CHAPTER 28
PRICES AND OUTPUT IN THE OPEN ECONOMY:
Aggregate Supply and Demand
I.
Outline
Introduction
Aggregate Demand and Supply in the Closed Economy
- Aggregate Demand in the Closed Economy
- Aggregate Supply in the Closed Economy
- Equilibrium in the Closed Economy
Aggregate Demand and Supply in the Open Economy
- Aggregate Demand in the Open Economy under Fixed Rates
- Aggregate Demand in the Open Economy under Flexible Rates
The Nature of Economic Adjustment and Macroeconomic Policy in the Open-Economy
Aggregate Supply and Demand Framework
- The Effect of Exogenous Shocks on the Aggregate Demand Curve under Fixed
and Flexible Rates
- The Effect of Monetary and Fiscal Policy on the Aggregate Demand Curve
under Fixed and Flexible Rates
- Summary
Monetary and Fiscal Policy in the Open Economy with Flexible Prices
- Monetary Policy
- Currency Adjustments under Fixed Rates
- Fiscal Policy
- Economic Policy and Supply Considerations
External Shocks and the Open Economy
Summary
II
Special Chapter Features
Case Study 1: U.S. Actual and Natural Income, Employment, and Unemployment
Case Study 2: Inflation and Unemployment in the United States, 1970-1996
V.
Answers to End-of-Chapter Questions and Problems
1.
The natural level of employment is the level of employment at which the demand for labor
equals the supply of labor and actual prices and real wages equal expected prices and real wages.
This need not, of course, correspond to some society-defined level of full employment. The longrun supply curve is vertical at this point since by definition, the long-run period is sufficiently long
for labor to adjust its wage demands to price changes such that the same amount of labor, and
hence output, is supplied at the constant equilibrium real wage.
2.
The short-run aggregate supply curve indicates the change in output produced because of
a change in the price level, but with no change in the expected real wage. As indicated in
Question #1 above, the long run is a period that is sufficiently long to allow workers to adjust
their nominal wage demands in response to changes in prices so as to maintain a constant real
wage. The long-run and the short-run supply curves are both vertical in the case where rational
expectations holds and are in fact the same curve. In this case, workers make full use of all
information available, anticipate the price changes resulting from policy actions, and raise their
wages at the same time as prices rise.
3.
The aggregate supply curves are shifted by underlying factors such as changes in
technology, scale economies, changes in the level of capital stock, improved management
techniques, and improved marketing arrangements. An increase in international transactions and
increased contact with other countries could certainly lead to shifts in the supply curves due to
technology transfers, adoption of foreign management approaches, more efficient use of resources
due to scale effects associated with larger world markets, increases in capital stock associated
with foreign real investment, etc. If increased international transactions also mean greater
vulnerability to exchange rate changes, these changes would affect aggregate supply curves
through their impacts on imported inputs.
4.
Other things equal, the restrictive monetary policy in Germany would push German
interest rates higher and stimulate an inflow into Germany of foreign short-term capital. In terms
of the IS/LM/BP apparatus, such a policy would shift the U.S. BP curve upward (to the left).
Without a monetary policy response on the part of the Federal Reserve leading to an offsetting
change in domestic interest rates and income in the United States, Germany’s restrictive monetary
policy would result in an incipient U.S. balance-of-payments deficit (under flexible exchange
rates) and a depreciation of the U.S. dollar. With currency depreciation, U.S. exports to Germany
increase and U.S. imports from Germany decrease. These foreign sector effects stimulate U.S.
aggregate demand (shift the AD curve to the right) and put upward pressure on U.S. prices and
income. However, given enough time for wages to adjust, the short-run supply curve will shift up
(to the left) and will return the U.S. economy to the “natural” level of income and employment,
but now at a higher price level.
5.
If imported inputs are important, the appreciation of the currency would have the effect of
reducing the price of those imported inputs and hence reducing costs of production. This could
lead to a rightward shift of both the long-run and the short-run aggregate supply curves, just as a
sudden increase in the price of an important imported input led to a leftward shift in the aggregate
supply curves in Figure 13 of the chapter.
6.
If discretionary policy is to have more than a short-run impact on income and employment,
it must result in changes in one or more of the structural factors that underlie the long-run
aggregate supply curve. It must lead to changes in factors such as the capital stock,
entrepreneurship, management techniques, scale effects, changes in technology, quality of the
labor force, etc.
7.
Expansionary monetary policy will increase aggregate demand, giving an even greater
boost to prices. The stagflation has resulted from a leftward shift in the aggregate supply curves,
and increasing demand alone will not solve the problem. Policies must be pursued to improve the
supply situation through better technology, increased capital stock, improved education, etc.
Income and employment will only increase in any permanent sense if there is an improvement in
aggregate supply conditions.
8.
If the home country’s currency is expected to depreciate, other things equal, it would lead
to an increased demand for foreign currency. Under a flexible-rate system, this causes a
depreciation of the home currency. As the currency depreciates, exports will increase and imports
will decrease, leading to an increase in aggregate demand. If the country uses imported inputs,
costs of production will also rise and both the short-run and long-run aggregate supply curves will
shift to the left. The end result is an increase in the domestic price level and a reduction in the
equilibrium level of income (output) in both the short run and long run. In addition, the natural
level of employment falls.
9.
Under the flexible exchange rate scenario of Figure 10, expansionary monetary policy
would have the impact of shifting the aggregate demand curve to the right, leading to an
expansion of income and accompanying increases in prices. With the appropriate level of money
expansion, the economy could return to the natural level of income and employment. While this is
desirable from the standpoint of employment, inflation would also occur. Were the government
to do nothing and wages were flexible in a downward direction, with sufficient time, wages
should fall and the short run aggregate supply curve would shift to the right until the natural level
of income is attained at a lower price level. Which strategy is preferable depends on the country’s
preferences with regard to reduced unemployment/inflation versus a longer period of
unemployment with eventual lower price levels. If there are longer-run supply effects on the level
of capital stock because of the continually-low interest rate, then the price level would have
downward pressure put upon it.