Open economy macroeconomics
In some cases, by not putting policy issues in an international perspective, we provide students with the “wrong” answers.
Joseph E. Stiglitz
In the previous chapter, we described the long-run relationship between the price level or rate of inflation and the exchange rate. As we have shown, many of the nominal fluctuations in the exchange rate are related to differences in national rates of inflation. When this is the case, changes in nominal exchange rates do not have a very important impact on an open economy in the short run. However, when a country’s real exchange rate changes, this change has a noticeable impact on imports and exports. As we will see, when the currency depreciates in real terms, the current account balance tends to improve: exports tend to increase and imports tend to fall. If the currency appreciates in real terms, the current account balance tends to worsen. Exports tend to decline as they become more expensive to foreign consumers, and imports tend to rise as they become cheaper to domestic consumers.
In Chapter 13, you learned that imports and exports are becoming an increasingly large percentage of GDP for the U.S. As the U.S. economy becomes more open, changes in the level of imports and exports have a perceptible effect on GDP. Changes in the rate of growth of GDP in the U.S. are still most heavily influenced by changes in consumption, investment, and government spending. However, international trade has become a sufficiently large part of the U.S. economy that changes in foreign trade now have a nontrivial impact on the rate of growth of GDP. In many other countries, the effects of international trade on a country’s growth rate are even larger due to the relative size of the international sector.
This brings us back to the importance of the real exchange rate in an open economy. Under these conditions, the real exchange rate becomes important because, in addition to affecting the level of international trade, it can also affect the rate of growth of GDP in the short run. These effects are the main point of this chapter. In order to examine how changes in the real exchange rate affect GDP, we present and describe a general model of output and price determination for an open economy. Once this general model has been developed, we will be able to analyze how changes in the real exchange rate affect more important variables such as GDP. Finally, we consider the effect of real exchange rate changes on the composition of a country’s output.
AGGREGATE DEMAND AND AGGREGATE SUPPLY: A REVIEW
In your Principles of Economics course(s), you developed and used a general framework for analyzing macroeconomic activity and events. This general framework was called the aggregate demand/aggregate supply model.
Aggregate demand is the relationship between the total quantity of goods and services that all sectors of the economy demand and the price level, holding all other determinants of spending unchanged. The aggregate demand (AD) curve, shown in Figure 16.1, is a graphical representation
The aggregate demand curve
The aggregate demand curve slopes downward and to the right, Indicating that as the price level changes, real GDP changes.
of this relationship. The horizontal axis measures the total output of goods and services demanded (measured by real GDP). As one moves to the right, the value of real GDP increases, and vice versa. The vertical axis measures the price level of the economy (measured by the GDP price deflator). Notice that the AD curve slopes downward and to the right, indicating that as the price level declines, the quantity of goods and services demanded increases.
The negative slope of the aggregate demand curve suggests that it behaves in the same way as an ordinary demand curve—one describing, for example, the demand for cars. This is an easy but incorrect assumption to make concerning aggregate demand. In the case of an individual product, two effects occur as the price of that product falls. First, the consumer’s real income rises. For a normal good, the increase in real income increases the amount consumed (the income effect).1 Second, the lower price induces consumers to buy more of this product because it is now cheaper than other, similar products (the substitution effect). Neither of these effects are relevant to a change in the aggregate price level. First, if the aggregate price level falls, this means that the prices consumers pay are falling, and the prices that people receive (wages, rents, interest, and profits) are falling as well. As the entire price level falls, goods and services are cheaper, but incomes are lower as well. As a result, there is no additional demand as the price level declines. Second, the price level is a measure of prices in general, not of a particular price. As the price level falls, there is no substitution effect because prices in general are falling rather than the prices of a particular product.
This means that for the overall economy, the aggregate demand curve has a negative slope for different reasons.2 First, when the price level changes, the value of people’s real wealth changes— this is called the wealth effect. An increase in the price level reduces the value of accumulated financial assets and induces people to reduce their consumption of goods and services. As the price level changes, real wealth changes, and the aggregate quantity demanded changes. Second, as the price level rises, interest rates increase—the so-called interest rate effect.3 The higher interest rates not only curtail the business community’s investment, but also curtail certain types of consumer spending, such as spending on housing and automobiles.4 The net result is that as the price level increases, aggregate quantity demanded falls, and vice versa.
Finally, as the price level changes, it impacts a country’s total exports and imports of goods and services—this is known as the international substitution effect. As the price level increases, the price of domestically produced goods rises relative to the price of foreign produced goods. As this occurs, foreign demand for domestically produced goods and services (exports) would decline, and domestic demand for foreign produced goods and services (imports) would increase. As a result, an increase in the price level increases a country’s imports and reduces exports. Again, this means that as the price level increases, aggregate quantity demanded declines.
Putting these three effects together, as the price level increases from Po to P[ in Figure 16.1, everything else being equal, the aggregate quantity demanded (output of goods and services) declines from Yo to Yp and vice versa. This inverse relationship is shown as a movement along a given aggregate demand curve from point A to point B.