Price and Output and
Macroeconomic Policies in
an Open Economy
The Effectiveness of
Macroeconomic Policies in an
Open Economy
• How do different monetary policies affect
the output and price level in an open
economy in the medium and long run?
• How do adjustments in the price level,
interest rates, and the exchange rate would
lead the economy toward a long-run
equilibrium?
Aggregate Demand
• An economy’s aggregate demand represents the
relationship between the economy’s total total
demand for its output of goods and services and its
price level.
• The aggregate demand is a downward-sloping curve
representing a negative relationship between the
price level and the quantity demand of goods and
services produced in the economy.
• Although the aggregate demand looks like a market
demand it represents a quite different type of
relationship.
The Aggregate Demand Curve
i
LM’
i
M/P’ M/P
LM
i’
i’’
i
L(Q,i)
L(Q’,i)
o
M/P
IS
IS’
o
Q
P’
P’>P
P
Changes in G, T, M, e, P*, and X
will cause shifts in AD
AD
o
O’
Q
Q
The Aggregate Supply Curve
(Short-Run, Medium-Run and Long-Run)
LRAS
MRAS
P
SRAS
o
Q
The Medium-Run Aggregate
Supply Curve
• What makes the m-r aggregate supply curve
upward-sloping?
• Imperfect information
• Institutional and contractual barriers to price adjustments
• Long-run price adjustments do not take place in all sectors at
the same time
• An increase in the general price level may be construed as a
relative price change
• What causes the m-r aggregate supply curve to
shift?
Macroeconomic Policy under a Fixed
Rate Regime
• The long-run automatic adjustment mechanism
• Monetary policy is generally not effective under a fixed
exchange rate regime
• Fiscal policy could be effective in the medium run in moving
the economy toward higher output and price levels: ΔG =>
shift of AD to the right => Δi => capital inflow=> surplus=>
purchase of FX by the central bank => ΔM => further shifts of
AD. Furthermore, given e, ΔP => ΔR => changes in exports
and imports.
• Long-run price adjustments would shift the MRAS curve to
the left, if the economy moves beyond the full-employment
output, bringing the output level back to the full-employment
level while pushing the price further up.
Exchange Rate Policy under
Fixed Exchange Rates
• A devaluation would shift AD to the right:
Δe => ΔR=> ΔIM &ΔX=> surplus =>
purchase of FX by the central bank=> ΔM
=> further shit of AD to the right
• In the long-run, if the economy moves
above the L-R full employment output,
price adjustments will bring it back to the
long-run Q and higher prices.
Monetary Policy Under a
Flexible Exchange Rate Regime
• Automatic adjustments under flexible
exchange rates
• Fiscal policy not very effective under
flexible FX regime
• Monetary policy: ΔM => shift of SD to the
right: ΔQ, ΔP, Δe => ΔR (lower relative
price)
• Exchange Rate overshooting.