chap018 4 (2010)

Global MacroPay Attention – Not in book

International Trade

• The flow of goods, labor, and money across national borders makes countries economically interdependent.

• International trade also affects a nation’s macro outcomes.

LO1

Imports as Leakage

• Imports are a source of leakage in the circular flow.– Imports – Goods and services purchased

from foreign sources.– Leakage – Income not spent directly on

domestic output, but instead diverted from the circular flow, such as saving, imports, taxes.

LO1

Imports as Leakage

• Income lost to imports limits domestic spending and the related multiplier effects.

Multiplier – The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.

LO1

Imports as Leakage

• In a closed (no-trade) economy, total income and domestic spending are always equal.

C + I + G = Y

LO1

Imports as Leakage

• In an open economy, imports and exports have to be taken into account.

C + I + G + X = Y + M

The combined spending of consumers, investors, and the government may not equal domestic output.

LO1

Marginal Propensity to Import

• Part of any increase in spending will be spent on imports.

• This fraction is called the marginal propensity to import (MPM).– The marginal propensity to import (MPM) –

the fraction of each additional (marginal) dollar of disposable income spent on imports.

LO1

Marginal Propensity to Import

• The marginal propensity to import:Reduces the initial impact on domestic demand of any income change.

Reduces the size of the multiplier.

LO1

Imports as Leakages

LO1

Imports and the Multiplier Effect

• The impact of the MPM on domestic demand is the same as its cousin, the marginal propensity to save (MPS).– Marginal Propensity to Save (MPS) – The

fraction of each additional (marginal) dollar of disposable income not spent on consumption; 1 – MPC.

LO1

Imports and the Multiplier Effect

• Imports reduce the value of the multiplier.

• The value of the multiplier depends on the extent of leakage.

The value of the multiplier depends on the extent of leakage.

LO1

Imports and the Multiplier Effect

• In a closed (no trade) and private (no taxes) economy, the multiplier takes the familiar Keynesian form.

LO1

Imports and the Multiplier Effect

• Once the economy is open to trade, the multiplier changes to reflect the additional leakage of the MPM.

LO1

Imports and the Multiplier Effect• The cumulative increase in aggregate

demand is:

Cumulative change in aggregate

demand= Initial change in

spendingIncome

multiplierx

LO1

Imports and the Multiplier Effect

• Imports, by increasing leakage, reduce the impact of fiscal stimulus.

LO1

Real Output (Income) (dollars per time period)

Pri

ce L

eve

l (av

era

ge p

rice

)Imports Reduce Multiplier

Effects

Induced C in closed economy

Induced C in open economy

AS

AD1

AD2AD3

AD4

Fiscal injection

LO1

Global Stabilizer

• Import leakages act as an automatic stabilizer.– Foreign producers absorb a large portion of a

U.S. slowdown when a decline in aggregate demand is concentrated in industries that rely heavily on imported inputs.

LO2

Exports as Injections

• Export sales inject spending into our circular flow at the same time that imports cause leakages from it.

• A change in export demand causes a shift of the aggregate demand curve.– Exports – Goods and services sold to foreign

buyers

LO2

Trade Imbalances

• The impact of trade on domestic AD depends on changes in the difference between exports (injections) and imports (leakages).

• Net exports (X – IM) equals the value of exports minus the value of imports.

LO2

Trade Imbalances

• A convenient way to emphasize the offsetting effects of exports and imports is to rearrange the income identity.

C + I + G + (X - IM) = Y

LO2

Trade Imbalances

• If exports and imports were always equal, the term (X- IM) would disappear and we could focus on domestic spending.

Exports and imports are not equal which leads to a trade imbalance.

LO2

Trade Imbalances

• A trade surplus is the amount by which the value of exports exceeds the value of imports in a given time period (positive net exports).

LO2

Trade Imbalances

• A trade deficit is the amount by which the value of imports exceeds the value of exports in a given time period (negative net exports).

LO2

Macro Effects

• A trade deficit permits domestic living standards to exceed domestic output.

• A trade deficit represents a net leakage that may frustrate government policies.

• Import leakages require larger fiscal injections to reach any particular spending goal.

LO2

Crowding Out Net Exports

• In an open economy, an increase in imports can reduce domestic crowding out.– Crowding out – A reduction in private sector

borrowing (and spending) caused by increased government borrowing.

LO2

Crowding Out Net Exports

• In an open economy fiscal stimulus tends to crowd out net exports by boosting imports.

The objective of reducing the trade deficit may conflict with the goal of attaining full employment.

LO2

Foreign Perspectives

• If the U.S. has a trade deficit, other countries must have a trade surplus.

• In real economic terms, a trade surplus subsidizes the standard of living of the nation with the trade deficit.

Foreign Perspectives

• We cannot focus exclusively on domestic macro goals and ignore international repercussions.

A Policy Constraint

• What we know for certain is:– Imports and exports alter the level of

aggregate demand.– Trade flows may help or impede domestic

macro policy attain its objectives.– Macro policy decisions need to take account

of international trade repercussions.

LO2

International Finance

• In addition to goods and services, money flows across international borders.

• These flows alter macro outcomes and complicate macro decision making.

Capital Inflows

• In 2006, over $1 trillion of foreign capital flowed into the United States.

• A lot of this inflow was used to purchase U.S. Treasury bonds.

• U.S. multinational firms also brought home profits from foreign operations.

Capital Outflows

• Most of the money outflow is used to pay for American imports.

• Outflows occur as U.S. investors purchase foreign land, labor and capital.

• Money flows out of the economy as foreign investors retrieve interest and profits.

Capital Outflows

• U.S. government spending on defense, embassies, economic development, and emergency relief abroad also cause capital outflows.

Capital Imbalances

• Like trade flows, capital flows will not always be balanced.

• Capital imbalances are directly related to trade imbalances.

Capital Imbalances

• A capital deficit is the amount by which the capital outflow exceeds the capital inflow in a given time period.

A capital surplus is the amount by which the capital inflow exceeds the capital outflow in a given time period.

Macro Effects

• Control of the money supply becomes more difficult when money is able to move across international borders at will.

LO3

Exchange Rates• The exchange rate is the price of one

country’s currency, expressed in terms of another’s – the domestic price of a foreign currency.

• If the dollar’s value in world markets is high, imports are cheap.

LO3

Capital Flows: Another Policy Constraint

• In addition to other macro worries, the economy has to be concerned about:– The flow of capital in and out of the country.– The effect of capital imbalances on domestic

macro performance.– How macro policy affects international capital

flows, exchange rates, and trade balances.

LO3

Productivity and Competitiveness

• It is very much to our advantage to participate in the global economy.

Specialization

• Imported goods and services broaden our consumption possibilities.

• Specialization among countries increases world productivity and output, making all nations richer.

Specialization

• Comparative advantage is the ability of a country to produce a specific good at a lower opportunity cost than its trading partners.

Competitiveness

• Trade stimulates improvements in productivity.– Productivity – output per unit of input, for

example, output per labor hour.

Competitiveness

• The presence of foreign producers keeps domestic producers on their toes.

Domestic producers must reduce costs and increase efficiency to compete in international markets.

Global Coordination

• The desire for coordination grows as all countries recognize the international dimensions of their economies.

IMF

• The most visible institution for global coordination is the International Monetary Fund (IMF).

• The IMF uses funds contributed by all nations to assist nations whose currency is in trouble.

Group of Eight• The eight largest industrial countries – the

United States, Japan, Canada, Germany, France, Italy, Great Britain, and Russia – attempt to coordinate macro policy.

• Any informal agreements they reach can have a substantial effect on global trade and capital flow.

A Global Currency?

• Eleven European nations adopted the Euro as a single currency on January 1, 1999.

The New Euro

• A common currency facilitates trade and capital flows across national borders.

• It eliminates the uncertainties and added costs of diverse currencies.

Macro Coordination

• To maintain a common currency, nations must maintain common macro policies.

• Monetary policy for the Euro nations is now controlled by a single central bank, the European Central Bank.

Theory and RealityChapter 18

Theory versus Reality

• No matter how hard we try to eliminate it, the business cycle seems to persist– What’s the ideal “package” of macro policies?– How well does our macro performance live up

to the promises of that package?– What kinds of obstacles prevent us from

doing better?

The Policy ToolsType of Policy Policy Instruments

Fiscal Tax cuts and increases Changes in government spending

Monetary Open market operations Reserve requirements Discount rates

Supply-side Tax incentives for investment and saving Deregulation Human-capital investment Infrastructure development Free trade Immigration

Fiscal Policy

• Fiscal policy: The use of government taxes and spending to alter macroeconomic outcomes

• Fiscal policy refers to deliberate changes in tax or spending legislation

Who Makes Fiscal Policy?

• Fiscal policy expands or shrinks the structural deficit to give the economy a shot of fiscal stimulus or fiscal restraint– Structural deficit: Federal revenues at full

employment minus expenditures at full employment under prevailing fiscal policy

Who Makes Fiscal Policy?

• Automatic stabilizers are federal expenditure or revenue items that automatically responds counter-cyclically to changes in national income.

They act as a basic counter-cyclical feature of the federal budget.

LO1

Who Makes Fiscal Policy?

• Fiscal stimulus – Tax cuts or spending hikes intended to increase (shift) aggregate demand.

Fiscal restraint – Tax hikes or spending cuts intended to reduce (shift) aggregate demand.

LO1

Monetary Policy

• Monetary Policy: The use of money and credit controls to influence macroeconomic outcomes

• Monetary policy tools include – Open-market operations– Discount-rate changes– Reserve requirements

Monetary Policy

• Keynesians believe that interest rates are the critical policy lever

• Monetarists believe money supply is the critical variable and that it should be expanded at a steady, predictable rate to ensure price stability at the natural rate of unemployment

Who Makes Monetary Policy?

• Monetary policy is made by the Federal Reserve’s Board of Governors

• Twice a year the Fed provides Congress with a broad overview of the economic outlook and monetary objectives

Monetary Policy

• Monetary Policy – The use of money and credit controls to influence macroeconomic activity.

• Monetary policy tools include open-market operations, discount-rate changes, and reserve requirements.

LO1

Supply-Side Policy

• The focus of supply-side policy is to provide incentives to work, invest, and produce

• Supply-side policy: The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

Who Makes Supply-Side Policy?

• Supply-siders argue that marginal tax rates and government regulation must be reduced in order to get more output without added inflation

• Deciding whether to increase spending is a fiscal policy decision; deciding how to spend available funds may entail supply-side policy

Idealized Uses

• Fiscal, monetary, and supply-side tools are potentially powerful levers for controlling the economy

• Depending on the situation, they can cure the excesses of the business cycle and promote faster economic growth

Case 1: Recession

• Output and employment levels are far short of the economy’s full-employment potential

• Keynesians emphasize need to increase aggregate demand by cutting taxes or boosting government spending– Modern Keynesians acknowledge that

monetary policy might also help

Case 1: Recession

• In the Monetarists view, the appropriate response to a recession is patience– So long as the velocity of money (V) is

constant, fiscal policy doesn’t matter

• As sales and output slow, interest rates will decline and new investment will be stimulated

Case 1: Recession

• Supply-siders emphasize the need to improve production incentives– Cut marginal tax rates on investment and

labor– Reduce government regulation– Focus any government spending on long-run

capacity expansion

Case 2: Inflation

• Keynesians would address an inflationary GDP gap by raising taxes and lowering government spending, shifting AD leftward– Keynesians would also increase interest rates

to curb investment spending

• Monetarists would simply cut the money supply

Case 2: Inflation

• Supply-siders would point out that inflation implies both “too much money” and “not enough goods”

• Look at the supply side of the market for ways to expand productive capacity

Case 3: Stagflation

• Stagflation is much more of a gray area, since attempting to address recession or inflation individually can make the other problem worse– Stagflation: The simultaneous occurrence of

substantial unemployment and inflation

• Knowing the causes of stagflation may help achieve the desired balance

Case 3: Stagflation• If prices are rising before full employment is

reached there may be structural unemployment

• High taxes or costly regulations might contribute to stagflation

• Stagflation may arise from an external shock like an earthquake

• No familiar policy tool is likely to provide a complete cure

Fine-Tuning

• At one time, it was felt that policy could fine-tune the economy to assure prosperity– Fine-tuning: Adjustments in economic policy

designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions

• The economy’s track record does not live up to the high expectations of fine-tuning

The Economic Record

– Economic history is punctuated by periods of recession, high unemployment, inflation, and recurring concern for the distribution of income and mix of output

Source: Economic Report of the President, 2009 and Congressional Budget Office

The Economic Record

Why Things Don’t Always Work

• Four obstacles to policy success:– Goal conflicts– Measurement problems– Design problems– Implementation problems

Goal Conflicts

• Most often goal conflicts originate in short-run trade-off between unemployment and inflation

• The goal conflict is often institutionalized in the decision making process– The Fed is traditionally viewed as the guardian

of price stability– The President and Congress worry more

about people’s jobs and government programs

Goal Conflicts

• Distributional goals may conflict with macro objectives– Anti-inflationary policies may require cutbacks

in programs for the poor, the elderly, or others– These cutbacks may be politically impossible

• All policy decisions entail opportunity costs

Provide aidTo Foreign Country

Increase expendituresFor Elderly in county

Measurement Problems

• The processes of data collection, assembly, and presentation take time

• At best, we know what was happening in the economy last month or last week

• An average recession lasts about 11 months, but official data generally don’t confirm its existence until 8 months after one begins

Forecasts

• In designing policy, policymakers must depend on economic forecasts — informed guesses about what the economy will look like in future periods

• Those guesses are often based on econometric macro models, which are mathematical summaries of the economy’s performance

Leading Indicators and Crystal Balls

• Many people prefer to use leading indicators– Leading indicators are things we can

observe today that are logically linked to future production

– One of the most popular is the Index of Leading Economic Indicators

• Others disregard economists’ forecasts and use their own “crystal balls”

Policy and Forecasts

• Forecasting the economic future is made more complex because forecasts, policy decisions, and economic outcomes are interdependent

Budget projections

Policy decisions

Economic forecasts

External shocks

External Shocks

• An external shock can disrupt the economy and ruin economic forecasts

• The very nature of external shocks is that they are unanticipated

Design Problem

• Suppose the outlook is bad and we want to steer the economy past looming dangers

• We need to design an economic plan

• It is difficult to predict how market participants will respond to any specific economic policy action

Implementation Problems

• Even if the right policy is formulated, there is no assurance it will be implemented

• Congressional deliberations can stall or derail fiscal policy

• Even if it is implemented, there is no assurance that it will take effect at the right time

Time Lags

• There is a danger that the policy will get enacted well after the problem it was created to fix is gone

Problem emerges

Policy impact

noticeable

Problem recognized

Response formulated

Action taken

Delay

Delay

Delay

Delay

Economic Policy Delays

There is a period of time from when an economic problem emerges until it can be recognized. Once it is recognized, it takes time to design a policy response and time for the policy to be implemented. By the time the policy has an impact on the economy the economic situation may have changed, and the action may propel the economy in the wrong direction.

EconomicProblem Emerges.

Economic ProblemRecognized.

DesignPolicy.

ImplementPolicy.

Economic Situation Changed.

EconomyPropelled inWrong Direction.

Politics vs. Economics

• A particular policy may be right for the economy but might never be enacted due to political pressures

• Congress tends to hold fiscal policy hostage to electoral concerns

• Politicians often rely on the Fed to take the unpopular actions necessary to fight inflation

Hands On or Hands Off?

• We haven’t been able to make all the minor adjustments necessary to fulfill our goals completely

• Everyone agrees that discretionary policies could result in better economic performance

Hands On or Hands Off?

• Some argue that the practical requirements of monetary and fiscal management are too demanding and thus prone to failure

• Proponents of a hands-on policy admit the possibility of occasional blunders, but emphasize the greater risks of doing nothing when the economy is faltering

Hands On or Hands Off?

• Historically, the economy has been much more stable during the time of discretionary policy (as opposed to earlier times)

• Even though it’s impossible to reach all our goals, we can’t abandon conscientious attempts to get as close as possible

New Classical Economics

• According to the New Classical Economists, it is best for the government to provide a stable environment and then stay out of the way.

LO3

New Classical Economics

• This laissez-faire conclusion is based on the notion of rational expectations.

Rational expectations – the hypothesis that people’s spending decisions are based on all available information, including the anticipated effects of government intervention.

LO3

New Classical Economics

• Acting on rational expectations, consumers anticipate the results of government policies and adapt immediately.

Thus rendering the policy ineffective.

The only policy that works is one that surprises people.

LO3

Modest Expectations• Public policy initiatives are worthwhile if

they:– create a few more jobs, – a better mix of output, – a little more growth and price stability, and/or – an improved distribution of income.

LO3

Theory and RealityEnd of Chapter 19