Session 22How Does the Open

Macro-economy Work?

National Macro-economic Performance Goals

Internal Balance

Full employment, or an acceptably low unemployment rate

Price stability, or an acceptably low inflation rate

External balance

Sustainable composition of the country’s balance of payments with the rest of the world

A Basic Framework for Macro-economic Analysis

Domestic production depends on aggregate demand.

GDP = C + I + G + (X – M)

Aggregate Expenditure = C + I + G + (X – M)

Aggregate Demand = C + I + G + (X – M)

Inflation =

Trade depends on income.

A More Complete Framework : Three MarketsMundell – Fleming Model

The Domestic Product Market

The Money Market

The Foreign Exchange Market (Balance of Payment)

The Investment – Saving Curve (Product Market)

Some Exogenous shocks that shift the IS curve up (or to the right)

IS2

up

An increase in government spending or a tax cut

An improved customer expectations about the future

The shift in the tastes of foreign customers toward the country’s products.

The Liquidity – Money Curve (Money Market)

Some Exogenous shocks that shift the LM curve down (or to the right)

LM2Down

An increase in government spending or a tax cut

A decrease in average price level ( i.e., due to a decline in oil prices)

The introduction of credit cards.

The Foreign Exchange Market (or Balance of Payment)

Some Exogenous shocks that shift the FE curve down (or to the right)

FE2

Down

An increase in exports

The country’s currency value decrease (i.e., from ฿ 25/ $ 1 to ฿ 50/ $ 1)

Inflow > Outflow(Export > Import)

A decrease in imports

Inflow < Outflow(Export < Import)

A decrease in foreign interest rate

A increase in the expected rate of appreciation of the country’s currency

฿ 25/ $ 1

More inflow dollars

Based on the expectation, the dollar holders could make the profit as follows

฿ 20/ $ 1 the expected rate of appreciation

$ 1 ฿ 25

Now ฿ 5 (profit)

฿ 20 = $1 (cost) $ 1

Future

As a result of the expected rate of appreciation, the following happens

More demand for baht

The value of baht will decrease (฿ 25/ $ 1 to ฿30/ $1)

Macro-economic Policies