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CHAPTER 22 HOW DOES THE OPEN MACROECONOMY WORK? Objectives of the Chapter This chapter sets up a model that allows us to relate two important goals of macroeconomic performance: internal balance (achieving full employment and price stability in the economy) and external balance (achieving balance in the country’s overall balance of payments). Using the IS-LM-FE framework, we can see that an economy will not necessarily achieve both balances at the same time. In fact, an event that moves an economy toward full employment could worsen its trade balance, and vice versa. Now, government authorities have a more difficult job than they did in a closed economy: they must be aware of both internal indicators (such as the level of income and the level of interest rates) and external indicators (the balance of payments). A policy that seemed simple to analyze in a closed economy, such as an increase in government spending, has more complex effects in an open economy. Such an increase in spending would not only raise income and interest rates, it would also be likely to produce a balance of payments deficit and so put downward pressure on the nation’s currency. This pressure has further implications for the level of income in the economy, depending upon which exchange rate regime is in effect. Before tackling this chapter, you may want to review the concept and determination of the equilibrium income and the spending multiplier in a closed economy. Take a look at your dusty old macroeconomics textbook! After studying Chapter 22 you should understand 1. the dependence of imports on the level income. 2. the concept (and determination) of equilibrium income in an open economy. 3. the spending multiplier for a closed economy versus an open economy. 4. the impact of various economic changes on domestic product and on the balance of trade. 5. the two goals of internal balance and external balance. 6. price movements in the macroeconomy in the short run and in the long run, and the relationship of price competitiveness to international trade. Important Concepts External balance: Performance goal in which the country’s economy has an overall balance of payments that is sustainable over time. FE curve: This curve shows all combinations of interest rate and income which result in a zero balance in the country’s overall international payments position (its official settlements balance is zero). The FE curve usually slopes upward because, as income rises, the demand for imports rises; interest rates must also rise to attract capital so that the current account deficit is offset by a financial account surplus. The FE curve is horizontal if there is perfect capital mobility
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This note was uploaded on 02/18/2010 for the course ECON 343 taught by Professor Dblack during the Fall '09 term at University of Delaware.

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