Open economy $AD$ and policy

An open economy adds some complications to the $AD$-$AS$ model and the long-run effects of fiscal and monetary policy.

Let’s begin with what is added to the $AD$ curve.

Open economy $AD$

When we first presented the $AD$ curve, it was mentioned that it can be thought of as a GDP equation. We only lightly discussed the $NX$ portion, with increases and decreases due to tastes and preferences. With exchange rates outlined, we can explain what is happening behind the scenes.

Recall that we gave two reasons why the $AD$ curve is downward sloping. To summarize they were,

• Wealth effect
  • As the price level falls, real income rises. Loosely speaking, “people feel richer, so they buy more.”
• Interest rate effect
  • When the price level falls, interest rates drop. This leads to higher investment and consumer spending.

Exchange rates provide an additional reason why the $AD$ curve slopes downwards.

• Exchange rate effect
  • As the domestic price level falls, interest rates fall and the exchange rate falls (depreciation).
  • As a consequence exports are relatively cheaper so $X$ increases. Imports also are relatively more expensive, so $M$ decreases. Thus $NX$ increases and so does real GDP.

This also makes the stories behind $NX$ shifts more clear.

Factor Increasing	Change in E	Impact	$AD$ shift
Foreign income	$E\uparrow$	$X\uparrow$	$AD\to$
Foreign tastes and preferences	$E\uparrow$	$X\uparrow$	$AD\to$
Domestic tastes and preferences	$E\uparrow$	$M\downarrow$	$AD\to$
Exchange rate (non-PL)	$E\uparrow$	$NX\downarrow$	$AD\leftarrow$

What happens in each of the first three cases is that the exchange rate change partially cancels out the direct effect. For example an increase in foreign income or foreign tastes and preferences first increases exports. This increases demand for dollars and lowers the supply of dollars, leading to an appreciation of the dollar. Because of this, imports rise and exports fall. The first change is usually thought to be larger, so $AD$ still shifts right just by less than the initial shift.

Our final shifter is non-PL changes in exchange rates. This would include an increase in risk of investing or other events that change demand/supply for investment or goods and services in a country. In that case, the exchange rate change is the direct change.

A negative event or an increase in risk would lead to a depreciation, which would lower imports and raise exports. Thus $NX$ rises and the $AD$ curve shifts right.

A positive event or a decrease in risk would lead to an appreciation, lowering exports and increasing imports. Thus $NX$ falls and the $AD$ curve shifts left.

Fiscal policy

Because capital flows impact the loanable funds market. Crowding out is also different in an open economy. As the government deficit increases, this shifts the supply of loanable funds to the left. In a closed economy, this would increase the domestic interest rate.

For a small open economy, the world interest rate “controls” the loanable funds market. An increased government budget deficit still shifts the supply of loanable funds to the left. But now this increases capital outflows instead of the interest rate. Correspondingly, net exports fall as well. So if an economy is running a trade deficit and the government borrows more, all else equal that makes the trade deficit larger.

Why does this happen?

Running consistent deficits places upward pressure interest rates and the value of the currency. Running consistent surpluses places downward pressure on interest rates and the value of the currency.

[USD vs EUR]

[USD vs ARS]

Monetary policy

The standard open economy story has free capital flows, central bank control over domestic interest rates and a floating exchange rate. We will consider the fixed exchange rate case at the end of this section.

If the Fed pursues expansionary monetary policy, the domestic interest rate is lowered, which makes US assets less desirable. This leads to capital outflows and a depreciation of the dollar. Net exports rise, and $AD$ increases more than in a closed economy.

Capital flows act as a headwind for fiscal policy, but they act as a tailwind for monetary policy. Smaller changes in interest rates can achieve the same change in $Y$ in an open economy compared to a closed economy.

At the AP Macro level, one final detail is that a large open economy, such as the United States, changes in monetary policy can affect the world interest rate. In smaller countries, this is not the case. Going into how that affects policy choices is past what you are expected to know.

Fixed exchange rate fiscal and monetary policy

One final brief consideration is what occurs if a country does not have a floating exchange rate. Consider Denmark, which has a fixed exchange rate with respect to the Euro.

With free capital flows, changing the interest rate puts pressure on the exchange rate. For monetary policy that means that the only sustainable solution would be for the Danish central bank, the Danmarks Nationalbank, to move the interest rate back where it started.

For monetary policy to be used with a fixed exchange rate, there need to be capital controls. For many years China had a fixed exchange rate versus the dollar and use of capital controls was how they were still able to use monetary policy as a stimulus for their domestic economy. That makes the Chinese interest rate different from the world interest rate, and capital cannot flow across borders to seek higher returns.

Finally, there is fiscal policy with a fixed exchange rate. New government borrowing puts upward pressure on interest rates and with capital flows that would lead to an increase in demand in the foreign exchange market and a currency appreciation. A central bank aiming to maintain a fixed exchange rate needs to prevent this. They can either add supply to the foreign exchange market to maintain the exchange rate or they can use capital controls to prevent the increase in demand.

The main issue is that adding supply requires having enough currency to do so. If asked to do this often, even a central bank may run out of reserves. Printing money may be the only way to meet demand and this would lead to inflation.

Trade barriers

Finally, we have trade barriers government policies designed to restrict, limit or eliminate certain types of trade. We have already discussed capital controls, limits on transfers of savings. What remains are policies that affect trade in goods and services.

Definitions

Import quota

A government policy that creates a maximum amount that can be imported of a specific good or service

Tariff

A tax on either imports of exports. Primarily used to refer to import taxes in common usage.

Any policy that restricts imports lowers the supply of the domestic currency. Continuing our example, US import tariffs on any goods from the Eurozone would reduce the amount of US dollars exchanged for Euros. This reduces the supply of US dollars and causes the dollar to appreciate relative to the euro.

So if these policies make the domestic currency appreciate, which reduces exports as well as imports, why would a country want to use this as a policy tool.

• Increase domestic production in specific industries

• Infant industry protection (new companies or new technology) For each of these reasons, tariffs on a specific good in general or a specific good from particular countries may make sense.

• Retaliation against other countries (response to policy against you) In this case, tariffs on specific imports or in extreme cases all imports from a particular country may make sense.

• Increase domestic employment

Tariffs, do technically raise government revenue. But they act as targeted sales taxes and thus are usually limited in revenue generation.