FIN 500 SEU Macroeconomic Policy in an Open Economy Discussion

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I’m working on a economics discussion question and need an explanation and answer to help me learn.

How do fiscal and monetary policies under the fixed exchange rate in Saudi Arabia help the country to increase the living standard? What are the goals of the monetary and fiscal policies, and how are they achieved? What are the challenges that the country may encounter on the journey to achieve these goals?
Readings Required:
Chapter 15 in International Economics (PowerPoint) attached
Kus, B. (2020). Relief, recovery, reform: a retrospective on the US policy responses to the Great Recession. Intereconomics, 55(4), 257-265. https://doi-org.sdl.idm.oclc.org/10.1007/s10272-020-0910-4 
Anis, A. (2020). Governance of public spending avenues by oil prices, oil revenues, and GDP in Saudi Arabia: proportionate sensitivity and trend analysis. Investment Management & Financial Innovations, 17(4), 152-164. https://doaj-org.sdl.idm.oclc.org/article/1dcd6831002d4111831cc484b328f004

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INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 15:
Macroeconomic
Policy in an
Open Economy
© 2019 Cengage. All rights reserved.
2
Chapter Outline
Economic Objectives of Nations
Policy Instruments
Aggregate Demand and Aggregate Supply: A Brief
Review
Monetary and Fiscal Policy in a Closed Economy
Monetary and Fiscal Policy in an Open Economy
Macroeconomic Stability and the Current Account:
Policy Agreement vs Policy Conflict
Inflation with Unemployment
International Economic Policy Coordination
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3
Economic Objectives of Nations
(1 of 2)
• Economic objectives of nations
•
•
•
•
•
Internal balance
External balance
Overall balance
Long-term economic growth
Reasonably equitable distribution of national
income
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4
Economic Objectives of Nations
(2 of 2)
• Economic objectives of nations (cont’d)
• Internal balance
• Economic stability at full employment
• A fully employed economy
• No inflation
• External balance
• Neither deficits nor surpluses in current account
• Overall balance
• Combination of internal balance and external
balance
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5
Policy Instruments
(1 of 3)
Expenditure-changing policies
• Alter level of total spending (aggregate
demand) on goods and services either
produced domestically or imported
• Fiscal policy
• Changes in government spending and taxes
• Responsibility of president & Congress
• Monetary policy
• Changes in money supply and interest rates
• Responsibility of central bank (Federal Reserve)
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6
Policy Instruments
(2 of 3)
• Expenditure-switching policies
• Modify direction of demand
• Use policies that shift demand between domestic
output and imports
• Under fixed exchange rate, nation with trade
deficit could devalue currency to increase
export competitiveness
• Under managed floating exchange rate, nation
with trade deficit could depreciate currency by
using it to purchase other currencies
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7
Policy Instruments
(3 of 3)
• Direct controls (e.g., tariffs)
•
•
•
•
Government restrictions in a market economy
Control particular items in the current account
Restrain capital outflows
Stimulate capital inflows
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8
Aggregate Demand & Aggregate
Supply: A Brief Review (1 of 4)
• Aggregate demand curve (AD)
• Level of real output (real GDP) purchased
at various price levels during year
• Spending by domestic consumers, businesses,
government, and foreign buyers (net exports)
• On aggregate demand curve, as price level
falls, quantity of real output demanded
increases
© 2019 Cengage. All rights reserved.
9
Aggregate Demand & Aggregate
Supply: A Brief Review (2 of 4)
© 2019 Cengage. All rights reserved.
10
Aggregate Demand & Aggregate
Supply: A Brief Review (3 of 4)
• Aggregate demand–aggregate supply
model
• Aggregate supply curve (AS)
• Relationship between price level and quantity of
real output produced by economy during a given
year
• Upward sloping
• Per-unit production costs and prices increase as real
output increases
• Macroeconomic Equilibrium: AD = AS
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11
Aggregate Demand & Aggregate
Supply: A Brief Review (4 of 4)
• Shifts of aggregate demand curve
• Changes in determinants of AD
• Consumption, investment, government purchases,
or net exports
• Shifts of aggregate supply curve
• Changes in prices of resources, technology,
business expectations
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12
Monetary and Fiscal Policy in a
Closed Economy (1 of 3)
• Monetary and fiscal policy are main
tools by which government can
influence economic performance
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13
Monetary and Fiscal Policy in a
Closed Economy (2 of 3)
If aggregate output is low and unemployment
high, government may increase aggregate
demand through expansionary monetary and/or
fiscal policies
• Lead to increase in domestic consumption,
investment, or government spending,
resulting in increase in country’s real GDP
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14
Monetary and Fiscal Policy in a
Closed Economy (3 of 3)
To control inflation, government will:
• Reduce level of aggregate demand for real
output by engaging through contractionary
monetary or fiscal policies
• Upward pressure on prices is softened and inflation
moderates
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15
Monetary and Fiscal Policies
in an Open Economy (1 of 13)
Expansionary monetary or fiscal policy
• In closed economy, initial effect is increase in
aggregate demand (domestic consumption,
investment, or government spending)
• In open economies, has secondary effects
• May increase or decrease in aggregate demand by
changing net exports and other determinants of
aggregate demand
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16
Monetary and Fiscal Policy
in an Open Economy (2 of 13)
• If initial and secondary effects both result
in increase in aggregate demand
• Strengthens effect of expansionary policy
• If initial and secondary effects have
conflicting impacts
• Expansionary effects are weakened
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17
Monetary and Fiscal Policy
in an Open Economy (3 of 13)
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18
Monetary and Fiscal Policy
in an Open Economy (4 of 13)
• Effect of fiscal and monetary policy under
fixed exchange rates
• Expansionary fiscal policy more successful
and expansionary monetary policy less
successful in stimulating economy in open
economy than in closed economy
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19
Monetary and Fiscal Policy
in an Open Economy (5 of 13)
TABLE 15.1 The Effectiveness of Monetary and Fiscal Policy in
Promoting Internal Balance for an Economy with a High Degree
of Capital Mobility
Exchange-Rate Regime
Monetary Policy
Fiscal Policy
Floating exchange rates
Strengthened
Weakened
Fixed exchange rates
Weakened
Strengthened
© 2019 Cengage. All rights reserved.
20
Monetary and Fiscal Policy
in an Open Economy (6 of 13)
• Fiscal policy is strengthened under fixed
exchange rates
• Initial effect: increase in aggregate demand
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21
Monetary and Fiscal Policy
in an Open Economy (7 of 13)
• Fiscal policy is strengthened under fixed
exchange rates (cont’d)
• Secondary effect: increase in aggregate
demand
• Budget deficit raises interest rate, leading to
increased demand for domestic currency in
foreign-currency market
• To maintain fixed exchange rate, central bank buys
foreign currency with domestic currency, increasing
domestic money supply and supply of loanable
funds, causing AD to rise further
© 2019 Cengage. All rights reserved.
22
Monetary and Fiscal Policy
in an Open Economy (8 of 13)
• Monetary policy is weakened under fixed
exchange rates
• Initial effect: higher aggregate demand
• Money supply increases, domestic interest rate falls,
leading to increased consumption and investment
© 2019 Cengage. All rights reserved.
23
Monetary and Fiscal Policy
in an Open Economy (9 of 13)
• Monetary policy is weakened under fixed
exchange rates (cont’d)
• Secondary effects: lower aggregate demand
• Decreasing demand for domestic currency due to low
interest rates
• To maintain fixed exchange rate, authorities purchase
domestic currency with foreign currency, causing
decrease in money supply
• Supply of loanable funds, causing AD to contract
© 2019 Cengage. All rights reserved.
24
Monetary and Fiscal Policy
in an Open Economy (10 of 13)
• Effect of fiscal and monetary policy under
floating exchange rates
• Monetary policy is strengthened under
floating exchange rates
• Initial effect: increase in aggregate demand
• Reduction in domestic interest rate
• Increased consumption and investment
© 2019 Cengage. All rights reserved.
25
Monetary and Fiscal Policy
in an Open Economy (11 of 13)
• Effect of fiscal and monetary policy under
floating exchange rates
• Monetary policy is strengthened under
floating exchange rates (cont’d)
• Secondary effects: increase in aggregate
demand
• Domestic currency depreciates; leads to increase in
exports, decrease in imports, improvement in current
account
• Monetary policy – strengthened under floating
exchange rates
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26
Monetary and Fiscal Policy
in an Open Economy (12 of 13)
• Effect of fiscal and monetary policy under
floating exchange rates (cont.)
• Fiscal policy is weakened under floating
exchange rates
• Initial effect: increase in aggregate demand
© 2019 Cengage. All rights reserved.
27
Monetary and Fiscal Policy
in an Open Economy (13 of 13)
• Effect of fiscal and monetary policy under
floating exchange rates (cont.)
• Fiscal policy is weakened under floating
exchange rates (cont’d)
• Secondary effects: Decrease in aggregate
demand
• Budget deficit; higher interest rate and increased
demand for domestic currency in foreign-exchange
market
• Domestic currency appreciates, leading to
worsening of current account, causing AD to fall
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28
Macroeconomic Stability & Current Account:
Policy Agreement vs Policy Conflict (1 of 2)
Can single policy restore overall balance?
Assume recession + current account deficit
and floating exchange rate
• Expansionary monetary policy to combat
recession leads to currency depreciation
• Rise in exports and fall in imports reduces current
account deficit
Thus, single economic policy promotes
overall balance
© 2019 Cengage. All rights reserved.
29
Macroeconomic Stability & Current Account:
Policy Agreement vs Policy Conflict (2 of 2)
• Inflation + current account deficit
• Contractionary monetary policy to combat
inflation increases domestic interest rate and
thus currency appreciation
• Fall in exports and rise in imports increases current
account deficit
• Thus, there is policy conflict: monetary policy
(or fiscal policy) alone will not restore both
internal and external balance
© 2019 Cengage. All rights reserved.
30
Inflation with Unemployment
(1 of 3)
Assume that as economy advances to full
employment, domestic prices unchanged
until full employment reached
Demand-pull inflation – once nation’s
production capacity achieved, further
increases in aggregate demand pull prices
upward
© 2019 Cengage. All rights reserved.
31
Inflation with Unemployment
(2 of 3)
• When nation suffers both inflation and
unemployment, internal balance cannot be
achieved by manipulating aggregate demand
• To decrease inflation, AD must be reduced
• To decrease unemployment, AD must be increased
© 2019 Cengage. All rights reserved.
32
Inflation with Unemployment
(3 of 3)
• Overall balance – three separate targets
• Current-account equilibrium
• Full employment
• Price stability
• Wage and price controls may be necessary to
achieve all three
© 2019 Cengage. All rights reserved.
33
International Economic Policy
Coordination (1 of 9)
Economic relations among nations
• Conflict — Independence — Integration
Policy cooperation
• Officials from different nations meet to
evaluate world economic conditions
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34
International Economic Policy
Coordination (2 of 9)
International economic policy
coordination
• Attempt to significantly modify national
policies—monetary policy, fiscal policy, and
exchange-rate policy—in recognition of
international economic interdependence
© 2019 Cengage. All rights reserved.
35
International Economic Policy
Coordination (3 of 9)
© 2019 Cengage. All rights reserved.
36
International Economic Policy
Coordination (4 of 9)
• Policy coordination in theory
• Some nations give higher priority to price
stability, or to full employment, than others
• Some nations have stronger legislatures or
weaker trade unions than others
• Party pendulums in different nations shift with
elections occurring in different years
© 2019 Cengage. All rights reserved.
37
International Economic Policy
Coordination (5 of 9)
• Policy coordination in theory (cont’d)
• One nation may experience economic
recession, while another may experience
rapid inflation
© 2019 Cengage. All rights reserved.
38
International Economic Policy
Coordination (6 of 9)
• Does policy coordination work?
• Plaza Agreement of 1985, Group of Five (G5) nations – United States, Japan, Germany,
Great Britain, and France
• Overvalued U.S. dollar
• Twin U.S. deficits (trade & federal budget) were too
large
© 2019 Cengage. All rights reserved.
39
International Economic Policy
Coordination (7 of 9)
• Does policy coordination work? (cont’d)
• Each country
• Made specific pledges on macroeconomic policy
• Agreed to initiate coordinated sales of dollars
• By 1986, dollar had dramatically depreciated
• But new concern: uncontrolled dollar plunge
• Louvre Accord of 1987, Group of Five (G-5)
• Intervention policies intended to curb pace of
dollar’s depreciation
• Other macroeconomic adjustments
© 2019 Cengage. All rights reserved.
40
International Economic Policy
Coordination (8 of 9)
• Does policy coordination work? (cont’d)
• By 2000s, more difficult to coordinate
• Rise of independent central banks makes
coordination more difficult
• Additionally, huge growth of global financial
markets has made currency intervention less
effective
© 2019 Cengage. All rights reserved.
41
International Economic Policy
Coordination (9 of 9)
• Does policy coordination work? (cont’d)
• 2000, Group of Seven (G-7) – U.S.,
Canada, Japan, U.K., Germany, France,
and Italy
• Coordinated purchases of euro to boost
value; rose from $0.84 per euro to more than
$0.88 per euro
• Within 2 weeks of intervention, euro’s value at
all-time low
• Intervention is a failure
© 2019 Cengage. All rights reserved.
42

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macroeconomic policy

saudi arabia

open economy

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