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Open-Economy Macroeconomics > Equilibrium
Equilibrium
• Open Economy Equilibrium
• Impacts of Policies and Events on Equilibrium
• Effect of a Government Budget Deficit on Investment and Equilibrium
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Open-Economy Macroeconomics > Equilibrium
Open Economy Equilibrium
• In the case of market equilibrium in an open economy, equilibrium occurs when a
market price is established through competition.
• The trade balance is a function of savings and investment. Since actors can save
or invest domestically or internationally relative changes can have large effects on
the trade balance and the health of the economy as a whole.
• There are three properties of equilibrium: the behavior of agents is consistent, no
agent has an incentive to change its behavior, and equilibrium is the outcome of
some dynamic process (stability).
Equilibrium
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Open-Economy Macroeconomics > Equilibrium
Impacts of Policies and Events on Equilibrium
• One type of event that can shift the equilibrium is a supply shock - an event that
suddenly changes the price of a commodity or service. It may be caused by a
sudden increase or decrease in the supply of a particular good.
• An increase in the price level can lower aggregate demand as a result of the
wealth effect, the interest rate effect, and the exchange rate effect.
• By implementing protectionism policies such as tariffs and quotas, a government
can make foreign goods relatively more expensive and domestic goods relatively
cheaper, increasing net exports and therefore aggregate demand.
• Capital flight occurs when assets or money rapidly flow out of a country. This
leads to an increase in the supply of the local currency and a drop in the
Supply Shock and Equilibrium
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exchange rate. Net exports rise as a component of aggregate demand.
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Open-Economy Macroeconomics > Equilibrium
Effect of a Government Budget Deficit on Investment and
Equilibrium
• A government's budget balance is the difference in government revenues
(primarily from taxes) and spending. If spending is greater than revenue, there is
a deficit. If revenue is greater than spending, there is a surplus.
• A government deficit can be thought of as consisting of two elements, structural
and cyclical. At the lowest point in the business cycle, there is a high level of
unemployment. This means that tax revenues are low and expenditures are high,
leading naturally to a budget deficit.
• The additional borrowing required at the low point of the cycle is the cyclical
deficit. The cyclical deficit will be entirely repaid by a cyclical surplus at the peak
of the cycle. This type of deficit serves as an automatic stabilizer.
U.S. Budget Deficits
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• The structural deficit is the deficit that remains across the business cycle because
the general level of government spending exceeds prevailing tax levels. Structural
deficits are the result of discretionary fiscal policy and can shift the aggregate
demand curve to the right.
• Crowding out is a negative consequence of budget deficits in which higher
interest rates lead to less private investment, higher exchange rates, and fewer
exports.
• Crowding out is a negative consequence of budget deficits in which higher
interest rates lead to less private investment, higher exchange rates, and fewer
exports.
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Appendix
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Open-Economy Macroeconomics
Key terms
• aggregate demand The the total demand for final goods and services in the economy at a given time and price level.
• business cycle A fluctuation in economic activity between growth and recession.
• cyclical deficit The deficit experienced at the low point of the business cycle when there are lower levels of business activity and
higher levels of unemployment.
• equilibrium The condition of a system in which competing influences are balanced, resulting in no net change.
• nominal Without adjustment to remove the effects of inflation (in contrast to real).
• output Production; quantity produced, created, or completed.
• protectionism A policy of protecting the domestic producers of a product by imposing tariffs, quotas or other barriers on imports.
• stagflation Inflation accompanied by stagnant growth, unemployment, or recession.
• structural deficit The portion of the public sector deficit which exists even when the economy is at potential; government
spending beyond government revenues at times of normal, predictable economic activity.
• trade Buying and selling of goods and services on a market.
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Open-Economy Macroeconomics
U.S. Budget Deficits
The graph shows the budget deficits and surpluses incurred by the U.S. government between 1901 and 2006. Although deficits may have an
expansionary effect, this is not the primary purpose of running a deficit.
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Wikipedia. "US annual federal deficits over receipts 1901 to 2006." Public domain
http://en.wikipedia.org/wiki/File:US_annual_federal_deficits_over_receipts_1901_to_2006.svg View on Boundless.com
Open-Economy Macroeconomics
Equilibrium
The graph shows that the point of equilibrium is where the supply and demand are equal. In an open economy, equilibrium is achieved when the amount
demanded by consumers is equal to the amount of a goods or service provided by producers.
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Wikimedia. "Simple supply and demand." CC BY-SA http://commons.wikimedia.org/wiki/File:Simple_supply_and_demand.svg View on Boundless.com
Open-Economy Macroeconomics
Supply Shock and Equilibrium
A supply shock shifts the aggregate supply curve. In this case, a negative supply shock raises prices and lowers output in equilibrium.
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Wikipedia. "Economics supply shock." GNU FDL http://en.wikipedia.org/wiki/File:Economics_supply_shock.png View on Boundless.com
Open-Economy Macroeconomics
Which of the following statements about open economy
equilibrium is NOT true?
A) For equilibrium to occur the behavior of the agents must be consistent.
B) No agent can have incentive to change its behavior.
C) Equilibrium occurs when the quantity supplied is greater than quantity
demanded after a shock.
D) Equilibrium is the result of market stability.
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Open-Economy Macroeconomics
Which of the following statements about open economy
equilibrium is NOT true?
A) For equilibrium to occur the behavior of the agents must be consistent.
B) No agent can have incentive to change its behavior.
C) Equilibrium occurs when the quantity supplied is greater than quantity
demanded after a shock.
D) Equilibrium is the result of market stability.
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Open-Economy Macroeconomics
Which of the following statements is NOT true about the effects of
protectionism?
A) There is no effect on the market for loanable funds
B) There is an increase in net exports
C) There is no change in demand for country's currency
D) There is an appreciation of the real exchange rate
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Open-Economy Macroeconomics
Which of the following statements is NOT true about the effects of
protectionism?
A) There is no effect on the market for loanable funds
B) There is an increase in net exports
C) There is no change in demand for country's currency
D) There is an appreciation of the real exchange rate
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Open-Economy Macroeconomics
Which of the following statements is true during a period of capital
flight?
A) There is an increase in supply of local currency and a decrease in the
exchange rate
B) There is a decrease in supply of foreign currency and an increase in
the exchange rate
C) There is a decrease in supply of local currency and an increase in the
exchange rate
D) There is an increase in supply of local currency, which leads to an
increase in the exchange rate
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Open-Economy Macroeconomics
Which of the following statements is true during a period of capital
flight?
A) There is an increase in supply of local currency and a decrease in the
exchange rate
B) There is a decrease in supply of foreign currency and an increase in
the exchange rate
C) There is a decrease in supply of local currency and an increase in the
exchange rate
D) There is an increase in supply of local currency, which leads to an
increase in the exchange rate
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Open-Economy Macroeconomics
According to the wealth effect, how will a drop in the price level in
the US affect demand within the country?
A) Demand will fall because people are poorer in real terms
B) Demand will rise because people hold more of their wealth in liquid
forms
C) Demand will fall because people hold more of their wealth in illiquid
forms
D) Demand will rise because people are wealthier in real terms
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Open-Economy Macroeconomics
According to the wealth effect, how will a drop in the price level in
the US affect demand within the country?
A) Demand will fall because people are poorer in real terms
B) Demand will rise because people hold more of their wealth in liquid
forms
C) Demand will fall because people hold more of their wealth in illiquid
forms
D) Demand will rise because people are wealthier in real terms
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Open-Economy Macroeconomics
Assume the Federal Reserve decided to maintain interest rates at
a constant level. What would happen to the aggregate demand?
A) It would rise sharply because the interest rate effect would be stronger
B) It would rise sharply because the wealth effect would be stronger
C) It would be stable because the wealth effect would be weak or
nonexistent
D) It would be stable because the interest rate effect would be weak or
nonexistent
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Open-Economy Macroeconomics
Assume the Federal Reserve decided to maintain interest rates at
a constant level. What would happen to the aggregate demand?
A) It would rise sharply because the interest rate effect would be stronger
B) It would rise sharply because the wealth effect would be stronger
C) It would be stable because the wealth effect would be weak or
nonexistent
D) It would be stable because the interest rate effect would be weak or
nonexistent
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Open-Economy Macroeconomics
What is a negative consequence of government investment?
A) Decreased investment in human capital
B) Lower interest rates
C) Crowding out
D) Decreasing exchange rates
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Open-Economy Macroeconomics
What is a negative consequence of government investment?
A) Decreased investment in human capital
B) Lower interest rates
C) Crowding out
D) Decreasing exchange rates
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Open-Economy Macroeconomics
What describes a cyclically balanced budget?
A) Runs a surplus in boom years and a deficit in lean years, and
balanced over the economic cycle
B) Runs a deficit in boom years and a surplus in lean years, and
balanced over the economic cycle
C) Runs a deficit in the first half of the economic cycle and a surplus in
the second half
D) Runs either a surplus or a balanced budget throughout the economic
cycle
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Open-Economy Macroeconomics
What describes a cyclically balanced budget?
A) Runs a surplus in boom years and a deficit in lean years, and
balanced over the economic cycle
B) Runs a deficit in boom years and a surplus in lean years, and
balanced over the economic cycle
C) Runs a deficit in the first half of the economic cycle and a surplus in
the second half
D) Runs either a surplus or a balanced budget throughout the economic
cycle
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Open-Economy Macroeconomics
Assuming that income tax is the only source of revenue for the
government, with a tax rate of 10%, an aggregate income of $500
billion, and government outlays of $70 billion, which of the
following is true of the government’s budget?
A) The government has a budget surplus of $430 billion.
B) The government has a budget deficit of $20 billion.
C) The government has a budget surplus of $20 billion.
D) More information is needed to calculate the budget’s surplus or deficit.
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Open-Economy Macroeconomics
Assuming that income tax is the only source of revenue for the
government, with a tax rate of 10%, an aggregate income of $500
billion, and government outlays of $70 billion, which of the
following is true of the government’s budget?
A) The government has a budget surplus of $430 billion.
B) The government has a budget deficit of $20 billion.
C) The government has a budget surplus of $20 billion.
D) More information is needed to calculate the budget’s surplus or deficit.
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Saylor OER. "Economics « Saylor.org – Free Online Courses Built by Professors." CC BY 3.0
http://www.saylor.org/majors/Economics/
Open-Economy Macroeconomics
Attribution
• Wikipedia. "Open economy." CC BY-SA 3.0
http://en.wikipedia.org/wiki/Open_economy#International_Capital_Flows_and_Trade_Balance
• Wiktionary. "output." CC BY-SA 3.0 http://en.wiktionary.org/wiki/output
• Wiktionary. "equilibrium." CC BY-SA 3.0 http://en.wiktionary.org/wiki/equilibrium
• Wikipedia. "Economic equilibrium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Economic_equilibrium
• Wiktionary. "trade." CC BY-SA 3.0 http://en.wiktionary.org/wiki/trade
• Wikipedia. "Open economy." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Open_economy
• Wikipedia. "Protectionism." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Protectionism
• Wikipedia. "Capital flight." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_flight
• Wikipedia. "Interest rate." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Interest_rate
• Wikipedia. "Wealth effect." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Wealth_effect
• Wikipedia. "1973 oil crisis." CC BY-SA 3.0 http://en.wikipedia.org/wiki/1973_oil_crisis
• Wikipedia. "Capital flight." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Capital_flight
• Wikipedia. "Supply shock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Supply_shock
• Wikipedia. "Foreign exchange market." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Foreign_exchange_market
• Wikispaces. "AS Macroeconomics - Exchange Rates." CC BY-SA http://asmacroeconomics.wikispaces.com/Exchange+Rates
• Wiktionary. "protectionism." CC BY-SA 3.0 http://en.wiktionary.org/wiki/protectionism
• Wiktionary. "nominal." CC BY-SA 3.0 http://en.wiktionary.org/wiki/nominal
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Open-Economy Macroeconomics
• Wiktionary. "stagflation." CC BY-SA 3.0 http://en.wiktionary.org/wiki/stagflation
• Wikipedia. "aggregate demand." CC BY-SA 3.0 http://en.wikipedia.org/wiki/aggregate%20demand
• Wikipedia. "Government budget balance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Government_budget_balance
• Wikipedia. "Government budget balance." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Government_budget_balance
• Wikipedia. "cyclical deficit." CC BY-SA 3.0 http://en.wikipedia.org/wiki/cyclical%20deficit
• Wiktionary. "structural deficit." CC BY-SA 3.0 http://en.wiktionary.org/wiki/structural+deficit
• Wiktionary. "business cycle." CC BY-SA 3.0 http://en.wiktionary.org/wiki/business+cycle
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