The following events occurred one day in November.

Transcription

1 3814_35_c35_ qxd 12/21/6 1:15 AM Page 753 chapter International Impacts 35 on the Economy Setting the Scene The following events occurred one day in November. 1:24 A. M. Janis Kendrickson owns a small company in the United States that produces bedroom furniture. During many months, about 15 percent of the furniture she produces is purchased by people living in France and Germany. Recently, Real GDP has declined in both France and Germany. As a result, Janis is worried. 2:32 P. M. A U.S. senator is sitting in his office reading The Wall Street Journal.The particular story he is currently reading is about the depreciation of the U.S. dollar.the senator believes that because of the U.S. dollar depreciating, the United States will sell more exports, buy fewer imports, and thus increase U.S. net exports.there is one SUSAN GOLDMAN/BLOOMBERG NEWS/LANDOV problem, though:the story in The Journal says that Americans are spending more not less on imports.the senator is wondering if he understands economics well enough. 4:15 P. M. Two economics professors at a college in the Midwest are sitting down talking and drinking coffee. One professor says that she thinks the nation s expansionary monetary policy will raise Real GDP (in the short run) by about 1/2 of 1 percent.the other professor says that she thinks Real GDP will rise by slightly more.the first professor says to the second professor: So, you think international effects will be stronger? 8:43 P. M. Tanya is watching a cable TV news show. The guests on the show are talking about interest rates in Japan.As they talk,tanya is thinking of switching to another channel. She thinks: What do interest rates in Japan have to do with me?? Here are some questions to keep in mind as you read this chapter: What does Janis have to be worried about? Does the senator understand economics well enough? What does the effectiveness of monetary policy at changing Real GDP have to do with international effects? What do interest rates in Japan have to do with Tanya? See analyzing the scene at the end of this chapter for answers to these questions.

2 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters International Factors and Aggregate Demand Earlier chapters describe the factors that can change aggregate demand and thus affect the U.S. economy. Changes that occur in other countries can also influence the U.S. economy. This section discusses two key international factors that can affect the U.S. economy by first affecting U.S. aggregate demand. Net Exports In an earlier chapter, net exports are defined as the difference between exports (EX) and imports (IM). For example, if exports are $8 billion and imports are $6 billion, then net exports are $2 billion. Also, recall that if net exports rise, the AD curve shifts to the right; if net exports fall, the AD curve shifts to the left. Now we discuss two factors that can change net exports: (1) foreign Real GDP and (2) the exchange rate.to simplify matters, we assume there are only two countries in the world: the United States and Japan.With respect to these two countries, let s consider the two factors. FOREIGN REAL GDP (OR FOREIGN REAL NATIONAL INCOME) As Japan s Real GDP (or real national income) rises, the Japanese buy more U.S. goods so U.S. exports rise. As a result, U.S. net exports rise, and the AD curve shifts to the right. As Japan s Real GDP falls, the Japanese buy fewer U.S. goods so U.S. exports fall. As a result, U.S. net exports fall, and the AD curve shifts to the left. This is how economic expansions and contractions in other countries are felt in the United States. Suppose there is a contraction in Japan.With a lower Real GDP in Japan, the Japanese buy fewer U.S. goods. U.S. exports fall and so do net exports. As a result, the AD curve in the United States shifts to the left. Because the AD curve shifts to the left, Real GDP in the United States falls. FAROOQ NAEEM/AFP/GETTY IMAGES EXCHANGE RATE Recall that the exchange rate is the price of one country s currency in terms of another country s currency. If a country s currency appreciates, it takes less of that country s currency to buy another country s currency. On the other hand, if a country s currency depreciates, it takes more of that country s country to buy another country s currency. What do appreciation and depreciation do to the prices of a country s goods? If, say, the U.S. dollar depreciates relative to the Japanese yen, U.S. residents have to pay more dollars to buy Japanese goods.to illustrate, suppose the dollar price of a yen is $.12 and that a Toyota is priced at 2 million yen. At this exchange rate, a U.S. resident pays $24, for a Toyota ($.12 x 2 million yen $24,). If the dollar depreciates to $.18 for 1 yen, then the U.S. resident will have to pay $36, for a Toyota. As the dollar depreciates, Japanese goods become more expensive for U.S. residents, so they buy fewer Japanese goods; thus, U.S. imports decline. 1 The other side of the coin is that as the dollar depreciates relative 1 Throughout this chapter, unless otherwise explicitly stated, we assume that if the physical quantity of exports rises (falls), the total spending on exports rises (falls). Also, if the physical quantity of imports rises (falls), the total spending on imports rises (falls). Because of this assumption, it will not be necessary to differentiate constantly between the physical quantity of imports and the total spending on imports. Given our assumption, they go up and down together. One place where we explicitly drop this assumption is in the discussion of the J-curve.

3 3814_35_c35_ qxd 12/21/6 1:15 AM Page 755 International Impacts on the Economy Chapter to the yen, the yen appreciates relative to the dollar. This means U.S. goods become less expensive for the Japanese, and they buy more U.S. goods so U.S. exports rise. In summary, a depreciation in the dollar and an appreciation in the yen will raise U.S. exports, lower U.S. imports, and therefore, raise U.S. net exports. This shifts the U.S. AD curve to the right, leading to a rise in the level. The series of events are symmetrical if the U.S. dollar appreciates relative to the Japanese yen. In this case, U.S. goods become more expensive for the Japanese, causing them to buy fewer U.S. goods so U.S. exports would fall. And Japanese goods become cheaper for U.S. residents, causing them to buy more Japanese goods so U.S. imports would rise. A decline in U.S. exports, along with a rise in U.S. imports, will cause U.S. net exports to fall.the U.S. AD curve shifts to the left, leading to a decline in U.S. Real GDP. For a quick review of the international factors that can shift the U.S. AD curve, see Exhibit 1. The J-Curve In our analysis so far, we have assumed that if the dollar depreciates relative to the Japanese yen, U.S. residents and the Japanese will buy more U.S. goods and fewer Japanese goods.thus, U.S. exports rise, U.S. imports fall, and therefore, U.S. net exports rise. But this scenario may not happen initially.there may be a difference between what initially happens and what ultimately happens. To illustrate, suppose U.S. residents are currently buying 1, cars from the Japanese, the average Japanese car sells for 2 million yen, and the exchange rate is currently $.12 per yen. This means U.S. residents are spending an average of $24, a car for 1, cars. Thus, a total of $2.4 billion is spent on imported Japanese cars. Now suppose the exchange rate changes, and the dollar depreciates to $.18 per yen. This causes the average price of a Japanese car to be $36,. At this higher price, U.S. residents buy fewer Japanese cars, but suppose they don t buy that many fewer initially. Instead of buying 1, cars, they initially buy 9, cars. Now a total of $3.24 billion is spent on imported Japanese cars. Instead of declining after a depreciation in the dollar, U.S. spending on imports has initially risen. If we assume U.S. exports have not changed yet, a rise in U.S. imports will lead to a fall in U.S. net exports and cause the U.S. AD curve to shift to the left. But will this situation last? Not likely. In time, U.S. residents will switch from the higher priced Japanese goods to lower priced U.S. goods. For example, in time, U.S. residents purchase only 6, Japanese cars. At this number, with the exchange rate of exhibit 1 Original AD curve AD 3 Leftward shift in U.S. AD curve brought on by 1. Decrease in Japan s Real GDP 2. Appreciation in the dollar Rightward shift in U.S. AD curve brought on by 1. Increase in Japan s Real GDP 2. Depreciation in the dollar International Impacts on the U.S. AD Curve Anything that increases U.S. net exports shifts the U.S. AD curve to the right. This includes an increase in Japan s Real GDP (in a two-country world, where the two countries are Japan and the United States) and a depreciation in the dollar. Anything that decreases U.S. net exports shifts the U.S. AD curve to the left. This includes a decrease in Japan s Real GDP and an appreciation in the dollar.

4 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters J-Curve The curve that shows a short-run worsening in net exports after a currency depreciation, followed later by an improvement. Thinking like AN ECONOMIST The discussion of the J-curve points out that economists sometimes think in terms of both the short run and the long run. Does the depreciation of a country s currency lead to an increase or a decrease in import spending? Well, according to the J-curve theory, the answer is both an increase and a decrease. Imports increase initially, but in the long run, they decrease. It is important to know that an economist s answers may be different depending on the time horizon under consideration. exhibit 2 $.18 per yen, U.S. spending on imported Japanese cars is $2.16 billion. In time, too, U.S. exports will rise, and the combination of rising exports and falling imports will lead to an increase in net exports.the U.S. AD curve will shift to the right. This phenomenon in which import spending initially rises after a depreciation and then later falls is summarized in the J-curve, so called because a curve showing the change in net exports due to a currency depreciation has the shape of a J. We explain with Exhibit 2. Suppose the United States initially has negative net exports of $4 billion (its imports of $13 billion are greater than its exports of $9 billion). This position is represented by point A in the exhibit. Next, the dollar depreciates relative to the yen. Total spending on imports rises to, say, $15 billion, so net exports rise to $6 billion. This is represented by point B. In time, though, exports rise to, say, $1 billion and imports fall to, say, $1 billion, making net exports equal to zero. This is represented by point C. If we start at point A and draw a line to point B and then to point C, we have a J-curve. This is the route that net exports may take after a depreciation in a country s currency. SELF-TEST (Answers to Self-Test questions are in the Self-Test Appendix.) 1. Explain how an economic boom in one country can be felt in another country. 2. Predict and explain what will happen to if the dollar appreciates relative to the Japanese yen. International Factors and Aggregate Supply Just as international factors can affect the demand side of the U.S. economy, certain international factors can affect the supply side of the U.S. economy. This section discusses a few international factors that can shift the U.S. aggregate supply curve. Foreign Input Prices In an earlier chapter, we stated that a change in the price of inputs will shift the shortrun aggregate supply (SRAS) curve. For example, if the price of labor (wage rate) rises, the SRAS curve shifts leftward. The J-Curve The United States starts with net exports of $4 billion. As the dollar depreciates, net exports increase to $6 billion. With time, net exports become $. If we follow the course of net exports, we map out a J. This is called the J-curve. Net Exports (exports imports) $4b $6b A B C J-Curve Time

5 3814_35_c35_ qxd 12/21/6 1:15 AM Page 757 American producers buy inputs not only from other Americans but also from foreigners. A rise in the price of foreign inputs leads to a leftward shift in the U.S. SRAS curve. A fall in the price of foreign inputs leads to a rightward shift in the U.S. SRAS curve. Why Do Foreign Input Prices Change? What could cause a rise in the price of foreign inputs? First, supply and demand in the input market in the foreign country could change. For example, suppose U.S. producers buy input X from Japan. The supply of X in Japan could fall, or the demand for X in Japan could rise. Either or both changes would increase the price of X for U.S. producers. THE EXCHANGE RATE A change in the exchange rate between the dollar and the yen could change the price for a foreign input. For example, a depreciation in the dollar relative to the yen would make input X more expensive for U.S. producers. An appreciation in the dollar would make input X less expensive for U.S. producers. Exhibit 3 presents a summary of the points in this section. Factors That Affect Both Aggregate Demand and Aggregate Supply Changes in some international factors can affect both aggregate demand and short-run aggregate supply in the United States. Two of these factors are the exchange rate and relative interest rates. The Exchange Rate As we have discussed, changes in exchange rates affect both the AD and SRAS curves. The overall, or net, effect on Real GDP depends on how much the AD curve shifts relative to the shift in the SRAS curve.we consider two cases: dollar depreciation and dollar appreciation. DOLLAR DEPRECIATION Suppose the dollar depreciates.this shifts the AD curve rightward and the SRAS curve leftward. If the AD curve shifts rightward by more than the SRAS International Impacts on the Economy Chapter Q&A Earlier in the chapter, it stated that a change in the exchange rate could change the AD curve. Now it is said that a change in the exchange rate can change the SRAS curve too. If a change in the exchange rate affects both the AD curve and the SRAS curve, what is the overall effect on the economy? It depends on how much the AD curve shifts relative to the SRAS curve. We explain this in the next section. Before we take up this subject, we need to emphasize the difference between the two ways foreign input prices can change. A change in the exchange rate can affect both the AD and SRAS curves. But if a change in the price of foreign inputs is due to a change in market conditions in the foreign country and not to a change in the exchange rate then only the SRAS curve changes.to illustrate, if U.S. producers buy input X from Japan and the price of input X (to Americans) rises due to the depreciation of the dollar, this depreciation will affect both the SRAS curve and the AD curve. But if the price of input X (to Americans) rises due to, say, a decrease in the supply of input X in the foreign country, then only the SRAS curve is affected. exhibit 3 Original SRAS curve SRAS 3 Rightward shift in U.S. SRAS curve brought on by 1. Decrease in foreign input prices 2. Appreciation in the dollar Leftward shift in U.S. SRAS curve brought on by 1. Increase in foreign input prices 2. Depreciation in the dollar International Impacts on the U.S. SRAS Curve The U.S. SRAS curve shifts if foreign input prices change. If foreign input prices rise, the U.S. SRAS curve shifts leftward; if foreign input prices fall, the SRAS curve shifts rightward. Similarly, if the dollar depreciates, foreign inputs become more expensive and the SRAS curve shifts leftward. If the dollar appreciates, foreign inputs become cheaper and the SRAS curve shifts rightward

6 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters curve shifts leftward, Real GDP rises (see Exhibit 4(a)). If the AD curve shifts rightward by less than the SRAS curve shifts leftward, Real GDP falls (see Exhibit 4(b)). If the AD curve shifts rightward by the same amount that the SRAS curve shifts leftward, Real GDP does not change (see Exhibit 4c). In each of these three cases, the price level rises. In summary, dollar depreciation raises the price level and may accompany an increasing, decreasing, or constant Real GDP. DOLLAR APPRECIATION Suppose the dollar appreciates. This shifts the AD curve leftward and the SRAS curve rightward. Once again, what happens to Real GDP depends on the relative shifts of the two curves. If the AD curve shifts leftward by more than the SRAS curve shifts rightward, Real GDP falls. If the AD curve shifts leftward by less than the SRAS curve shifts rightward, Real GDP rises. If the AD curve shifts leftward by the same amount that the SRAS curve shifts rightward, Real GDP does not change. In each case, though, the price level falls. In summary, dollar appreciation lowers the price level and may accompany an increasing, decreasing, or constant Real GDP. exhibit 4 Depreciation in the Dollar: Effects on the and Real GDP A change in exchange rates affects both aggregate demand and shortrun aggregate supply. If the dollar depreciates, the AD curve shifts rightward and the SRAS curve shifts leftward. The overall impact on Real GDP up, down, or unchanged depends on whether the AD curve shifts rightward by (a) more, (b) less, or (c) an amount equal to the leftward shift in the SRAS curve. In all three cases, dollar depreciation leads to a higher price level. What Role Do Interest Rates Play? Again we assume a two-country world with only the United States and Japan. Suppose real interest rates rise in the United States while they remain constant in Japan. The higher real interest rates in the United States will attract foreign capital (in search of the highest return possible). Because foreigners will be interested in dollar-denominated assets that pay interest, they will have to exchange their country s currency for U.S. dollars. This will increase the demand for U.S. dollars and lead to an appreciation in the dollar. What happens next? If the dollar appreciates, we know that both the U.S. AD and SRAS curves are affected.the AD curve shifts leftward and the SRAS curve shifts rightward. As we learned earlier, the effect on Real GDP depends on the relative shifts in the two curves. Many economists argue, however, that given the interest rate differential discussed here, the AD curve typically tends to shift leftward by more than the SRAS curve shifts rightward, and thus, Real GDP falls (see Exhibit 5(a)). In summary, typically, a rise in real interest rates in the United States relative to foreign interest rates tends to decrease. Now suppose real interest rates fall in the United States relative to interest rates in Japan. The higher real interest rate in Japan attracts capital to Japan. The demand for yen rises, and as a result, the yen appreciates and the dollar depreciates. A depreciated dollar P 2 2 P 2 2 P 2 2 P 1 1 P 1 1 P 1 1 Q 1 Q 2 (a) Q 2 Q 1 (b) Q 1 (c)

7 3814_35_c35_ qxd 12/21/6 1:15 AM Page 759 International Impacts on the Economy Chapter exhibit 5 2 Q 2 Q 1 (a) Higher Real Interest Rates in the United States 1 Q 1 Q 2 (b) Lower Real Interest Rates in the United States shifts the U.S. AD curve rightward and the SRAS curve leftward (see Exhibit 5(b)). Many economists argue that given the interest rate differential discussed here, the AD curve typically tends to shift rightward by more than the SRAS curve shifts leftward, and thus, Real GDP rises. In summary, typically, a fall in real interest rates in the United States relative to foreign interest rates tends to increase. 1 2 International Interest Rates, Exchange Rates, and Real GDP (a) If the U.S. real interest rate is higher than the Japanese real interest rate, capital will flow from Japan to the United States. In the process, the demand for the dollar rises, and the dollar appreciates. Dollar appreciation causes the AD curve to shift leftward by more than the SRAS curve shifts rightward, which is typical given the initial event. As a result, falls. (b) If the U.S. real interest rate is lower than the Japanese real interest rate, capital will flow from the United States to Japan. In the process, the demand for yen rises, the supply of dollars rises, and the yen appreciates and the dollar depreciates. Dollar depreciation causes the AD curve to shift rightward and the SRAS curve to shift leftward. We have drawn the AD curve shifting rightward by more than the SRAS curve shifts leftward, which is typical given the initial event. As a result, rises. SELF-TEST 1. How do foreign input prices affect the U.S. SRAS curve? 2. What is the effect on the U.S. price level of lower real interest rates in Japan than in the United States? Explain your answer. Deficits: International Effects and Domestic Feedback Deficits in the United States both budget and trade deficits affect the U.S. economy. Earlier chapters explored how the budget deficit can directly affect the U.S. economy. But the budget deficit can also have international effects. Might these international effects have domestic feedback that also affects the U.S. economy? This section looks at the possibilities of international feedback effects and the relationship between the budget deficit and the trade deficit. The Budget Deficit and Expansionary Fiscal Policy Suppose North Dakotans want their elected representatives in Congress to push for a particular spending program that will assist them and no one else. Their elected representatives oblige them. Congress passes the spending program but does not raise the taxes necessary to pay for it. Does this domestic action affect the international economic scene? It certainly could.the following is a scenario in which it would. Start with a budget deficit. Congress then passes the spending program to help North Dakotans but neither raises taxes to finance the program nor cuts any other spending programs on the books. As a result of these actions one more spending program, no fewer spending programs, and no more taxes the budget deficit grows.

8 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters To finance the growing budget deficit, the U.S. Treasury borrows more funds in the credit (or loanable funds) market than it would have borrowed if the latest spending program had not been passed.the increased demand for credit raises the real interest rate. The higher U.S. interest rate attracts foreign capital. The demand for dollars in the foreign exchange market rises, and the dollar appreciates. As this happens, the U.S. AD curve shifts leftward and the SRAS curve shifts rightward. The AD curve shifts leftward by more than the SRAS curve shifts rightward, putting downward pressure on Real GDP. Does Real GDP actually decrease? Before we answer, consider that we have only discussed how a rising budget deficit affects the exchange rate (via the interest rate) and feeds back in the domestic economy.the direct effect of the rising budget deficit on the domestic economy also needs to be considered. In an earlier chapter, we noted that, under certain conditions (e.g., zero crowding out), expansionary fiscal policy raises aggregate demand and is effective at raising Real GDP. So we have this situation: 1. The rising budget deficit affects the domestic economy directly and pushes Real GDP upward. 2. But increased deficit financing raises U.S. interest rates and prompts increased foreign capital inflows, an increased demand for dollars, and dollar appreciation. Under typical conditions, an appreciated dollar feeds back into the domestic economy and pushes Real GDP downward. Closed Economy An economy that does not trade goods and services with other countries. Open Economy An economy that trades goods and services with other countries. Obviously, what happens on net depends on how strong the international feedback effects are on the domestic economy. Are they strong enough to offset the initial expansionary push in Real GDP? Even if the international feedback effects on the domestic economy do not outweigh the initial expansionary push (upward) in Real GDP, and Real GDP rises on net, we can still conclude that expansionary fiscal policy raises Real GDP more in a closed economy than in an open economy.this is because in a closed economy the international feedback effects that reduce Real GDP (see point 2 earlier) are absent. Exhibit 6(a) illustrates our point. With zero crowding out, expansionary fiscal policy shifts the aggregate demand curve from to. But because of the higher interest rates, increased foreign capital inflows, and dollar appreciation, the AD curve shifts leftward from to AD 3, and the SRAS curve shifts rightward from to. In a closed economy, Real GDP rises from Q 1 to Q 2. In an open economy, where international feedback effects play a role, Real GDP ends up at a lower level, Q 3. The Budget Deficit and Contractionary Fiscal Policy In the previous section, we learned that expansionary fiscal policy raises Real GDP more in a closed economy than in an open economy. But what about contractionary fiscal policy? Are its effects different depending on whether it is initiated in a closed or open economy? Suppose government spending is reduced, thus reducing the budget deficit. With a diminished budget deficit, the U.S. Treasury borrows fewer funds in the credit market than it would have borrowed if government spending had not been reduced. The decreased demand for loanable funds lowers the real interest rate. The lower U.S. interest rate (relative to foreign interest rates) makes foreign assets seem more desirable.the demand for foreign currencies increases, and the dollar depreciates in value. As this happens, the U.S. AD curve shifts to the right and the SRAS curve shifts to the left. The AD curve shifts rightward by more than the SRAS curve shifts leftward, putting upward pressure on Real GDP. Does Real GDP actually increase? Perhaps not because we haven t yet considered the effect of the lower budget deficit (due to the reduction in government spending) on

9 3814_35_c35_ qxd 12/21/6 1:15 AM Page 761 International Impacts on the Economy Chapter exhibit 6 Starting Point A C (a) B Q 1 Q 3 Q 2 Open Economy AD 3 Closed Economy the domestic economy. Under certain conditions, a cut in government spending reduces aggregate demand and therefore reduces Real GDP. So we have this situation: Closed Economy B C Open Economy (b) A Q 2 Q 3 Q 1 AD 3 Starting Point Expansionary and Contractionary Fiscal Policy in Open and Closed Economies (a) The consequences of expansionary fiscal policy for both open and closed economies. Congress passes a spending program without raising taxes, and the AD curve shifts from to. To finance the growing budget deficit, the Treasury borrows more funds in the loanable funds market, and the interest rate rises. The higher interest rate attracts foreign capital and causes the dollar to appreciate. As the dollar appreciates, the AD curve shifts from to AD 3, and the SRAS curve shifts from to. Real GDP goes from Q 1 to Q 2 in a closed economy, and from Q 1 to Q 3 in an open economy. Expansionary fiscal policy raises Real GDP more in a closed economy than in an open economy. (b) Contractionary fiscal policy lowers Real GDP more in a closed economy than in an open economy. 1. The cut in government spending reduces the budget deficit and affects the domestic economy directly, pushing Real GDP downward. 2. But reduced deficit financing lowers U.S. interest rates and prompts increased capital outflows, increased demand for foreign currencies, and dollar depreciation. Under typical conditions, a depreciated dollar feeds back into the domestic economy and pushes Real GDP upward. What happens on net depends on how strong the international feedback effects are on the domestic economy. Are they strong enough to offset the initial contractionary push in Real GDP? Even if the international feedback effects on the domestic economy do not outweigh the initial contractionary push (downward) in Real GDP, and Real GDP falls on net, we can still conclude that contractionary fiscal policy lowers Real GDP more in a closed economy than in an open economy. Exhibit 6(b) illustrates our point. The cut in government spending shifts the AD curve from to. But because of the lower interest rates, increased capital outflows, and dollar depreciation, the AD curve shifts rightward from to AD 3, and the SRAS curve shifts leftward from to. In a closed economy, Real GDP falls from Q 1 to Q 2. In an open economy, where international feedback effects play a role, Real GDP ends up at a higher level, Q 3. The Effects of Monetary Policy Does monetary policy affect international economic factors that feed back to the United States? It certainly does. Here we consider both expansionary and contractionary monetary policy. EXPANSIONARY MONETARY POLICY Suppose the Federal Reserve increases the money supply. In Exhibit 7(a), this causes the AD curve to shift rightward from to and Real GDP to rise from Q 1 to Q 2.

10 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters economics 24/7 PROPER BUSINESS ETIQUETTE AROUND THE WORLD Customs and traditions differ between some countries sometimes when it comes to conducting business. Not knowing how business is done in a certain country can act as a stumbling block to getting business done. What follows is a list of countries and certain rules of business etiquette in the different countries. 2 Beijing, China If someone offers you his or her business card, accept with both hands, read it immediately, and then present your business card to the person. In business, a suit and tie is the norm for men. Berlin, Germany When out with German business associates, try not to talk about sports. Many businesspeople believe that sports talk is the domain of the uneducated. It is considered impolite to drink before all have raised their glasses together. Dubai, United Arab Emirates Do not arrange appointments on Friday because it is Dubai s day of prayer and rest. Business slows down during the month of Ramadan (when Muslims fast). Foreign businesspeople are expected to observe the slower pace. Hong Kong It is considered impolite to run out of business cards. Mexico City It is considered good form to have business cards printed in English on one side and in Spanish on the other. Business wear is fairly formal. Sydney, Australia It is important to know about the latest sports matches. Don t take yourself too seriously. Tokyo, Japan Remove your shoes when entering a Japanese home. Zurich, Switzerland People often greet each other when entering an office or shop. Try to do the same, even if your greeting is in your own language. It is frowned upon to talk about money or personal wealth. 2 The reference guide here is The Economist s City Guide. Are there any international effects of an increase in the money supply? Yes. Expansionary monetary policy causes interest rates to fall in the short run (remember the liquidity effect from an earlier chapter), and this leads to an outflow of capital from the United States. Americans begin to supply more dollars on the foreign exchange market so that they can purchase foreign assets. As the supply of dollars rises, the dollar depreciates. Dollar depreciation affects both U.S. aggregate demand and U.S. short-run aggregate supply. As we learned earlier, it shifts the AD curve to the right and the SRAS curve to the left. In Exhibit 7(a), the AD curve shifts to the right and the SRAS curve shifts to the left. In Exhibit 7(a), the AD curve shifts from to AD 3, and the SRAS curve shifts from to. Consequently, Real GDP rises from Q 2 to Q 3. We conclude that expansionary monetary policy raises Real GDP more in an open economy than in a closed economy. CONTRACTIONARY MONETARY POLICY Suppose the Federal Reserve contracts the money supply. In the AD-AS framework, this causes the AD curve to shift leftward from to and Real GDP to fall from Q 1 to Q 2 (see Exhibit 7(b)). Are there any international effects of a decrease in the money supply? Yes. Contractionary monetary policy causes interest rates to rise, and this leads to an inflow of foreign

11 3814_35_c35_ qxd 12/21/6 1:15 AM Page 763 International Impacts on the Economy Chapter Starting Point A B (a) C Q 1 Q 2 Q 3 Closed Economy AD 3 Open Economy capital into the United States. The demand for dollars rises on the foreign exchange market, and the dollar appreciates. Dollar appreciation affects both U.S. aggregate demand and U.S. short-run aggregate supply. As we learned earlier, it shifts the AD curve to the left and the SRAS curve to the right. In Exhibit 7(b), the AD curve shifts from to AD 3, and the SRAS curve shifts from to. Consequently, Real GDP falls from Q 2 to Q 3. We conclude that contractionary monetary policy lowers Real GDP more in an open economy than in a closed economy. Open Economy C B Closed Economy (b) A Q 3 Q 2 Q 1 AD 3 Starting Point exhibit 7 Expansionary and Contractionary Monetary Policy in Open and Closed Economies (a) The consequences of expansionary monetary policy for both open and closed economies. The Fed increases the money supply, and the AD curve shifts from to. Real GDP rises from Q 1 to Q 2. The increased money supply leads to lower interest rates in the short run, promoting U.S. capital outflow and a depreciated dollar, which raises U.S. exports, lowers U.S. imports, and raises U.S. net exports. Higher net exports shift the AD curve rightward from to AD 3. The depreciated dollar shifts the SRAS curve leftward from to. Real GDP rises from Q 2 to Q 3. Expansionary monetary policy raises Real GDP more in an open economy than in a closed economy. (b) Contractionary monetary policy lowers Real GDP more in an open economy than in a closed economy. SELF-TEST 1. Explain how expansionary monetary policy works in an open economy. 2. Explain how expansionary fiscal policy works in an open economy. a reader A Reader asks... Asks... Exports and Imports What countries buy the most from the United States? What countries sell the most to the United States? Here is a list of the top 1 countries that bought goods from the United States in Canada 2 Mexico 3 Japan 4 China 5 United Kingdom 6 Germany 7 South Korea 8 Netherlands 9 France 1 Singapore

12 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters Here is a list of the top 1 countries that sold goods to the United States in Canada 2 China 3 Mexico 4 Japan 5 Germany 6 United Kingdom 7 South Korea 8 Venezuela 9 France 1 Taiwan! analyzing the scene What does Janis have to be worried about? Janis s income can be adversely affected by a decline in Real GDP in France and Germany. If Real GDP declines in France and Germany, then the French and Germans may not buy as many exported goods.as a result, Janis may not sell as many goods, thus lowering her income. Does the senator understand economics well enough? What the senator does not understand is that initially import spending (on imported goods) may rise as a result of a depreciated dollar. In the long run, though, it is likely that import spending will decline as a result of a depreciated dollar. Simply put, the senator may not understand or be aware of the economics behind the J-curve. What does the effectiveness of monetary policy at changing Real GDP have to do with international effects? In an open economy, the international effects of monetary policy move Real GDP in the same direction as the domestic effects (see Exhibit 7).The stronger the international effects, the more Real GDP rises as a result of expansionary monetary policy. What do interest rates in Japan have to do with Tanya? Interest rates in Japan (when compared to interest rates in the United States) can end up affecting capital flows in the world, which can affect exchange rates, which can affect the AD and SRAS curves in the United States, which can affect Real GDP in the United States, which can affect Tanya s standard of living. chapter summary Net Exports and Aggregate Demand An increase in net exports will shift the AD curve to the right. A decrease in net exports will shift the AD curve to the left. The following factors can change net exports: foreign Real GDP (or real national income) and exchange rates. For example, in a two-country world (Japan and the United States), an increase in Japan s Real GDP and a depreciation in the dollar will increase U.S. net exports and shift the U.S. AD curve to the right. Alternatively, a decrease in Japan s Real GDP and an appreciation in the dollar will decrease U.S. net exports and shift the U.S. AD curve to the left. The Aggregate Supply Curve and International Factors A change in foreign input prices will impact the U.S. SRAS curve. For example, an increase in foreign input prices will shift the U.S. SRAS curve to the left. A decrease in foreign input prices will shift the U.S. SRAS curve to the right. A change in foreign input prices can be the result of changes in the input market in the foreign country. A change in foreign input prices (paid by U.S. producers) can be the result of a change in the exchange rate. For example, if the dollar depreciates, U.S. producers

13 3814_35_c35_ qxd 12/21/6 1:15 AM Page 765 International Impacts on the Economy Chapter will pay higher prices for foreign inputs. If the dollar appreciates, U.S. producers will pay lower prices for foreign inputs. International Factors and Aggregate Demand and Short-Run Aggregate Supply A change in the exchange rate will affect both the U.S. AD curve and the U.S. SRAS curve. For example, if the dollar depreciates, the AD curve will shift to the right, and the SRAS curve will shift to the left. A change in real interest rates will affect both the U.S. AD curve and the U.S. SRAS curve. To illustrate, suppose the U.S. real interest rate rises relative to the Japanese interest rate. Higher real interest rates in the United States will attract foreign capital. Foreigners, in search of U.S. assets that pay interest, will bid up the price of a dollar thus, the dollar appreciates. If the dollar appreciates, the AD curve will shift to the left, and the SRAS curve will shift to the right. The U.S. price level will fall. What happens to the U.S. Real GDP depends on the relative shifts in the AD and SRAS curves. Typically, the AD curve shifts leftward by more than the SRAS curve shifts rightward, and so Real GDP falls. Fiscal and Monetary Policy in Closed and Open Economies Expansionary fiscal policy raises Real GDP more in a closed economy than in an open economy. Contractionary fiscal policy lowers Real GDP more in a closed economy than in an open economy. Expansionary monetary policy raises Real GDP more in an open economy than in a closed economy. Contractionary monetary policy lowers Real GDP more in an open economy than in a closed economy. key terms and concepts J-Curve Closed Economy Open Economy questions and problems 1 Assume a two-country world where the two countries are the United States and Japan. Note the impact on of each of the following: a A fall in the real interest rate in the United States relative to the real interest rate in Japan b An economic expansion in Japan 2 Give a numerical example to illustrate what depreciation (of a country s currency) does to the prices of its imports. 3 If Americans buy fewer units of good X, which is produced in Japan, does it follow that they will spend less money overall on good X? Explain your answer. 4 In a Thinking Like an Economist feature, we noted, The discussion of the J-curve points out that economists sometimes think in terms of both the short run and the long run. Do you agree or disagree? Explain your answer. 5 Explain how a change in the exchange rate can change both the U.S. AD and SRAS curves. 6 Suppose country A undertakes a policy mix of contractionary fiscal policy and expansionary monetary policy. What do you predict would happen to real interest rates, the value of country A s currency, and net exports? Explain your answer. 7 Why might import spending rise in a country soon after a depreciation of its currency? Is import spending likely to fall over time? Explain your answers. 8 Explain why expansionary monetary policy is more likely to increase Real GDP in an open economy than in a closed economy. 9 Explain why contractionary fiscal policy is more likely to decrease Real GDP in a closed economy than in an open economy. 1 Explain why contractionary monetary policy lowers Real GDP more in an open economy than in a closed economy.

14 3814_35_c35_ qxd 12/21/6 1:15 AM Page Part 12 Web Chapters working with numbers and graphs 1 Starting with an exchange rate of $1 114 yen and a price tag of 1, yen for a Japanese item, show what happens to the price of the Japanese item if the yen depreciates by 5 percent. 2 Graphically show and explain the domestic and feedback effects on Real GDP in the United States as a result of contractionary fiscal policy. 3 Graphically show and explain the domestic and feedback effects on Real GDP in the United States as a result of contractionary monetary policy. self-test answers PAGE In country A, there is an economic expansion, and real income in the country rises. As a result, residents of the country buy more imports from country B. In country B, exports rise relative to imports, thus increasing net exports. As net exports in country B rise, the AD curve for country B shifts to the right, increasing Real GDP. 2 If the dollar appreciates, the Japanese yen depreciates. U.S. products become more expensive for the Japanese, and Japanese products become cheaper for Americans. U.S. imports will rise, U.S. exports will fall, and consequently, U.S. net exports will fall. As a result, the AD curve in the United States will shift leftward, pushing down Real GDP. PAGE Foreign input prices can change directly as a result of supply conditions in the foreign country, or they can change indirectly as a result of a change in the exchange rate. In either case, as foreign input prices rise either directly or as a result of a depreciated dollar the U.S. SRAS curve shifts leftward. If foreign input prices fall either directly or as a result of an appreciated dollar the SRAS curve shifts rightward. 2 The higher real interest rates in the United States attract capital to the United States. This increases the demand for the dollar. As a result, the dollar appreciates and the yen depreciates. An appreciated dollar shifts the U.S. AD curve leftward and the U.S. SRAS curve rightward. The AD curve shifts leftward by more than the SRAS curve shifts rightward, so the price level falls. PAGE When the money supply is raised, the AD curve shifts rightward, pushing up Real GDP. Also, as a result of the increased money supply, interest rates may decline in the short run. This promotes U.S. capital outflow and a depreciated dollar. As a result of the depreciated dollar, imports become more expensive for Americans, and U.S. exports become cheaper for foreigners. Imports fall and exports rise, thereby increasing net exports and again shifting the AD curve to the right. Real GDP rises. 2 Expansionary fiscal policy pushes the AD curve rightward and (under certain conditions) raises Real GDP. If the expansionary fiscal policy causes a deficit, then the government will have to borrow to finance the deficit, and interest rates will be pushed upward. As a result of the higher interest rates, there will be increased foreign capital inflows and dollar appreciation, thus pushing the AD curve leftward and the SRAS curve rightward.

15 3814_35_c35_ qxd 12/21/6 1:15 AM Page 767 Index A acreage allotments (agriculture), aggregate demand (AD) and international economic factors, aggregate supply (AS) and international economic factors and, agriculture, facts about, farmers income and, 741, 751 income inelasticity and, 743 nonrecourse commodity loans, politics of, 747 price inelasticity and, price support, 746 price variability and futures contracts, production flexibility contract payments, 749 productivity, 741, 742, restricting supply, subsidy payments, 749, 75 target prices and deficiency payments, weather and, 745 appreciation, , 758 Australia, business etiquette in, 762 C China, business etiquette in, 762 Consumers and subsidies, 747 contractionary fiscal policy, contractionary monetary policy, D deficiency payments, to farmers, 748 deficit, depreciation, , dollar, valuation of, E economy, international impacts on, etiquette and international economics, 762 exchange rate and international economic factors, 754, 757, 76 expansionary fiscal policy, expansionary monetary policy, expected inflation rate, defined, 763 exports, defined, 763 net exports, F foreign input prices, foreign Real GDP, 754 futures contracts, G Germany, business etiquette in, 762 I international economic factors, aggregate demand and, , aggregate supply and, business etiquette and, 762 deficits and, J-curve, net exports, J Japan, business etiquette in, 762 J-Curve, M Mexico, business etiquette in, 762 Monetary policy and international factors, N net exports, nonrecourse commodity loans, O open economy, 76

16 3814_35_c35_ qxd 12/21/6 1:15 AM Page Index P policy and agriculture, political market and agriculture, 747 price, foreign input, price variability and agriculture, production flexibility contract payments, productivity in agriculture, 741, 742, , 751 put option, Q quotas, 748 R Real GDP, 759 S SARS curve and international economic factors, supply and agriculture, T target price system, taxes on farm subsidies, 747 U United Arab Emirates, business etiquette in, 762 United States exports/imports,