Week 2 Flashcards
Define internal balance (IB) and its two key objectives. Explain why each is crucial for maintaining a healthy domestic economy.
Internal Balance (IB): The goal of maintaining a stable and healthy domestic economy.
Two Key Objectives:
Full Employment: Ensures the economy produces at or near its productive capacity, improving citizens’ living standards.
Stable Prices: Creates a predictable economic environment, encouraging long-term investment and planning.
What is external balance (EB), and how is it primarily measured? Why is achieving CA equilibrium desirable?
External Balance (EB): A country’s trade and financial interactions with the rest of the world, primarily measured by the current account (CA).
CA Equilibrium: Occurs when exports = imports, reflecting a sustainable trade and financial exchange level with other nations.
Desirability: Prevents unsustainable debt (CA deficits) or underutilization of resources (CA surpluses) in the long run.
If a country faces both high unemployment and a current account (CA) deficit, outline the trade-offs involved in addressing these issues.
Reducing Unemployment: Increase absorption (A = C + I + G) through higher government spending (G) or encouraging private spending (C/I). However, this worsens the CA deficit by boosting imports.
Reducing CA Deficits: Decrease absorption by reducing government spending or private consumption, which reduces demand but can increase unemployment.
Trade-Off: Policy actions to improve one objective can negatively affect the other.
How can exchange rate manipulation serve as an additional policy tool to address the trade-off between internal and external balance?
For Reducing Unemployment: Increase absorption (domestic demand through higher G or C).
For Reducing CA Deficit: Depreciate the domestic currency by increasing the real exchange rate (S). This makes exports cheaper for foreign buyers and imports more expensive for domestic buyers, boosting exports and reducing imports.
Explain the historical example of the 1930s Great Depression and how policies to prioritize internal balance (IB) worsened external balance (EB).
Context: High unemployment during the Great Depression.
Policies: Governments used devaluations and trade restrictions to reduce unemployment by making exports cheaper and limiting imports.
Impact: These policies increased domestic production and employment but disrupted international trade and worsened international relations.
Conclusion: Prioritizing IB led to sacrificing EB.
Discuss the Eurozone Sovereign Debt Crisis as an example of how external balance (EB) was prioritized at the expense of internal balance (IB).
Crisis Context: Southern European countries faced high debt and financial instability, threatening Eurozone stability.
Response: Northern European countries provided financial support to maintain EB by preserving the eurozone as a unified currency region.
Trade-Off: While this approach maintained EB by preventing economic collapse, it increased Northern Europe’s public debt and constrained fiscal policies, reducing IB stability.
Conclusion: Preserving the euro was essential for maintaining EB, even at the expense of IB stability.
How did Brexit represent a decision to prioritize internal balance (IB) at the expense of external balance (EB)?
UK’s Prioritization: Brexit allowed the UK to reclaim control over its economy, borders, and laws, emphasizing national economic independence (IB).
Impact on EB: This led to trade disruptions with the European Union, reducing exports and increasing trade barriers.
Conclusion: While Brexit improved UK sovereignty, it negatively impacted trade relations, undermining external balance.
How did the Trump administration’s “America First” policy represent an internal balance (IB) strategy, and what were the consequences for external balance (EB)?
Policy Focus: Emphasized prioritizing American jobs and reducing reliance on imports through trade protectionist measures.
Impact on EB:
Reduced international cooperation.
Disrupted trade flows and created trade conflicts (e.g., tariffs on China).
Conclusion: Although “America First” sought to protect IB by boosting domestic employment, it harmed EB by reducing trade interdependence and cooperation.
How does the trade-off between achieving internal balance (IB) and external balance (EB) affect policymaking?
Trade-Off: Policies that focus on improving IB (e.g., full employment through higher spending) may worsen EB by increasing imports. Conversely, policies aimed at correcting CA deficits by reducing demand may lead to unemployment.
Real-Life Example 1: The 1930s Great Depression saw governments prioritizing IB by imposing trade restrictions, worsening EB.
Define multiple policy instruments and explain their role in addressing both internal balance (IB) and external balance (EB) simultaneously.
Multiple Policy Instruments: These are tools used by governments or central banks, such as fiscal policy, monetary policy, and exchange rate adjustments, to simultaneously achieve objectives related to internal balance (full employment and stable prices) and external balance (sustainable current account).
Role: They help policymakers address the trade-offs between achieving internal economic objectives and maintaining stable international trade relations.
Example: A government might combine fiscal stimulus (increase in government spending) with currency depreciation to combat unemployment (IB) while addressing a current account deficit (EB).
Suppose a country is facing both a high unemployment rate and a current account deficit. What two policy instruments could a government use to address these issues simultaneously? Explain how each would work.
Fiscal Policy (Increase Government Spending):
Boosting government spending (e.g., G) stimulates domestic demand, reduces unemployment by creating jobs, but may worsen the CA deficit by increasing imports.
Monetary Policy (Depreciate the Currency):
A weaker domestic currency (through lower interest rates or other monetary adjustments) makes exports cheaper and imports more expensive. This improves export competitiveness and reduces the current account deficit while limiting excessive reliance on imports.
A country wants to reduce unemployment but is at risk of worsening its current account deficit. How can it use exchange rate policy as a multiple policy instrument to balance these goals?
Exchange Rate Policy (Depreciation): Depreciating the domestic currency makes exports more affordable to foreign buyers and imports more expensive for domestic consumers.
Effect on EB: Export demand increases, reducing the current account deficit.
Effect on IB: Employment improves as domestic industries become more competitive internationally.
Example: A country can implement monetary easing (lowering interest rates) to trigger a weaker exchange rate, boosting exports without relying solely on fiscal stimulus.
What is the Swan diagram and what is its purpose in macroeconomic analysis?
Definition: The Swan diagram is a graphical model used to analyze the trade-offs between internal balance (IB) and external balance (EB) in an economy. It represents the interaction between real domestic absorption, real exchange rate, and output to determine equilibrium states.
Purpose: To show how changes in real exchange rates and domestic spending impact the trade-offs between maintaining full employment and achieving a balanced current account.
Real-life Example: A country with a trade deficit may use the Swan diagram to evaluate whether currency depreciation or changes in government spending can reduce the trade deficit without causing excessive unemployment.
What does the upward-sloping EB line represent in the Swan diagram? How does it explain the relationship between real exchange rates and absorption?
EB Line (Equilibrium in External Balance): Represents combinations of real exchange rate (Sr) and real domestic absorption (A) that result in a balanced current account (CA = 0).
Upward Sloping: Indicates that a depreciation in the real exchange rate leads to increased imports and reduced exports (creating a CA deficit). To restore equilibrium, absorption must increase, which stimulates domestic demand and offsets the external imbalance.
How does the downward-sloping IB line in the Swan diagram represent the trade-offs for achieving internal balance?
IB Line (Internal Balance Isoline): Represents combinations of real domestic absorption (A) and real exchange rate (Sr) that lead to full employment output (Y=Yfe, or full employment equilibrium).
Downward Sloping: Indicates that an appreciation in the real exchange rate (domestic goods become relatively more expensive) reduces exports and increases imports, thereby lowering net exports and demand for domestic goods. To maintain full employment, absorption must increase, offsetting this decline.
If a country faces a CA deficit and unemployment at the same time, how can adjustments along the Swan diagram address these dual objectives? Provide policy examples.
Exchange Rate Depreciation: Depreciate the currency to make exports cheaper and imports more expensive. This would improve the current account by boosting exports and reducing imports.
Increase Domestic Absorption: Increase government spending (G) or support investment (I) to reduce unemployment by stimulating demand.
Trade-off: Increasing absorption could worsen the CA deficit by boosting demand for imports unless balanced by exchange rate adjustments.
Example: A coordinated monetary easing (lowering interest rates) to depreciate the exchange rate while combining fiscal stimulus to address unemployment.
How does a change in the real exchange rate (Sr) impact full employment and absorption levels? Explain the trade-offs illustrated by the Swan diagram.
Impact of Real Exchange Rate Changes:
Appreciation (increase in Sr): Makes domestic goods relatively expensive, reducing exports and increasing imports, leading to a net decrease in demand for domestic goods and increasing unemployment.
Depreciation (decrease in Sr): Makes domestic goods relatively cheaper, boosting exports and reducing imports, increasing demand for domestic goods and improving employment but potentially worsening the CA.
Trade-off: Policymakers must balance exchange rate adjustments to maintain full employment without excessively worsening the CA.
How does the trade-off between full employment and external balance manifest in the Swan diagram when the real exchange rate is adjusted?
Trade-off:
Depreciating the real exchange rate (moving along the EB curve) can improve the CA but may lead to reduced domestic demand and higher unemployment if it leads to higher inflation or less consumer spending.
Conversely, measures to boost domestic demand (increasing absorption) can improve internal employment (moving along the IB curve) but worsen the CA by increasing demand for imports.
The Swan diagram shows how a movement toward equilibrium requires careful navigation of these two competing objectives.
What would happen to the equilibrium in the Swan diagram if a government implements austerity measures to reduce absorption? How would this affect both internal and external balance?
Effect on Absorption: Austerity reduces government spending, thereby reducing domestic absorption. This would reduce demand and shift the economy toward the IB line, likely reducing unemployment.
Effect on External Balance: Reduced absorption leads to reduced imports, improving the current account (shifting along the EB line toward balance).
Trade-Off: While reducing the CA deficit, austerity may increase unemployment by decreasing demand.
Explain how the Swan diagram could illustrate the impact of Brexit on a country’s trade-offs between internal balance and external balance.
Brexit Example: The UK prioritized internal balance by regaining economic sovereignty, focusing on full employment, and reducing reliance on EU imports.
In the Swan diagram:
Brexit policies could shift the UK’s position toward higher absorption (increased domestic spending) to maintain employment, represented by movement along the IB line.
However, these policies negatively impacted external balance by reducing trade with the EU (movement along the EB curve toward imbalance).
Trade-Off: A clear example of how prioritizing one objective (IB) can lead to external imbalances (EB).
What is the significance of being “above EB” and “above IB” in the context of the four quadrants? Explain using economic indicators.
Above EB (Equilibrium in External Balance): This indicates that CA>0, meaning the country has a current account surplus.
Above IB (Internal Balance): This implies that Y>Yfe, leading to inflationary pressures because the economy is operating above its full employment level.
Example: A booming economy with high exports may lead to a current account surplus (above EB), but excessive domestic demand could also lead to inflation (above IB).
What is the Tinbergen rule, and how does it relate to achieving internal balance (IB) and external balance (EB)?
Tinbergen Rule: The number of policy instruments must be equal to or greater than the number of policy targets.
Relation to IB and EB:
To achieve both internal and external balance, two policy tools (monetary or fiscal) must be used simultaneously to target both objectives.
Real-World Example: During the Eurozone crisis, European countries used both fiscal stimulus (to address unemployment) and monetary policies like exchange rate adjustments to stabilize both employment and the current account.
How does the elasticity approach differ from the Swan diagram in addressing external balance (EB) and internal balance (IB)?
Focuses solely on achieving external balance (EB) by adjusting exchange rates to address CA deficits.
Example: Depreciating the currency to make exports cheaper and imports more expensive.
Swan Diagram:
Provides a general approach by targeting both IB (full employment) and EB simultaneously.
Disadvantage of Swan Model:
Simplistic assumptions, neglects international capital movement, and does not differentiate monetary from fiscal policies.
Why does the Swan model fail to account for international capital movements, and how does this affect its application?
Reason: The Swan model was developed during the 1950s, a period when international capital movements were less significant.
Impact: Modern economies have significant international capital flows, which affect exchange rates, investment, and monetary policy.
Consequence: Neglecting capital movement can lead to inaccuracies when applying the Swan model to contemporary economies.
explain how the trade-off between achieving internal balance and external balance could lead to policy choices that favor one objective over the other.
Example: 2010s Eurozone Sovereign Debt Crisis:
Southern European nations faced debt crises, high unemployment, and financial instability.
Northern European countries prioritized external balance by maintaining the stability of the euro and supporting EU integration.
This meant sacrificing some aspects of internal balance (unemployment reduction) to maintain economic stability and investor confidence.
What are the disadvantages of relying solely on the Swan diagram when addressing an economy’s internal and external imbalances?
Simplistic Assumptions: Underlying economic relationships are overly simplified.
No Role for International Capital Movement: The Swan diagram doesn’t account for capital flows, which can significantly influence exchange rates and policy outcomes.
No Distinction Between Fiscal and Monetary Policies: The Swan model treats fiscal and monetary adjustments in aggregate rather than as distinct tools to affect aggregate demand and economic performance.
What are the three market equilibria in the Mundell-Fleming model, and how do they interact?
IS Curve (Goods Market Equilibrium): Ensures equilibrium in the goods market with Y=C+I+G+CA.
LM Curve (Money Market Equilibrium): Ensures equilibrium in the money market with L=M, where money demand depends on transaction and speculative purposes.
BP Curve (Balance of Payments Equilibrium): Represents equilibrium in the foreign exchange market (CA+K=0), ensuring no net outflow or inflow in a country’s balance of payments.
These curves intersect to determine equilibrium levels of income, interest rate, and exchange rate.
What does the IS curve represent in the Mundell-Fleming model, and why is it downward sloping?
IS Curve Explanation: Represents equilibrium in the goods market where output (Y) equals aggregate demand (C+I+G+CA).
Downward Sloping Reason: An increase in the interest rate reduces investment (I) and thus reduces overall demand, leading to lower equilibrium output (Y).
Example: Higher interest rates make borrowing more expensive, leading to lower investment spending and therefore lower equilibrium income.
What is the LM curve in the Mundell-Fleming model, and why is it upward sloping?
LM Curve Explanation: Represents equilibrium in the money market where money demand (L) equals money supply (M).
Upward Sloping Reason: Higher income levels increase transaction demand for money, requiring higher interest rates to equilibrate the money market with a constant money supply.
Transaction and Speculative Demand: Money demand depends on transaction needs and speculative balances.
Explain how the BP curve represents equilibrium in the foreign exchange market. How is the slope of the BP curve influenced by capital mobility?
BP Curve: Represents balance of payments equilibrium (CA+K=0), meaning net capital flows are balanced with trade (current account).
Slope of BP Curve:
High Capital Mobility: Flatter BP curve because small changes in interest rates cause large capital movements.
Low Capital Mobility: Steeper BP curve because capital is less responsive to interest rate changes.
Perfect Capital Mobility: Horizontal BP curve as even small interest rate changes lead to large capital flows without requiring income adjustment.
Perfect Capital Immobility: Vertical BP curve because capital flows are insensitive to interest rate changes—equilibrium depends only on changes in income (Y).
How would an increase in capital mobility affect the shape of the BP curve? Explain with reasoning.
High Capital Mobility: Capital flows easily across borders in response to small interest rate differentials, making the BP curve flatter. This implies that only small changes in output (Y) are needed to restore equilibrium in response to shocks.
Example: If capital can move freely in response to interest rate changes, a small change in r can attract or repel large flows of capital, making it easier to stabilize the economy without significant income adjustments.
Suppose a country faces a sudden drop in exports leading to a shift in the IS curve. What would be the likely impact on equilibrium income and interest rates in the Mundell-Fleming model?
Shift in IS Curve: A reduction in exports lowers aggregate demand, shifting the IS curve leftward.
Impact on LM and BP curves: With a leftward shift in IS, there is downward pressure on equilibrium income and interest rates unless monetary or exchange rate policies intervene.
LM Curve Response: Given constant money supply, the LM curve intersects at a lower income and interest rate.
BP curve adjustments: Capital mobility might exacerbate this by driving capital flows, depending on international response.
The country would likely experience lower output and lower interest rates unless counteracted by policy adjustments.
How would perfect capital immobility affect monetary policy decisions and the adjustment process in the Mundell-Fleming framework?
Capital Immobility: Capital does not respond to interest rate differentials, meaning changes in monetary policy (interest rate adjustments) will not directly affect capital flows.
Adjustment Process:
Equilibrium adjustments depend on changes in real income (Y) rather than changes in monetary variables.
Policy effectiveness relies on shifts in the goods market or changes in real output rather than international capital flows.
Example: If a country uses monetary stimulus (lower interest rates) under capital immobility, it affects domestic output but has minimal effects on capital flows.
How would a government implement policies to restore BP equilibrium if it experiences a sudden capital outflow? Discuss monetary vs. fiscal policy responses.
Monetary Policy:
Central banks could raise interest rates to attract capital by offering higher returns to investors.
Fiscal Policy:
Reducing government spending or increasing taxation could lower domestic demand, reducing imports and improving the current account.
Exchange Rate Policies:
Allowing the currency to depreciate can make exports more competitive, thus improving the current account and restoring BP equilibrium.
Trade-offs: Monetary tightening reduces inflation but could slow economic growth, while fiscal adjustments might increase unemployment.
Using the Mundell-Fleming model, explain how a sudden increase in international investor confidence could affect the equilibrium in the forex market (BP curve) under high capital mobility.
Investor Confidence Increase: Investors are more likely to invest in the country’s assets.
BP Curve Response:
A capital inflow shifts the BP curve upward.
Increased demand for the domestic currency leads to an appreciation of the exchange rate.
Result: This reduces net exports by making domestic goods more expensive abroad, potentially causing a shift in the IS curve leftward unless policy offsets are implemented.
Why does the LM curve slope upwards, and how does this relate to transaction and speculative motives in the demand for money?
Upward Slope Reason: As income (Y) increases, demand for money for transaction purposes rises. Since the money supply is constant, higher demand leads to higher equilibrium interest rates.
Speculative Motive: Money balances held above transaction needs are speculative; investors demand higher returns (interest rates) to hold these balances during times of uncertainty.
Example: An increase in income (Y) from higher consumer spending forces interest rates to rise to equilibrate the money market by reducing excess demand for money.
What does the intersection of the IS and LM curves represent in the Mundell-Fleming model, and how does it relate to equilibrium?
The intersection of the IS curve (goods market equilibrium) and LM curve (money market equilibrium) determines the short-run equilibrium in the goods and money markets.
At this intersection, the economy’s output (Y) and interest rate (r) satisfy both markets simultaneously.
Key Idea: However, this equilibrium does not necessarily represent full employment or external balance unless the BP curve (balance of payments) is also at equilibrium.
