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3 Deficit reduction, expectations and output

3 Deficit reduction, expectations and output

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Chapter 16 Expectations, output and policy   337







Now recall that output must be equal to spending, and that spending is the sum of public

spending and private spending. Given that output is unchanged and that public spending is

lower, private spending must therefore be higher. Higher private spending requires a lower ➤ In the medium run, output, Y, does not

change; investment, I, is higher.

equilibrium interest rate. The lower interest rate leads to higher investment, and thus to

higher private spending, which offsets the decrease in public spending. Output is unchanged. ➤ In the long run,

I increases 1 K increases 1

● In the long run – that is, taking into account the effects of capital accumulation on output –

Y increases.

higher investment leads to a higher capital stock and therefore a higher level of output.

● This was the main lesson of Chapter 11. The higher the proportion of output saved (or

invested; investment and saving must be equal for the goods market to be in equilibrium

in a closed economy), the higher the capital stock, and thus the higher the level of output

The way this is likely to happen: forein the long run.

casts by economists will show that



We can think of our future period as including both the medium and the long run. If people,

these lower deficits are likely to lead

firms and financial market participants have rational expectations, then, in response to the to higher output and lower interest

announcement of a deficit reduction, they will expect these developments to take place in the ➤ rates in the future. In response to these

future. Thus, they will revise their expectation of future output (Y =e) up and their expectation forecasts, long-term interest rates will

decrease and the stock market will

of the future interest rate (r =e) down.

increase. People and firms, reading

these forecasts and looking at bond and

stock prices, will revise their spending

plans and increase spending.



Back to the current period

We can now return to the question of what happens this period in response to the announcement and start of the deficit reduction plan. Figure 16.5 draws the IS and LM curves for the

current period. In response to the announcement of the deficit reduction, there are now three

factors shifting the IS curve:













Current government spending (G) goes down, leading the IS curve to shift to the left. At

a given interest rate, the decrease in government spending leads to a decrease in total

spending and so a decrease in output. This is the standard effect of a reduction in government spending, and the only one taken into account in the basic IS–LM model.

Expected future output (Y =e) goes up, leading the IS curve to shift to the right. At a given

interest rate, the increase in expected future output leads to an increase in private spending, increasing output.

The expected future interest rate (r =e) goes down, leading the IS curve to shift to the right.

At a given current interest rate, a decrease in the future interest rate stimulates spending

and increases output.



What is the net effect of these three shifts in the IS curve? Can the effect of expectations

on consumption and investment spending offset the decrease in government spending?



Current interest rate, r



IS



LM



Figure 16.5

DG < 0



Dr ′ < 0

DY ′e > 0



Current output, Y



M16 Macroeconomics 85678.indd 337



e



The effects of a deficit

reduction on current output

When account is taken of its effect on

expectations, the decrease in government spending need not lead to a

decrease in output.



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338  extensions expectations

Without much more information about the exact form of the IS relation and about the

details of the deficit reduction plan, we cannot tell which shifts will dominate and whether

output will go up or down. But our analysis suggests that both cases are possible; that output may go up in response to the deficit reduction. And it gives us a few hints as to when

this might happen:





Timing matters. Note that the smaller the decrease in current government spending (G),

the smaller the adverse effect on spending today. Note also that the larger the decrease

in expected future government spending (G =e), the larger the effect on expected future

output and interest rates, thus the larger the favourable effect on spending today. This

suggests that credibly backloading the deficit reduction plan towards the future, with

small cuts today and larger cuts in the future, is more likely to lead to an increase in

output. On the other hand, backloading raises an obvious issue. Announcing the need

for painful cuts in spending, and then leaving them to the future, is likely to decrease

the plan’s credibility, which is the perceived probability that the government will do

what it has promised when the time comes to do it. The government must play a delicate

balancing act: enough cuts in the current period to show a commitment to deficit reduction; enough cuts left to the future to reduce the adverse effects on the economy in the

short run.



Focus



Can a budget deficit reduction lead to an output expansion? Ireland

in the 1980s

Ireland went through two major deficit reduction plans in

the 1980s:

1 The first plan was started in 1982. In 1981, the budget

deficit had reached a high 13% of GDP. Government

debt, the result of the accumulation of current and

past deficits, was 77% of GDP, which was also a high

level. The Irish government clearly had to regain

control of its finances. Over the next three years, it

embarked on a plan of deficit reduction, based mostly

on tax increases. This was an ambitious plan. Had output continued to grow at its normal growth rate, the

plan would have reduced the deficit by 5% of GDP.

The results, however, were dismal. As shown in row 2

of Table 16.1, output growth was low in 1982 and negative in 1983. Low output growth was associated with a

major increase in unemployment, from 9.5% in 1981 to

15% in 1984 (row 3). Because of low output growth,

tax revenues – which depend on the level of economic

activity – were lower than anticipated. The actual deficit reduction from 1981 to 1984, shown in row 1, was

only of 3.5% of GDP. And the result of continuing high

deficits and low GDP growth was a further increase in

the ratio of debt to GDP to 97% in 1984.

2 A second attempt to reduce budget deficits was made

starting in February 1987. At the time, things were



M16 Macroeconomics 85678.indd 338



still bad. The 1986 deficit was 10.7% of GDP; debt

stood at 11.6% of GDP, a record high in Europe at the

time. This new plan of deficit reduction was different

from the first. It was focused more on reducing the

role of government and cutting government spending than on increasing taxes. The tax increases in the

plan were achieved through a tax reform widening

the tax base – increasing the number of households

paying taxes – rather than through an increase in the

marginal tax rate. The plan was again ambitious. Had

output grown at its normal rate, the reduction in the

deficit would have been 6.4% of GDP.

The results of the second plan could not have been

more different from the results of the first. The years of

1987 to 1989 were years of strong growth, with average

GDP growth exceeding 5%. The unemployment rate

was reduced by almost 2%. Because of strong output

growth, tax revenues were higher than anticipated, and

the deficit was reduced by nearly 9% of GDP.

A number of economists have argued that the striking difference between the results of the two plans can

be traced to the different reaction of expectations in each

case. The first plan, they argue, focused on tax increases

and did not change what many people saw as too large

a role of government in the economy. The second plan,

with its focus on cuts in spending and on tax reform, had a



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Chapter 16 Expectations, output and policy   339







much more positive impact on expectations, and so a positive impact on spending and output.

Are these economists right? One variable, the household saving rate – defined as disposable income minus

consumption, divided by disposable income – strongly

suggests that expectations are an important part of the

story. To interpret the behaviour of the saving rate, recall

the lessons from the previous chapter about consumption

behaviour. When disposable income grows unusually

slowly or falls – as it does in a recession – consumption

typically slows down or declines by less than disposable

income because people expect things to improve in the

future. Put another way, when the growth of disposable

income is unusually low, the saving rate typically comes

down. Now look (in row 4) at what happened from 1981

to 1984. Despite low growth throughout the period and

a recession in 1983, the household saving rate actually

increased slightly during the period. Put another way,

people reduced their consumption by more than the

reduction in their disposable income: The reason must

be that they were pessimistic about the future.

Now turn to the period 1986 to 1989. During that

period, economic growth was unusually strong. By the

same argument as in the previous paragraph, we would

have expected consumption to increase less strongly, and

thus the saving rate to increase. Instead, the saving rate

dropped sharply, from 15.7% in 1986 to 12.6% in 1989.

Consumers must have become much more optimistic about

the future to increase their consumption by more than the

increase in their disposable income.



The next question is whether this difference in the

adjustment of expectations over the two episodes can be

attributed fully to the differences in the two fiscal plans.

The answer is surely no. Ireland was changing in many

ways at the time of the second fiscal plan. Productivity

was increasing much faster than real wages, reducing the

cost of labour for firms. Attracted by tax breaks, low labour

costs and an educated labour force, many foreign firms

were relocating to Ireland and building new plants. These

factors played a major role in the expansion of the late

1980s. Irish growth was then strong, usually more than 5%

per year from 1990 to the time of the crisis in 2007. Surely,

this long expansion is the result of many factors. Nevertheless, the change in fiscal policy in 1987 probably played an

important role in convincing people, firms – including foreign firms – and financial markets that the government was

regaining control of its finances. And the fact remains that

the substantial deficit reduction of 1987–1989 was accompanied by a strong output expansion, not by the recession

predicted by the basic IS–LM model.

For a more detailed discussion, look at Francesco Giavazzi and Marco Pagano, ‘Can severe fiscal contractions

be expansionary? Tales of two small European countries’,

in Olivier Jean Blanchard and Stanley Fischer (eds), NBER

Macroeconomics Annual (Cambridge, MA: MIT Press, 1990).

For a more systematic look at whether and when fiscal consolidations have been expansionary (and a mostly

negative answer), see ‘Will it hurt? Macroeconomic effects

of fiscal consolidation’, World Economic Outlook, International Monetary Fund, October 2010, Chapter 3.



Table 16.1  Fiscal and other macroeconomic indicators, Ireland, 1981 to 1984, and 1986 to 1989



1

2

3

4



Budget deficit (% of GDP)

Output growth rate (%)

Unemployment rate (%)

Household saving rate (% of disposable income)



1981



1982



1983



1984



1986



1987



1988



1989



- 13.0

3.3

9.5

17.9



- 13.4

2.3

11.0

19.6



- 11.4

- 0.2

13.5

18.1



- 9.5

4.4

15.0

18.4



- 10.7

- 0.4

16.1

15.7



- 8.6

4.7

16.9

12.9



- 4.5

5.2

16.3

11.0



- 1.8

5.8

15.1

12.6



Source: OECD Economic Outlook, June 1998.











Composition matters. How much of the reduction in the deficit is achieved by raising taxes,

and how much by cutting spending, may be important. If some government spending

plans are perceived as ‘wasteful’, cutting these plans today will allow taxes to be cut in

the future. Expectations of lower future taxes and lower distortions could induce firms to

invest today, thus raising output in the short run.

The initial situation matters. Take an economy where the government appears to have, in

effect, lost control of its budget. Government spending is high, tax revenues are low and

the deficit is large. Government debt is increasing fast. In such an environment, a credible deficit reduction plan is also more likely to increase output in the short run. Before

the announcement of the plan, people may have expected major political and economic



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340  extensions expectations







troubles in the future. The announcement of a plan of deficit reduction may well reassure

them that the government has regained control, and that the future is less bleak than they

anticipated. This decrease in pessimism about the future may lead to an increase in spending and output, even if taxes are increased as part of the deficit reduction plan. Investors

who thought that the government might default on the debt and were asking for a large

risk premium may conclude that the risk of default is much lower and ask for much lower

interest rates. Lower interest rates for the government are likely to translate into lower

interest rates for firms and people.

Monetary policy matters. The three previous arguments focused on the direction of the

shift in the IS curve, with no change in monetary policy. But as we have discussed before,

even if it cannot fully offset the effect of an adverse shift in the IS curve, monetary policy

can, by decreasing the policy rate, help reduce the adverse effects of the shift on output.



Let’s summarise.

A plan of deficit reduction may increase output even in the short run. Whether it does or

Note how far we have moved from the ➤ does not depends on many factors:

results of Chapter 3, where, by choosing

spending and taxes wisely, the government could achieve any level of output

it wanted. Here, even the sign of the

effect of a deficit reduction on output

is ambiguous. More on current fiscal

policy issues later (in Chapter 22).

















The credibility of the plan. Will spending be cut or taxes increased in the future as

announced?

The composition of the plan. Does the plan remove some of the distortions in the economy?

The state of government finances in the first place. How large is the initial deficit? Is this

a ‘last chance’ plan? What will happen if it fails?

Monetary and other policies. Will they help offset the direct adverse effect on demand in

the short run?



This gives you a sense both of the importance of expectations in determining the outcome

and of the complexities involved in the use of fiscal policy in such a context. And it is far more

than an illustrative example. This has been a major bone of contention in the euro area since

the beginning of 2010.

By 2010, the sharp economic downturn, together with the fiscal measures taken to limit

the fall in demand during 2009, had led to large budget deficits and large increases in government debt. There was little question that the large deficits could not go on for ever, and debt

had to be eventually stabilised. The question was: When and at what pace?

Some economists, and most of the policy makers in the euro area, believed that fiscal

consolidation had to start right away and be strong. They argued that this was essential to

convince investors that the fiscal situation was under control. They argued that, if coupled

with structural reforms to increase future output, the effect through anticipations of higher

output later would dominate the direct adverse effects of consolidation. For example, the

President of the European Central Bank, Jean Claude Trichet, said in September 2010:

[Fiscal consolidation] is a prerequisite for maintaining confidence in the credibility of

governments’ fiscal targets. Positive effects on confidence can compensate for the reduction in demand stemming from fiscal consolidation, when fiscal adjustment strategies are

perceived as credible, ambitious and focused on the expenditure side. The conditions for

such positive effects are particularly favourable in the current environment of macroeconomic uncertainty.

Others were more sceptical. They were sceptical that, in a depressed environment, the positive expectation effects would be strong. They pointed out that the policy rate was already

at the zero bound, and so monetary policy could not help much, if at all. They argued for a

slow and steady fiscal consolidation, even if it were to lead to higher levels of debt until debt

stabilised.

The debate became known as the fiscal multipliers debate. Those in favour of strong consolidation argued that the fiscal multipliers, that is the net effects of fiscal consolidation once

direct and expectation effects were taken into account, were likely to be negative. Smaller

deficits would lead, other things being equal, to an increase in output. Those against it argued

that fiscal multipliers were likely to be positive and possibly large. Smaller deficits would lead

to a decrease in output, or at least slow down the recovery.



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Chapter 16 Expectations, output and policy   341







Growth forecast error



5



SWE

DEU

FINMLT POL

AUT

BEL

CHE

BGR

CYP

FRA

ITA PRT

CZE

NLD

DNK

HUNESP

GBRISL

NOR SVK SPN



0



IRL



ROM



–5



Figure 16.6

GRC



–10

–2



0

2

4

Forecast of fiscal consolidation



6



Growth forecast errors

and fiscal consolidation in

Europe, 2010–11

European countries with stronger fiscal

consolidations in 2010 and 2011 had

larger negative growth forecast errors.



The sceptics turned out, unfortunately, to be right. As evidence accumulated, it became

clear that the net effect of fiscal consolidation was contractionary. The strongest piece of

evidence was the relation between forecast errors and the size of fiscal consolidation across

countries. In most euro countries, growth in 2010 and 2011 turned out to be much lower

than had been forecast. Looking across countries, these negative forecast errors were closely

correlated with the size of fiscal consolidation. As shown in Figure 16.6, which plots growth

forecast errors against a measure of fiscal consolidation, countries with larger fiscal consolidations showed a larger (negative) forecast error. This was particularly striking in the case of

Greece, but was true of other countries as well. Given that the forecasts had been constructed

using models which implied small positive multipliers, this evidence implied that the fiscal

multipliers were in fact not only positive, but larger than had been assumed. Expectation

effects did not offset the adverse direct effects of lower spending and higher taxes.



Summary





Private spending in the goods market depends on current

and expected future output and on current and expected

future real interest rates.







Expectations affect demand and, in turn, affect output.

Changes in expected future output or in the expected

future real interest rate lead to changes in spending and

in output today.







By implication, the effects of fiscal and monetary policy

on spending and output depend on how the policy affects

expectations of future output and real interest rates.







Rational expectations is the assumption that people, firms

and participants in financial markets form expectations of

the future by assessing the course of future expected policy

and then working out the implications for future output,

future interest rates, and so on. Although it is clear that

most people do not go through this exercise themselves,

we can think of them as doing so indirectly by relying on

the predictions of public and private forecasters.







Although there are surely cases in which people, firms or financial investors do not have rational expectations, the assump-



M16 Macroeconomics 85678.indd 341



tion of rational expectations seems to be the best benchmark to

evaluate the potential effects of alternative policies. Designing

a policy on the assumption that people will make systematic

mistakes in responding to it would be unwise.





The central bank controls the short-term nominal interest

rate. Spending, however, depends instead on current and

expected future real interest rates. Thus, the effect of monetary policy on activity depends crucially on whether and

how changes in the short-term nominal interest rate lead to

changes in current and expected future real interest rates.







A budget deficit reduction may lead to an increase rather

than a decrease in output. This is because expectations of

higher output and lower interest rates in the future may

lead to an increase in spending that more than offsets the

reduction in spending coming from the direct effect of

the deficit reduction on total spending. Whether it does

depends on the pace, the credibility, the nature of the

deficit reduction and the ability of monetary policy to

accommodate and to sustain demand. These conditions

were not satisfied in Europe in the 2010s.



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342  extensions expectations



Key terms

aggregate private spending,

or private spending 331



animal spirits 335



adaptive expectations 335



credibility 338



static expectations 335



backloading 338



fiscal multipliers 341



rational expectations 335



Questions and problems

Quick Check

All ‘Quick check’ questions and problems are available on

MyEconLab.

1.Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly.

a. Changes in the current one-year real interest rate are likely

to have a much larger effect on spending than changes in

expected future one-year real interest rates.

b.The introduction of expectations in the goods-market

model makes the IS curve flatter, although it is still downward sloping.



a. Why do both quotes focus on what policy will be in the

future, rather than just explain what the Fed is doing in

the present?

b.Why do you think the Fed Chairman made the second

statement?

c. On 25 January 2012, while the nominal policy interest rate

was at the zero lower bound, the Fed announced an inflation target of 2%. What was the goal of this announcement?

3.For each of the changes in expectations in parts (a) to (d),

determine whether there is a shift in the IS curve, the LM curve,

both curves, or neither. In each case assume that no other exogenous variable is changing.



c. Investment depends on current and expected future interest rates.



a. A decrease in the expected future real interest rate.



d.The rational expectations assumption implies that consumers take into account the effects of future fiscal policy

on output.



c. An increase in expected future taxes.



e. Expected future fiscal policy affects expected future economic activity but not current economic activity.



4.Consider the following statement: ‘The rational expectations

assumption is unrealistic because, essentially, it amounts to the

assumption that every consumer has perfect knowledge of the

economy.’ Discuss.



f. Depending on its effect on expectations, a fiscal contraction may actually lead to an economic expansion.

g. Ireland’s experience with deficit reduction plans in 1982

and 1987 provides strong evidence against the hypothesis

that deficit reduction can lead to an output expansion.

h. The euro area experience in 2010 and 2011 suggests that

fiscal consolidations, through expectations, lead to substantial increases in output growth.

2.Consider these two quotes concerning recent Federal

Reserve policy



b. An increase in the current real policy interest rate.

d. A decrease in expected future income.



5.A new president, who promised during the campaign that

she would cut taxes, has just been elected. People trust that she

will keep her promise, but expect that the tax cuts will be implemented only in the future. Determine the impact of the election

on current output, the current interest rate and current private

spending under each of the assumptions in parts (a) to (c). In

each case, indicate what you think will happen to Y =e, r =e and

T =e, and then how these changes in expectations affect output

today.



On 12 December 2012, the Federal Reserve issued the following statement: ‘In particular, the Committee decided to keep

the target range for the federal funds rate at 0 to 1/4 percent

and currently anticipates that this exceptionally low range for

the federal funds rate will be appropriate at least as long as the

unemployment rate remains above 6.5 percent.’



a. The Fed will not change its current real policy interest rate.



On 10 July 2013, Ben Bernanke, Chairman of the Federal

Reserve, said: ‘There will not be an automatic increase in interest rate when unemployment hits 6.5%.’



6.The Irish deficit reduction packages



M16 Macroeconomics 85678.indd 342



b.The Fed will act to prevent any change in current and

future output.

c. The Fed will not change either the current real policy

interest rate or the future real policy interest rate.



The last Focus box above provides an example of fiscal consolidation. Ireland had a large budget deficit in 1981 and 1982.



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Chapter 16 Expectations, output and policy   343







a. What does a deficit reduction imply for the medium run

and the long run? What are the advantages of reducing the

deficit?

b.The box discusses two deficit reduction plans. How did

they differ?

c. The box presents evidence that the two deficit reduction

plans had different effects on household expectations.

What is that evidence?

d. Although the data shows strong output growth from 1987

to 1989, there is some evidence of continued macroeconomic weakness in Ireland during the second fiscal consolidation. What is that evidence?



Dig Deeper

All ‘Dig deeper’ questions and problems are available on

MyEconLab.

7.A new Federal Reserve chairman

Suppose, in a hypothetical economy, that the chair of the Fed

unexpectedly announces that he will retire in one year. At the

same time, the US president announces her nominee to replace

the retiring Fed chair. Financial market participants expect the

nominee to be confirmed by the US Congress. They also believe

that the nominee will conduct a more contractionary monetary

policy in the future. In other words, market participants expect

the policy interest rate to increase in the future.

a. Consider the present to be the last year of the current Fed

chair’s term and the future to be the time after that. Given

that monetary policy will be more contractionary in the

future, what will happen to future interest rates and future

output (at least for a while, before output returns to its

natural level)? Given that these changes in future output

and future interest rates are predicted, what will happen

to output and the interest rate in the present? What will

happen to the yield curve on the day of the announcement

that the current Fed chair will retire in one year?

Now suppose that instead of making an unexpected announcement, the Fed chair is required by law to retire in one year (there

are limits on the term of the Fed chair), and financial market

participants have been aware of this for some time. Suppose, as

in part (a), that the president nominates a replacement who is

expected to raise interest rates more than the current Fed chair.

b. Suppose financial market participants are not surprised

by the president’s choice. In other words, market participants had correctly predicted who the president would

choose as nominee. Under these circumstances, is the

announcement of the nominee likely to have any effect

on the yield curve?



M16 Macroeconomics 85678.indd 343



c. Suppose instead that the identity of the nominee is a surprise and that financial market participants had expected

the nominee to be someone who favoured an even more

contractionary policy than the actual nominee. Under

these circumstances, what is likely to happen to the yield

curve on the day of the announcement? (Hint: Be careful.

Compared with what was expected, is the actual nominee

expected to follow a more contractionary or more expansionary policy?)

d.On 9 October 2013, Janet Yellen was nominated to succeed Ben Bernanke as Chair of the Federal Reserve. Do an

Internet search and try to learn what happened in financial

markets on the day the nomination was announced. Were

financial market participants surprised by the choice? If

so, was it believed that Janet Yellen would favour policies

that would lead to higher or lower interest rates (as compared with the expected nominee) over the next three to

five years? (You may also do a yield curve analysis of the

kind described in Problem 8 for the period around Janet

Yellen’s nomination. If you do this, use one- and five-year

interest rates.)



Explore Further

8.Deficits and fiscal consolidation

As seen in the following table for fiscal consolidation in the

United States, 2009–14, the crisis left the country with an enormous federal budget deficit in 2009.

There was a substantial fiscal consolidation from 2011 onwards

yet real output continued to grow.

Year



Receipts

(% of GDP)



Outlays

(% of GDP)



Surplus or

deficit ( - )

(% of GDP)



Growth in

real GDP

(%)



2008

2009

2010

2011

2012

2013

2014



17.1

14.6

14.6

15.0

15.3

16.7

17.5



20.2

24.4

23.4

23.4

22.1

20.8

20.3



- 3.1

- 9.8

- 8.7

- 8.5

- 6.8

- 4.1

- 2.8



- 0.3

- 2.8

2.5

1.6

2.3

2.2

2.4



Source: Table B-1, Table B-20, Economic Report of the President 2015.



a.Which played a larger role in the fiscal consolidation,

raising taxes or reducing outlays?

b. In terms of the language of the text, if this fiscal consolidation was anticipated as of 2009, was it ‘backloaded?’ How

might this help minimise the effects of the fiscal consolidation on output growth?



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344  extensions expectations

c. We know from Problem 2 and from Chapters 4 and 6 that

monetary policy maintained the nominal policy rate of

interest of close to 0% throughout this period and promised to maintain low interest rates into the future. How

would this policy framework have helped the fiscal consolidation to take place without a decline in output?

d.The Federal Reserve introduced a target rate of inflation

during the consolidation period on 25 January 2012. What

is one advantage of introducing a policy where inflation is



targeted at 2% during a period of zero interest rates and

fiscal consolidation?

e. We used the University of Michigan’s Index of Consumer

Sentiment in the previous chapter as a measure of expectations of households about the future. You can look at the

values of this index at the FRED database maintained by

the Federal Reserve Bank of St. Louis (series UMCSENT1).

Find this index and comment on its evolution from 2010

to 2014 as the fiscal consolidation proceeded.



Log on to MyEconLab and complete the study plan exercises for this chapter to see

how much you have learnt, and where you need to revise most.



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The open economy

The next four chapters cover the second extension of the core. They look at the implications of openness – the fact that most economies trade both goods and assets with the rest of the world.



Chapter 17

Chapter 17 discusses the implications of openness in goods markets and financial markets. Openness

in goods markets allows people to choose between domestic goods and foreign goods. An important

determinant of their decisions is the real exchange rate – the relative price of domestic goods in terms

of foreign goods. Openness in financial markets allows people to choose between domestic assets and

foreign assets. This imposes a tight relation between the exchange rate, both current and expected, and

domestic and foreign interest rates – a relation known as the interest parity condition.



Chapter 18

Chapter 18 focuses on equilibrium in the goods market in an open economy. It shows how the demand

for domestic goods now depends also on the real exchange rate. It shows how fiscal policy affects both

output and the trade balance. It discusses the conditions under which a real depreciation improves the

trade balance and increases output.



Chapter 19

Chapter 19 characterises goods and financial markets’ equilibrium in an open economy. In other words,

it gives an open economy version of the IS–LM model we saw in the core. It shows how, under flexible

exchange rates, monetary policy affects output not only through its effect on the interest rate, but also

through its effect on the exchange rate. It shows how fixing the exchange rate also implies giving up the

ability to change the interest rate.



Chapter 20

Chapter 20 looks at the properties of different exchange rate regimes. It first shows how, in the medium

run, the real exchange rate can adjust even under a fixed exchange rate regime. It then looks at exchange

rate crises under fixed exchange rates and at movements in exchange rates under flexible exchange

rates. It ends by discussing the pros and cons of various exchange rate regimes, including the adoption

of a common currency such as the euro.



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Chapter



17



Openness in goods

and ­financial markets

We have assumed until now that the economy we looked at was closed, that is it did not interact

with the rest of the world. We had to start this way to keep things simple and to build up intuition for the basic macroeconomic mechanisms. Figure 17.1, which repeats for convenience the

first figure in the text, Figure 1.1, shows how bad, in fact, this assumption is. The figure plots

the growth rates for advanced and emerging economies since 2005. What is striking is how the

growth rates have moved together. Despite the fact that the crisis originated in the United States,

the outcome was a worldwide recession with negative growth in both advanced and emerging

economies. It is therefore time to relax our closed economy assumption. Understanding the

macroeconomic implications of openness will occupy us for this and the next three chapters.

Openness has three distinct dimensions:

1. Openness in goods markets, which is the ability of consumers and firms to choose between

domestic goods and foreign goods. In no country is this choice completely free of restrictions.

Even the countries most committed to free trade have tariffs – taxes on imported goods – and

quotas – restrictions on the quantity of goods that can be imported – on at least some foreign

15



Emerging market and developing economies



Figure 17.1

Growth in advanced and

emerging economies since

2005

The crisis started in the United States,

but it affected nearly all countries in

the world.

Source: World Economic Outlook Database.



M17 Macroeconomics 85678.indd 346



Per cent change



10



5



0



World

–5



Advanced economies

–10

2005



2006



2007



2008



2009



2010



2011



2012



2013



2014



2015



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Chapter 17  Openness in goods and ­financial markets   347







goods. At the same time, in most countries, average tariffs are low and getting

lower.

2. Openness in financial markets is the ability of financial investors to choose

between domestic assets and foreign assets. Until recently even some of the richest countries in the world, such as France and Italy, had capital controls, which

are restrictions on the foreign assets their domestic residents could hold and

the domestic assets foreigners could hold. These restrictions have largely disappeared. As a result, world financial markets are becoming more closely integrated.

3. Openness in factor markets is the ability of firms to choose where to locate

production, and of workers to choose where to work. Here also trends are clear.

Multinational companies operate plants in many countries and move their operations around the world to take advantage of low costs. In Europe, immigration from

low-wage countries is a hot political issue, as well as the relocation of European

firms to new member states of the EU. In North America, much of the debate

about the North American Free Trade Agreement (NAFTA) signed in 1993 by

the United States, Canada and Mexico centred on how it would affect the relocation of US firms to Mexico. Similar fears have centred on China, where many

European and US firms relocated to benefit from lower production costs due to

fiscal and factor advantages, and to be able to serve the more dynamic market in

the world.

In the short run and in the medium run – the focus of this and the next three chapters –

openness in factor markets plays much less of a role than openness in either goods

markets or financial markets. Thus, we shall ignore openness in factor markets and

focus on the implications of the first two dimensions of openness here.





Section 17.1 looks at openness in the goods market, the determinants of the

choice between domestic goods and foreign goods, and the role of the real

exchange rate.







Section  17.2 looks at openness in financial markets, the determinants of the

choice between domestic assets and foreign assets, and the role of interest rates

and exchange rates.







Section 17.3 gives a map to the next three chapters.



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