home fiscal expansion independent of ER regime – output increases at home and decreases in foreign – so beggar thy neighbour effect of home’s fiscal expansion Thus the locomotive effect of home’s fiscal expansion under flexible ER’s is reversed in the MR • The SR locomotive effect for Foreign comes from ER depreciation but this pushes Foreign out of its ERU curve and inflation goes up once wages and prices respond. As competitiveness falls, returns to ERU at lower output than initially as world IR higher • Conversely, home economy reinforces output gain as falling inflation boosts competitiveness The beggar thy neighbour effect is reduced in the MR o Spillovers and the case for policy coordination Suppose Home and Foreign are identical economies with a floating ER and that the initial position of the ‘world’ is that each country is outside its ERU curve so inflation in both countries is rising • If each country wishes to reduce inflation but at minimum cost in terms of the associated rise in u/e – if they simultaneously do contractionary MP each will return to stable inflation equilibrium with higher u/e and an unchanged ER • But if home implements a more restrictive MP than Foreign – it will benefit from stronger disinflation since ER appreciation will reinforce the downward pressure on inflation coming from the reduction in output. o Whereas consequent depreciation of Foreign’s ER will exacerbate Foreign’s inflation o So Foreign has an incentive to implement overly restrictive MP o Not both economies can appreciate so unnecessary and costly rise in i* and reduction in world output. o Prisoners dilemma o ‘Given the difficulty in securing binding agreements between countries in the example discussed, it is interesting to interpret the creation of ER arrangements as a way of establishing a longer term form of policy coordination.’ CHAPTER 9 • Opening the goods market
o ‘holding all else constant, imports of goods depress domestic output because demand for home production goes down and conversely, exports raise domestic output as foreign orders boost demand for home production.’ o If there is a trade surplus, exports > imports with the result that the home economy is increasing its wealth and so it can buy foreign assets/increase its official forex reserves o Goods market equilibrium Domestic absorption (Abs) is defined as total spending by home agents on consumption, investment, and government purchases irrespective of the origin of the goods or services: • [domestic absorption] • • • Assume that: o o where is the marginal propensity to import o o Level of income at which trade is balanced: 4 different ways of expressing goods market equilibrium: • If we assume o First form: Y = Abs + BT • Second form – output is equal to the multiplier times the exogenous components of demand: o o Where is the marginal propensity to save o As compared with the closed economy, the multiplier is lower because of the marginal propensity to import • Third form: planned leakages = planned injections o o FIGURE 9.1
At A, where planned leakages = planned injections, it is clear from the level of output that there is a trade deficit Trade balance would require yBT which could be achieved either through a reduction in the size of the multiplier (through a tax increase or a drop in MPC), which steepens the planned leakages line, or by a fall in one of the exogenous components of domestic demand (a downward shift in the planned injections line) o FIGURE 9.2
o ‘holding all else constant, imports of goods depress domestic output because demand for home production goes down and conversely, exports raise domestic output as foreign orders boost demand for home production.’ o If there is a trade surplus, exports > imports with the result that the home economy is increasing its wealth and so it can buy foreign assets/increase its official forex reserves o Goods market equilibrium Domestic absorption (Abs) is defined as total spending by home agents on consumption, investment, and government purchases irrespective of the origin of the goods or services: • [domestic absorption] • • • Assume that: o o where is the marginal propensity to import o o Level of income at which trade is balanced: 4 different ways of expressing goods market equilibrium: • If we assume o First form: Y = Abs + BT • Second form – output is equal to the multiplier times the exogenous components of demand: o o Where is the marginal propensity to save o As compared with the closed economy, the multiplier is lower because of the marginal propensity to import • Third form: planned leakages = planned injections o o FIGURE 9.1
At A, where planned leakages = planned injections, it is clear from the level of output that there is a trade deficit Trade balance would require yBT which could be achieved either through a reduction in the size of the multiplier (through a tax increase or a drop in MPC), which steepens the planned leakages line, or by a fall in one of the exogenous components of domestic demand (a downward shift in the planned injections line) o FIGURE 9.2
