CHAPTER 13

THE BALANCE OF PAYMENT, FOREIGN EXHANGE MARKETS, AND EXHANGE RATES

Balance of payments A summary statement of all the international transactions of the residents of a nation with the rest of
the world during a particular period of time, usually a year.

BALANCE OF PAYMENT ACCOUNTING PRINCIPLES

Credit transactions: Transactions that involve the receipt of payments from foreigners. These include the export of goods and
services, unilateral transfers from foreigners, and capital inflows.
Debit transactions Transactions that involve payments to foreigners. These include the import of goods and services,
unilateral transfers to foreigners, and capital outflows.
• Capital inflows: an increase in foreign assets in the nation, or a reduction in the nation’s assets abroad.
• Capital outflows: a reduction in foreign assets in the nation, or an increase in the nation’s assets abroad

Double-entry bookkeeping The accounting procedure whereby each (international) transaction is entered twice, once as a
credit and once as a debit of an equal amount.

Unilateral transfers Gifts or grants extended to or received from abroad.

THE INTERNATIONAL TRANSACTIONS OF THE UNITED STATES (look at table 13.1 page 436)
Statistical discrepancy The entry made in a nation’s balance of payments to make total credits equal to total debits, as
required by double-entry bookkeeping

ACCOUNTING BALANCES AND DISEQUILIBRIUM IN INTERNATIONAL TRANSACTION

Current account The account that includes all sales and purchases of currently produced goods and services, income on
foreign investments, and unilateral transfers.
• Goods
• Services
• Income: wages and interests
• Unilateral transfers

Capital account It includes debt forgiveness and goods and financial assets that migrants take with them as they leave or
enter the country.
• Official reserve assets
• Statistical discrepancy
• Autonomous transactions and accommodating transactions

Autonomous transactions: International transactions that take place for business or profit motives (except for unilateral
transfers) and independently of balance-of-payments considerations; also called above-the-line items.
Accommodating transactions Transactions in official reserve assets required to balance international transactions; also
called below-the-line items.

Official reserve account It measures the change in U.S. official reserve assets and the change in foreign official reserve assets
in the United States.
Official settlements balance The net credit or debit balance in the official reserve account.

Deficit in the balance of payments The excess of debits over credits in the current and capital accounts, or autonomous
transactions; equal to the net credit balance in the official reserve account, or accommodating transactions
Surplus in the balance of payments The excess of credits over debits in the current and capital accounts, or autonomous
transactions; equal to the net debit balance in the official reserve account, or accommodating transactions.

INTERNATIONAL INVESTMENT POSITION IN US

International investment position The total amount and the distribution of a nation’s assets abroad and foreign assets in the
nation at year-end; also called the balance of international indebtedness.
CHAPTER14
Cross-exchange rate The exchange rate between currency A and currency B, given the exchange rate of currency A and
currency B with respect to currency C.

For example, if the exchange rate (R) were 2 between the U.S. dollar and the British pound and 1.25 between the dollar and the
euro, then the exchange rate between the pound and the euro would be 1.60 (i.e., it takes €1.6 to purchase 1￡). Specifically,

Forward discount (FD): The percentage per year by which the forward rate on the foreign currency is below its spot rate.

Forward premium (FP): The percentage per year by which the forward rate on the foreign currency is above its spot rate

Covered interest arbitrage parity (CIAP): The situation where the interest differential in favor of the foreign monetary
center equals the forward discount on the foreign currency.

Covered interest arbitrage margin (CIAM): The interest differential in favor of the foreign monetary center minus the
forward discount on the foreign currency, or the interest differential in favor of the home monetary center minus the forward
premium on the foreign currency.
CHAPTER15

PURCHASING-POWER PARITY THEORY

Purchasing-power parity (PPP) theory: The theory that postulates that the change in the exchange rate between two
currencies is proportional to the change in the ratio in the two countries’ general price levels.

Absolute purchasing-power parity theory: Postulates that the equilibrium exchange rate is equal to the ratio of the price
levels in the two nations. This version of the PPP theory can be very misleading.

This version of the PPP theory can be very misleading. There are several reasons for this.
 Appears to give the exchange rate that equilibrates trade in goods and services while completely disregarding the
capital account. Thus, a nation experiencing capital outflows would have a deficit in its balance of payments, while a
nation receiving capital inflows would have a surplus if the exchange rate were the one that equilibrated international
trade in goods and services.
 Second, this version of the PPP theory will not even give the exchange rate that equilibrates trade in goods and
services because of the existence of many nontraded goods and services. International trade tends to equalize the
prices of traded goods and services among nations but not the prices of nontraded goods and services. Since the
general price level in each nation includes both traded and nontraded commodities, and prices of the latter are not
equalized by international trade, the absolute PPP theory will not lead to the exchange rate that equilibrates trade.
 Furthermore, the absolute PPP theory fails to take into account transportation costs or other obstructions to the free
flow of international trade. As a result, the absolute PPP theory cannot be taken too seriously (see Case Studies 15-1
and 15-2). Whenever the purchasing-power parity theory is used, it is usually in its relative formulation.

Relative purchasing-power parity theory Postulates that the change in the exchange rate over a period of time should be
proportional to the relative change in the price levels in the two nations. This version of the PPP theory has some value.

Difficulties remain with the relative PPP theory:

 One of these results from the fact that the ratio of the price of non-traded goods to the price of traded goods and
services is systematically higher in developed nations than in developing nations. To remain in non-traded goods and
services sectors in developed nations, however, labor must receive wages comparable to the high wages in traded-
goods sectors. This makes the price of non-traded goods and services systematically higher in developed than in
developing
 Significant structural changes also lead to problems with the relative PPP theory. For example, the PPP theory
indicated that the British pound was undervalued immediately after World War I, when it was obvious that the
opposite was the case (and the exchange rate of the pound should have been even higher). The reason was that the
United Kingdom had liquidated many of its foreign investments during the war, so that the equilibrium exchange rate
predicted by the relative PPP theory (which did not take into consideration the drop in earnings from foreign
investments) would have left a large deficit in the U.K. balance of payments after the war

MONETARY APPROACH TO THE BP AND EXCHANGE RATES

Monetary approach to the balance of payments: The approach that views the balance of payments as an essentially
monetary phenomenon with money playing the key role in the long run as both the cause and the cure of balance-of-payments
disequilibria or in determining exchange rates.

Monetary Approach under Fixed Exchange Rates

The monetary approach begins by postulating that the demand for nominal money balances is positively related to the level of
nominal national income and is stable in the long run.
Thus, the equation for the demand for money can be written as:

The symbol k is the desired ratio of nominal money balances to nominal national income; k is also equal to 1/V.
On the other hand, the nation’s supply of money is given by:

Where:
 Ms = the nation’s total money supply
 m = money multiplier
 D = domestic component of the nation’s monetary base
 F = international or foreign component of the nation’s monetary base

The domestic component of the nation’s monetary base (D) is the domestic credit created by the nation’s monetary authorities
or the domestic assets backing the nation’s money supply. The international or foreign component of the nation’s money
supply (F) refers to the international reserves of the nation, which can be increased or decreased through balance-of-
payments surpluses or deficits, respectively. D + F is called the monetary base of the nation, or high-powered money

Monetary base The domestic credit created by the nation’s monetary authorities plus the nation’s international reserves

Monetary Approach under Flexible Exchange Rates

Under a flexible exchange rate system, balance-of-payments disequilibria are immediately corrected by automatic changes in
exchange rates without any international flow of money or reserves. Thus, under a flexible exchange rate system, the nation
retains dominant control over its money supply and monetary policy. Adjustment takes place as a result of the change in
domestic prices that accompanies the change in the exchange rate

The actual exchange value of a nation’s currency in terms of the currencies of other nations is determined by the rate of
growth of the money supply and real income in the nation relative to the growth of the money supply and real income in the
other nations.

Thus, according to the monetary approach, a currency depreciation results from excessive money growth in the nation over
time, while a currency appreciation result s from inadequate money growth in the nation.
Monetary Approach to Exchange Rate Determination

k∗ and Y∗ and k and are assumed to be constant, R is constant as long as Ms and M∗s remain unchanged.

Note:
 It depends on the purchasing-power parity (PPP) theory and the law of one price.

 Second, Equation (15-7) was derived from the demand for nominal money balances in the form of Equation (15-3),
which does not include the interest rate.

 Third, the exchange rate adjusts to clear money markets in each country without any flow or change in reserves.

Thus, for a small country (one that does not affect world prices by its trading), the PPP theory determines the price level under
fixed exchange rates and the exchange rate under flexible rates.

Expectations, Interest Differentials, and Exchange Rates

Since monetarists assume that domestic and foreign bonds are perfect substitutes (so that there is no additional risk in
holding the foreign bond with respect to holding the domestic bond), the interest differential between two countries will
always equal the expected change in the exchange rate between the two currencies. That is,

(Uncovered interest parity condition)

Where i is the interest rate in the home country (say, the United States), i* is the interest rate in the foreign country (say, the
European Monetary Union), and EA is the expected percentage appreciation per year of the foreign currency (the €) with
respect to the home country’s currency (the $).

ASSET MARKET MODEL (PORTFOLIO BALANCE MODEL) AND EXCHANGE RATE

Portfolio balance approach: The theory that postulates that exchange rates are determined in the process of equilibrating or
balancing the demand and supply of financial assets in each country.

The portfolio balance approach (also called the asset market approach) differs from the monetary approach in that domestic
and foreign bonds are assumed to be imperfect substitutes, and by postulating that the exchange rate is determined in the
process of equilibrating or balancing the stock or total demand and supply of financial assets (of which money is only one) in
each country. Thus, the portfolio balance approach can be regarded as a more realistic and satisfactory version of the
monetary approach.

Extended Portfolio balance approach: The uncovered interest parity condition of Equation must, therefore, be extended to
include the risk premium (RP) that is required to compensate home-country residents for the extra risk involved in holding
the foreign bond.
Thus, the condition for uncovered interest parity becomes

Equation (15-9) postulates that the interest rate in the home country (i ) must be equal to the interest rate in the foreign
country (i∗) plus the expected appreciation of the foreign currency (EA) minus the risk premium on holding the foreign bond
(RP).
Expected change in the spot rate The change in the spot (exchange) rate that is expected to occur in the future.
Exchange rate overshooting The tendency of exchange rates to immediately depreciate or appreciate by more than required
for long-run equilibrium, and then partially reversing their movement as they move toward their long-run equilibrium levels.

• Adjustments of Financial Assets are much larger and quicker than adjustments in trade flow.
• Differences in the size and quickness of stock adjustments in financial assets as opposed to adjustments in trade flows
have very important implications for the process by which exchange rates are determined and change (dynamic) over
time.

The time path to a new equilibrium exchange rate (Rudi Dornbusch overshooting model):
How is related with Uncovered Interest Parity (UIP) and PPP theory?

Empirical Evidence:
• Not so good for most models
• PPP and hence Monetary model seems OK in the Long Run and in high inflation situation.
• Need better empirical techniques and models.
CHAPTER16
THE PRICE ADJUSTMENT MECHANISM WITH FLEXIBLE AND FIXED EXCHANGE RATES
• Depreciation implies flexible regimes.
• Devaluation implies fixed regimes.
Depreciation An increase in the domestic currency price of the foreign currency.
Devaluation A deliberate (policy) increase in the exchange rate by a nation’s monetary authorities from one fixed or pegged
level to another.

Balance-of-Payments Adjustments with Exchange Rate Changes

The process of correcting a deficit in a nation’s balance of payments by a depreciation or devaluation of its currency is shown
in this figure: (elasticity of demand and supply is the key)

Derivation of the demand and supply curves of FX

EFFECT OF EXCHANGE RATE CHANGES ON INFLATION

• Depreciation will decrease prices in foreign currency

• Depreciation will increase prices in domestic currency Adjustment mechanism
• Inflation will reduce the effect of depreciation (Table 16.1)
• Effect on terms of trade is unclear

Dutch disease The appreciation of a nation’s currency resulting from the exploitation of a domestic resource that was
previously imported, and the resulting loss of international competitiveness in the nation’s traditional sector

STABILITY OF FX MARKET

Stable foreign exchange market The condition in a foreign exchange market where a disturbance from the equilibrium
exchange rate gives rise to automatic forces that push the exchange rate back toward the equilibrium rate. depreciation may
rectify deficit.

Unstable foreign exchange market The condition in a foreign exchange market where a disturbance from equilibrium
pushes the exchange rate farther away from equilibrium. appreciation may be necessary to eliminate deficit.

Marshall–Lerner condition indicates a stable foreign exchange market if the sum of the price elasticities of the demand for
imports (DM) and the demand for exports (DX), in absolute terms, is greater than 1. If the sum of the price elasticities of DM
and DX is less than 1, the foreign exchange market is unstable, and if the sum of these two demand elasticities is equal to 1, a
change in the exchange rate will leave the balance of payments unchanged.

ELASTICITIES IN THE REAL WORLD

Elasticity pessimism The belief, arising from the empirical studies of the 1940s, that foreign exchange markets were either
unstable or barely stable.

Identification problem The inability of the regression technique to identify shifts in demand curves from shifts in supply
curves, leading to the underestimation of price elasticities in empirical studies of international trade.
J-curve effect The deterioration before a net improvement in a country’s trade balance resulting from a depreciation or
devaluation.

Pass-through effect The proportion of an exchange rate change that is reflected in export and import price changes.

• The pass-through from depreciation to domestic prices may be less than complete.
• For example, 10% depreciation in the nation’s currency may result in a less-than-10 percent increase in the domestic-
currency price of the imported commodities in the nation.

Gold standard The international monetary system operating from about 1880 to 1914 under which gold was the only
international reserve, exchange rates fluctuated only within the gold points, and balance-of-payments adjustment was
described by the price-specie-flow mechanism.
Under the gold standard, each nation defines the gold content of its currency and passively stands ready to buy or sell any
amount of gold at that price. Since the gold content in one unit of each currency is fixed, exchange rates are also fixed.

Mint parity The fixed exchange rates resulting under the gold standard from each nation defining the gold content of its
currency and passively standing ready to buy or sell any amount of gold at that price.
Gold export point The mint parity plus the cost of shipping an amount of gold equal to one unit of the foreign currency
between the two nations.
Gold import point The mint parity minus the cost of shipping an amount of gold equal to one unit of the foreign currency
between the two nations.

The automatic adjustment mechanism under the gold standard is the Price-specie-flow mechanism
It is The automatic adjustment mechanism under the gold standard. It operates by the deficit nation losing gold and
experiencing a reduction in its money supply. This in turn reduces domestic prices, which stimulates the nation’s exports and
discourages its imports until the deficit is eliminated. A surplus is corrected by the opposite process.

Quantity theory of money Postulates that the nation’s money supply times the velocity of circulation of money is equal to the
nation’s general price index times physical output at full employment. With V and Q assumed constant, the change in P is
directly proportional to the change in M.
The reduction of internal prices in the deficit nation as a result of the gold loss and reduction of its money supply was based on
the quantity theory of money. This can be explained by using Equation (16-1)

Rules of the game of the gold standard The requirement under the gold standard that monetary authorities restrict credit in
the deficit nation and expand credit in the surplus nation (thus reinforcing the effect of changes in international gold flows on
the nation’s money supply).
CHAPTER 17
THE INCOME ADJUSTMENT MECHANISM AND SYNTHESIS OF AUTOMATI ADJUSTMENT
1. Income determination in a closed economy (No trade)
2. Small open economy case (No repercussion)
3. Large open economy case (repercussion)
4. Price and income adjustments
5. Monetary and a synthesis

INCOME DETERMINATION IN A CLOSED ECONOMY

Closed economy An economy in autarky or not engaging in international transactions.

Equilibrium level of national income (YE ) The level of income at which desired or planned expenditures equal the value of
output, and desired saving equals desired investment.

Desired or planned investment The level of investment expenditures that business would like to undertake.

Marginal propensity to consume (MPC) The ratio of the change in consumption expenditures to the change in income, or
_C/_Y .

Consumption function C(Y) The relationship between consumption expenditures and income. In general, consumption is
positive when income is zero (i.e., the nation dissaves) and rises as income rises, but by less than the rise in income.
Saving function The relationship between saving and income.
In general, saving is negative when income is zero and rises as income rises, in such a way that the increase in consumption
plus the increase in saving equals the increase in income.

Marginal propensity to save (MPS) The ratio of the change in saving to the change in income, or _S /_Y .

Investment function (exogenous, indipendant) The relationship between investment expenditures and income. With
investment exogenous, the investment function is horizontal when plotted against income.
That is, investment expenditures are independent of (or do not change with) the level of national income.

Multiplier (k) The ratio of the change in income to the change in investment; in a closed economy without government, k
=1/MPS.

INCOME DETERMINATION IN A SMALL OPEN ECONOMY

Import function M(Y) The positive relationship between the nation’s imports and national income.

Marginal propensity to import (MPM) The ratio of the change in imports to the change in national income, or ∆M/∆Y .

Average propensity to import (APM) The ratio of imports to national income, or M/Y .

Income elasticity of demand for imports (nY) The ratio of the percentage change in imports to the percentage change in
national income; it is equal to MPM/APM

Export function The relationship between exports and income.

With exports exogenous (horizontal), the export function is horizontal. That is, exports are independent of (or do not change
with) the level of national income.
Equilibrium condition:

Y=C+I+X-M
Y=C+S

Foreign trade multiplier (k’) The ratio of the change in income to the change in exports and/or investment. It equals k’=
1/(MPS + MPM).
INCOME DETERMINATION IN A LARGE OPEN ECONOMY
• For two countries, increase in the exports in Nation 1 will induce to increase in the imports
in Nation 2, which will decrease the national income in Nation 2.

FOREIGN REPERCUSSIONS
Foreign repercussions The effect that a change in a large nation’s income and trade has on the rest of the world and which
the rest of the world in turn has on the nation under consideration. This is how business cycles are transmitted internationally.

ABSORPTION APPROACH
Absorption approach Examines and integrates the effect of induced income changes in the process of correcting a balance-of-
payments disequilibrium by a change in the exchange rate.

If there is depreciation in the deficit economy, export will increase and income will increase as well if elasticity condition is
met. But the precondition is that Y is less than the potential Y.

When Y is fixed, the only way to increase B is to decrease A.

• If there is full employment, Y cannot increase any more, the only way to increase balance of payment is to decrease
absorption (expenditure).
MONETARY ADJUSTMENTS AND SYNTHESIS OF THE AUTOMATIC ADJUSTMENTS
 monetary adjustments to balance-of-payments disequilibria.
 synthesis of the automatic price, income, and monetary adjustments, and examine how they work in the real world.
 disadvantages of automatic adjustment mechanisms.

MONETARY ADJUSTMENTS

When the Exchange Rate is Not Free Flexible

• A region with deficit in BOP
 Reducing the domestic money supply
 Rising interest rate
 Less investment, low income
 Less import -reducing deficit
Meanwhile,
 High interest rate will draw more capital
inflow
 Finance the deficit--reducing deficit
Moreover,
 Less money supply tends to reduce price. The commodities in deficit regions get more
competiveness

• This automatic monetary-price adjustment mechanism could by itself eliminate the nation’s deficit and
unemployment, but only in the long run.

SYNTHESIS OF AUTOMATIC ADJUSTMENTS

Synthesis of automatic adjustments The attempt to integrate the automatic price, income, and monetary adjustments to
correct balance-of-payments disequilibria.

• Price adjustment: deficit induces to depreciation under the flexible exchange rate regime.
• Income adjustment: depreciation will improve income, which will decrease surplus or increase deficit.
• Monetary adjustment: deficit will decrease money supply, which will increase interest rate and decrease price level
and help to rectify the deficit.

Flexible Exchange rate (deficit region)

• Depreciation-enhance export and reduce import- stimulate production and income
• -More import
The depreciation required to eliminate a balance-of-payment deficit is larger than if these automatic income changes were
not present.

Not Flexible Exchange rate (deficit region)

• Deficit-Reducing money supply- Rising interest rate low investment and income-reduce deficit.
• Meanwhile, rising interest rate attract foreign capital.
• Moreover, less money supply lower price rising competiveness-improving BOP
CHAPTER 18

OPEN-ECONOMY MACROECONOMICS: ADJUSTMENT POLICIES

The most important economic goals or objectives of nations are (1) internal balance, (2) external balance, (3) a reasonable rate
of growth, (4) an equitable distribution of income, and (5) adequate protection of the environment

Internal balance The objective of full employment with price stability; usually a nation’s most important economic objective.
(rate of unemployment 4-5)
External balance The objective of equilibrium in a nation’s balance of payments.

Expenditure-changing policies Fiscal and monetary policies directed at changing the level of aggregate demand of the nation.

which postulates that a government budget deficit (G > T) must be financed by an excess of S over I and/or an excess of M over
X (see Case Study 18-1). Expansionary fiscal policy refers to an increase in (G −T), and this can be accomplished with an
increase in G, a reduction in T, or both. Contractionary fiscal policy refers to the opposite.

Expenditure-switching policies Devaluation or revaluation of a nation’s currency directed at switching the nation’s
expenditures from foreign to domestic or from domestic to foreign goods.
Direct controls: Tariffs, quotas, and other restrictions on the flow of international trade and capital.

Principle of effective market classification (by Mundell) Maintains that policy instruments should be paired or used for the
objective toward which they are most effective.
INTERNAL AND EXTERNAL BALANCE WITH EXPENDITURE-CHANGING AND EXPENDITURE- SWITCHING
POLICIES

Assumptions:
 zero international capital flow (so that the balance of payments is equal to the nation’s trade balance).
 We also assume that prices remain constant until aggregate demand begins to exceed the full-employment level of
output Prices unchanged when Y is lower than full employment level

Both expenditure-changing and expenditure-switching policies need to be used

EQUILIBRIUM IN THE GOODS MARKET, IN THE MONEY MARKET, AND IN THE BALANCE OF PAYMENTS
How a nation can use fiscal policy and monetary policy to achieve both Internal and external balance
without any change in exchange rate

Mundell–Fleming model The model that shows how a nation can use fiscal and monetary policies to achieve both internal
and external balance without any change in the exchange rate

Transaction demand for money The demand for active money balances to carry on business transactions; it varies directly
with the level of national income and the volume of business transactions.
Speculative demand for money The demand for inactive money balances in preference to interest-bearing securities (which
can fall in price) so that one may take advantage of future investment opportunities. The speculative, or liquidity, demand for
money varies inversely with the rate of interest.

IS curve The negatively inclined curve showing the various combinations of interest rates and national income levels at which
the goods market is in equilibrium.
LM curve The usually positively inclined curve showing the various combinations of interest rates and national income levels
at which the money market is in equilibrium.
BP curve The usually positively inclined curve showing the various combinations of interest rates and national income levels
at which the nation’s balance of payments is in equilibrium at a given exchange rate
FISCAL AND MONETARY POLICIES FOR INTERNAL AND EXTERNAL BALANCE WITH FIXED EXCHANGE RATES

fiscal policy very effective but

monetary policy does not work
THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES

THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES AND IMPERFECT CAPITAL MOBILITY

THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES AND PERFECT CAPITAL MOBILITY
MUNDELL POLICY MIX AND PRICE CHANGES

• The case when Exchange rate cannot be adjusted.

• Mundell policy mix graph: why IB and EB curves are positive and IB is steeper?

Note that the EB line is flatter than the IB line. This is always the case whenever short-term international capital flows are
responsive to international interest differentials. This can be explained as follows. Expansionary fiscal policy raises national
income and increases the transaction demand for money in the nation. If monetary authorities increase the money supply
sufficiently to satisfy this increased demand, the interest rate will remain unchanged. Under these circumstances, fiscal policy
affects the level of national income but not the nation’s interest rate. On the other hand, monetary policy operates by changing
the money supply and the nation’s interest rate. The change in the nation’s interest rate affects not only the level of investment
and national income (through the multiplier process) but also international capital flows. As a result, monetary policy is more
effective than fiscal policy in achieving external balance, and so the EB line is flatter than the IB line.

• Principle of effective classification:

– Monetary policy for external balance

– Fiscal policy for internal balance

The more responsive international short-term capital flows are to interest rate differentials across nations, the flatter is the EB
line in relation to the IB line. On the other hand, if short-term capital flows did not respond at all to interest differentials, the
EB line would have the same slope as (and coincide with) the IB line so that no useful purpose could be served by separating
fiscal and monetary policies as was done above. In that case, the nation could not achieve internal and external balance at the
same time without also changing its exchange rate
DIRECT CONTROLS
Direct controls Tariffs, quotas, and other restrictions on the flow of international trade and capital.

Trade controls Tariffs, quotas, advance deposits on imports, and other restrictions imposed by a nation on international trade.

Exchange controls Restrictions on international capital flows, official intervention in forward markets, multiple exchange
rates, and other financial and monetary restrictions imposed by a nation.

Multiple exchange rates The different exchange rates often enforced by developing nations for each class of imports
depending on the usefulness of the various imports as determined by the government.

CHAPTER 19
PRICES AND OUTPUT IN AN OPEN ECONOMY: AGGREGATE DEMAND AND AGGREGATE SUPPLY

AGGREGATE DEMAND, AGGREGATE SUPPLY, AND EQUILIBRIUM IN A CLOSED ECONOMY

• The derivation of AD curve: increase in P reduces real money stock: LM curve shifts to the left and vice-
versa
• AS in the long run: classical case
• AS in the short run: Keynesian case.
• Determination of equilibrium.

Aggregate demand (AD) curve The graphical relationship between the total quantity demanded of goods and services at
various prices.
Aggregate supply (AS) curve The graphical relationship between the nation’s output and the price level over a given time
period.
AGGREGATE SUPPLY IN THE LONG RUN AND IN THE SHORT RUN

Long-run aggregate supply (LRAS) curve The fixed relationship between the nation’s price level and its natural level of
output, which depends on the availability of labor, capital, natural resources, and technology in the nation.

Natural level of output (YN ) The fixed level of output that a nation can produce in the long run with its given quantity of
labor, capital, natural resources, and technology.

Short-run aggregate supply (SRAS) curve The temporary positive relationship between the nation’s output and the price
level resulting from imperfect information or market imperfections.

SHORT-RUN AND LONG-RUN EQUILIBRIUM IN A CLOSED ECONOMY

Expected prices The prices that are believed will prevail.

AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FIXED AND FLEXIBLE EXCHANGE RATES
Open economy which means that when the price rising, it will induce trade effect and then affect the short-
run equilibrium. The key is to understand the influence of P on IS, LM and BP
• Fixed rate case.
• Flexible rate case.

AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FIXED EXCHANGE RATES

AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FLEXIBLE EXCHANGE RATES

EFFECT OF ECONOMIC SHOCKS AND MACROECONOMIC POLICIES ON AGGREGATE DEMAND IN OPEN
ECONOMIES WITH FLEXIBLE PRICES

• Real shocks: assuming an increase in export. Have effects under fixed rate but ineffective under
flexible rate.
• Monetary shocks: assuming an inflow of money. Have different effects under fixed rate and flexible
rate.
• Demand policies: fiscal policy effective under fixed rate and monetary policy effective under
flexible rate. (assuming elastic capital flow)

REAL-SECTOR SHOCKS AND AGGREGATE DEMAND

MONETARY SHOCKS AND AGGREGATE DEMAND

FISCAL AND MONETARY POLICIES AND AD IN OPEN ECONOMY

Fixed EX Flexible EX

Any shock affect real sector Effective No

Any monetary shock affects AD (e.g., Capital Effective Effective

inflow) (AD move right) (AD move left)

Fiscal policy Effective No

Monetary policy No Effective

EFFECT OF FISCAL AND MONETARY POLICIES IN OPEN ECONOMIES WITH FLEXIBLE PRICES
• Expansionary policy when Y is at full employment level.
• Expansionary policy when Y is under full employment level.
• Problem of letting the recession to clear the market.
• Independence of central banks.
MACROECONOMIC POLICIES TO STIMULATE GROWTH AND ADJUST TO SUPPLY SHOCKS
Fiscal and monetary policy could also be used to stimulate the long-run growth by increasing the
expenditure on education, infrastructures, basic research and to improve the functions of markets.
 If LR growth, P can be lower and Y will be high

MACROECONOMIC POLICIES FOR GROWTH

MACROECONOMIC POLICIES TO ADJUST TO SUPPLY SHOCKS