Chapter 18 & 19 Flashcards
(14 cards)
Suppose output is at its natural level, but the economy is running a large trade deficit. How can the government reduce the trade deficit while leaving output unchanged (to avoid overheating)?
A depreciation alone will reduce the trade deficit, but also increase output.
A fiscal contraction will reduce the trade deficit but also decrease output.
Gov. Should combine these.
It must achieve a depreciation sufficient to eliminate the trade deficit at the initial level of output. So the depreciation must be such as to shift the net exports relation from NX to NX’ (se handwritten notes). The problem is that this depreciation, and the associated increase in net exports, also shifts the demand curve. The new equilibrium would be A’ and the new level of output would be Y’.
To avoid the increase in output, the government must reduce government spending, so as to shift ZZ’ back to ZZ. This combination of a depreciation and fiscal contraction leads to the same level of output and an improved trade balance.
Does the eq. in goods market have to be related to trade balance?
No. The equilibrium on the goods market is not necessarily associated with an equilibrium of the trade balance. The equilibrium on the goods markets can be associated with a surplus, a deficit (see graph) or an equilibrium of the trade balance.
What happens when government spending increases?
Fiscal policy: government spending increases: Demand is higher, the demand relation shifts up. Output increases (more than the initial increase in G: multiplier effect) Increase in output leads to an increase in imports (keeping the level of exports unaffected): deterioration of the trade balance (increase in the trade deficit or decrease in the trade surplus)
Is the multiplier larger or smaller in open economy than in closed economy?
An increase in G leads to an increase in demand and then in supply. Output increases.
Therefore consumption increases too but the increase in consumption not only concerns domestic goods but also foreign goods.
The effect on the demand for domestic goods is smaller than it would be in a closed economy. The multiplier is smaller.
Graphically: the slope of the demand relation is smaller in open economy ⇒ the multiplier is smaller.
What happens when foreign demand increases?
DD represents the demand function in closed economy.
DD is not affected by a change in foreign demand.
The 45 degree line represents the supply function. It is not affected by a change in foreign demand.
ZZ represents the demand function in open economy. The ZZ line shifts up when foreign demand (and therefore exports) increases.
NX represents net exports = X − IM/ε. An increase in foreign demand increases exports and shifts the net exports curve up.
Increasing foreign demand means an increase in the demand for domestic goods, so the ZZ curve shifts upwards.
Net exports increase, the trade balance becomes more positive. (In the graph: trade balance assumed zero initially, so it turns positive.)
As domestic incomes are higher, domestic demand (for domestic and foreign goods) increases, so domestic output increases by more than the initial increase (multiplier effect)
What things are of importance of openness for fiscal policy?
The multiplier is smaller in the open economy. Fiscal policies are less effective in fuelling domestic demand.
An expansionary fiscal policy deteriorates the trade surplus. Accumulation of debt vis A ̃ vis the rest of the world
Domestic policy-makers have no control over an important determinant of output: foreign demand. A shock to demand in one country affect all other countries. Policy coordination?
What is the Marshall-Lerner condition?
A real depreciation leads to an increase in net exports. Because when domestic currency depreciates, imports goes down, but exports goes up which increases output and will strengthen the currency.
What are direct effects of a depreciation of the domestic currency?
(1) Exports increase
(2) Imports decrease
(3) The price of foreign goods relative to domestic goods, 1/ε, increases, pushing the import bill up.
Net exports increase if the positive effect of (1) and (2) is stronger than the negative effect of (3). Empirically, this is the case.
Marshall-Lerner condition: A real depreciation leads to an increase in net exports.
What are the indirect effects of a depreciation of the domestic currency?
- Direct effect: Net exports increase (Marshall-Lerner), the NX line shifts up, the ZZ line shifts up
- Domestic output goes up (with multiplier effect)
- Same graph as in the case of an increase in foreign demand
- Improvement of the trade balance even though imports increase too
- But while domestic production increases, domestic consumers are worse off relative to the case where Y* increases: they have to pay more for imported goods
What is the no-arbitrage condition?
The expected return on two identical assets has to be equal as otherwise investors would take advantage of the return difference until the difference disappears.
What are the dynamics of the exchange rate?
The nominal exchange rate depends positively on the domestic bond return i:
i ↑ → investing in the domestic economy becomes more attractive → higher demand for the domestic currency → the domestic currency appreciates, E ↑
Same reasoning goes in reverse for i*
The nominal exchange rate depends positively on the future exchange rate E ̄e:
E ̄e ↑ → investing in the domestic currency today to benefit from appreciation next period becomes attractive → demand for domestic currency rises → the nominal exchange rate appreciates
How do we interpret the downward slope of the IS curve?
An increase in the interest rate leads to a drop in investment, in demand, and in output
New channel (open economy): An increase in the interest rate leads to an appreciation of the domestic currency (because domestic bonds become more attractive), a decrease in net exports, and therefore in demand and in output
What are the effects of an expansionary fiscal policy?
An increase in G increases demand, the IS shifts to the right, leading to an increase in output (through the multiplier): A to A′
Consumption increases. Investment increases.
Because the interest rate is stable, the exchange rate is unaffected.
Because domestic income increases, imports will go up, whereas the determinants of exports are unaffected, therefore exports remain stable. As a result, the trade balance deteriorates.
What are the effects of a contractionary monetary policy?
The monetary contraction leads to an increase in the interest rate.
This increase in the interest rate leads to an appreciation (because domestic investment are more attractive than before).
The increase in the interest rate and the appreciation both lead to a fall in demand and output (through both a decrease in investment and in net exports).
The total effect on net exports is ambiguous. The appreciation tends to decrease NX, and the fall in output that is due to the decrease in NX and I tend to increase NX.
