D. Macroeconomic shocks and policies

    Key to tracking macroeconomic events:
    focus on interest rates: rdom and rwld

Macro events shift NFI by affecting rdom or rwld (r*)     (1) Internal shocks affect rdom     (2) External shocks affect rwld (r*)     Internal shocks start in the domestic sector and spill over into the foreign sector.     External shocks originate in the foreign sector and influence the domestic economy via NX, one of the four key components of the economy's aggregate demand.

1. Internal shocks

    Focuses on internal workings of the economy
        (1) business cycles
        (2) stabilization policies by the government

    Context: how macroeconomic stabilization works in an open economy
        SR deviations from the LR equilibrium

    The SR matters because nearly everything interesting about macroeconomic stabilization policies (trying to maintain Yf and stable prices) concerns SR deviations from a LR equilibrium.
    Without a SR there would be no business cycles--we would just move directly from one full-employment equilibrium to another.

    SR exists because of different speeds of adjustment of key macro variables.
    Example 1: If prices rose and fell just as quickly as the money supply, the real money supply would never change, so there would be no effect at all of monetary policy (MP)
    Example 2: If higher government spending immediately crowded out an equal amount of other spending, then fiscal policy (FP) would never cause output to deviate from its full-employment level

    But empirically, monetary and fiscal policies do have real effects, and it is the purpose of macroeconomics to understand them. Those effects come from differential adjustment rates.

    Key to SR effects in open-economy macroeconomics:
    Financial assets adjust faster than goods and services

    Our SR focus--the impact (immediate) effect of policies
    the immediate SR effect as asset markets respond to the policies

    Review of macroeconomic policies

    Summary of policy effects on Y and r:

Policy tools:	Fiscal Policy	Monetary Policy
Expansionary	hG, iT g hY, hr	iRRR,  idiscount rate buy bonds g hY, ir
Contractionary	iG, hT g iY, ir	hRRR, hdiscount rate sell bonds g iY, hr

    One extra complication: Like SR vs LR for a closed economy, we need to consider SR vs LR policy effects in the foreign sector as well.
    Fortunately, means just one more curve to add.

Short-run NX: NX     Location: LR equilibrium point     Slope: steeper than NXLR because trade is less elastic in the SR than in the LR     SR equilibrium above NXLR => R>RLR & r>r*     SR equilibrium below NXLR => R<RLR & r<r*

    The LR assumption of fully adjusted output markets doesn't hold in the SR
    Why less elastic in SR?
    (1) Passing ER changes on in domestic currency prices takes awhile
    Example1: dollar plunged vs. yen in late 1994, but only after several months did Chrysler lower Jeep prices in yen (by 10%, end of March 1995)
    Example2: dollar fell against the euro by 11.5% in 2007, but european exporters cut costs rather than raised prices
    (2) Executing existing contracts and finding new suppliers take time.
    Example: You'll switch to a foreign car, but not until the next time you buy one..
    (3) ER changes prompt entry and exit decisions involving tradable products, and those take even more time.

    Like SRAS v LRAS in macro:
    SR shows you where your actual current equilibrium is.
    LR shows you where you'll end up eventually

a. Monetary policy (MP)

    Example: Expansionary MP

Closed:	ExpMPg ir g	hI g hY
Open:		and iR which g hNX g hY

? Which direction does NFI shift?     ? Impact on R, NX?     (1) SR: +Smoney --> -rdom     (2) LR: offsetting inflation         --> real Smoney shifts back

    Note: In LR, price effects will cause this process to reverse =>Monetary policy is neutral in the long run -- true for both domestic and foreign sector effects

    Note2: Real depreciation can make expansionary MP a beggar-thy-neighbor policy: +NX => -NXfor
        A key reason for policy coordination: Group of 8 meets 2x a year for that purpose.

b. Fiscal policy (FP)

    Look at changes in government purchases or taxes. The analysis works just as well for any other initial spending shock to the economy.

    Example: Expansionary FP (Reaganomics--the twin deficits)

? Which direction does NFI shift?     ? Impact on R, NX?

    Recap of expansionary FP: See FP handout