# Teaching tools: internationalizing macroeconomic principles.

I. INTRODUCTION

It is now commonly observed that the United States economy is no longer independent of the international marketplace. While for many years U.S. imports, as a percentage of GNP, were much smaller than those of its major trading partners, this gap has narrowed significantly in recent years. In fact, by 1983 imports as a percentage of GNP were of the same order of magnitude for the U.S. as for Japan. This "internationalizing" of the macroeconomy has important implications for policymakers, since it affects their ability to conduct fiscal and monetary policy. As a result macroeconomic policy, even at the principles level, must be taught with an emphasis on international issues.

This paper argues that the essentials of international macroeconomics can be taught using simple supply and demand techniques, in conjunction with the standard Keynesian cross and/or aggregate supply/aggregate demand (AS/AD) model. The following section will introduce the method by comparing two markets for dollars-the domestic money market and the foreign exchange market-and show how capital flows tie the two markets together. The complete principles model and the effects of monetary and fiscal policy for an internationalized economy are presented in Section III.

II. THE PARALLEL BETWEEN THE INTEREST RATE AND EXCHANGE RATES

In the standard principles model of the closed economy, the relationship between the interest rate and investment is key in explaining issues in fiscal and monetary policy. The relationship between exchange rates and net exports is equally important when these issues are discussed for the open macroeconomy. Given the complexity of the open economy model, careful preparation is required to provide an effective introduction for students. Fully developing the parallels between the interest rate and exchange rates provides the foundation for this preparation.

The key is to help students understand that both the interest rate and exchange rates represent prices of money. In the domestic money market, the interest rate represents the opportunity cost of holding money-it is the "time" value of money. In the open macroeconomy, we must also consider exchange rates-the "place" value of money. Foreign agents who choose to hold U.S. currency sacrifice the opportunity to have a dollar's worth of goods at home. Assuming that exchange rates are measured in terms of the foreign currency per dollar, the exchange rate gives the foreign agents' opportunity cost of holding U.S. dollars. Just as the interest rate is the price that coordinates buying and selling across different times, exchange rates serve to coordinate buying and selling across different places. Furthermore, changes in both the interest rate and exchange rates affect aggregate demand in similar ways-the interest rate by changing the investment-savings balance and exchange rates by shifting net exports.

To help students see this parallel, the basic supply/demand model can be used. The two markets for U.S. dollars that students need to master. The left side shows the domestic money market. The right side shows the foreign exchange market for U.S. dollars with flexible exchange rates." This diagram allows students to interpret the exchange rate as the familiar phrase "the value of the dollar." This approach also helps students by developing a close parallel between the interest rate and exchange rates. The principles instructor can use his or her standard arguments to introduce these two markets. (For concreteness, the diagrams will show the U.S./Japan foreign exchange market.)

Introducing Capital Flows

After developing the supply/demand frameworks for the interest rate and exchange rates, it is natural to introduce students to the idea of capital flows. This topic establishes a bridge between the two markets which strengthens students' comprehension of the two prices of money. Furthermore, an understanding of capital flows enhances both theoretical and intuitive understanding of the internationalized economy. For example, the foreign demand for our financial assets and its effect on the value of the dollar are highlighted in a study of capital flows. Capital inflows; capital outflows can be discussed in a similar fashion.

The Fed contracts the supply of money, putting upward pressure on the interest rate. Introduce the world interest rate in the diagram and assume that Fed policy has driven the domestic interest rate above this level. Given some degree of capital mobility (i.e., international trading of financial assets), this will lead to an increase in the demand for dollars in the foreign exchange market.

The higher-than-average interest rate attracts foreign lenders with available financial capital. But to lend to the U.S. and get this interest rate (by buying our short-term treasury bills, for example), their funds must be converted to U.S. dollars. This capital inflow increases the demand for dollars in the foreign exchange market, putting upward pressure on the value of the dollar.

Thus the capital inflow drives up exchange rates. By using the domestic money market and the foreign exchange market together, we continue to develop the parallel between the interest rate and exchange rates. Upward pressure on the interest rate in turn puts upward pressure on the value of the dollar. Furthermore, with reminders about the interest rate/investment and exchange rates/net exports relationships, students can begin to see the parallel roles the two prices for money will play in macroeconomic policy.

III. FISCAL AND MONETARY POLICY

The above supply/demand model is designed to aid analysis of fiscal and monetary policy when a country has significant international involvement. At the intermediate level, this analysis would be done using the IS-LM-BOP model, or the AS/AD model derived from the IS-LM-BOP model. The same basic ideas can be introduced to principles students without this complexity by simply combining the above supply/demand analysis with the basic AS/AD or Keynesian cross model.

Assume exchange rates are flexible and capital markets are mobile. These assumptions seem to most closely approximate the international environment of the U.S., especially as trade vis-a-vis the other major industrialized countries is concerned. For the internationalized economy, we discuss two standard principles topics using the model: monetary policy and the crowding out of fiscal policy.

Monetary Policy

The use of contractionary monetary policy to lower real GNP and reduce inflation. In the traditional closed economy model, this policy is successful when the decreased supply of money causes a rise in the interest rate and a decrease in investment spending. The resulting decrease in aggregate demand and real GNP.

How to extend this analysis to the internationalized economy. Students are already familiar with the first part of the story from previous work with the supply/demand framework. The rise in the U.S. interest rate triggers a capital inflow, which increases the demand for U.S. dollars in the foreign exchange markets and drives up exchange rates. Concluding the policy analysis requires students add only two additional steps: (1) observe that the higher value of the dollar will increase the relative price of U.S. goods and thus stimulate imports and reduce exports; (2) observe that lower net exports, like lower investment, will reduce aggregate demand and put further downward pressure on real GNP and the price level.

First-round effects of the monetary policy, and some students may recognize this fact. For example, students may ask why the falling income level doesn't shift the demand for money at the top of the figure. The answer is that it does-real GNP and the price level are two of the "other factors held constant" in the two markets for dollars. In fact the instructor may wish to assign students the problem of diagramming other second-round effects, such as how falling U.S. prices increase the demand for dollars in Japan, or how falling U.S. incomes decrease the supply of dollars to the foreign exchange market. This is also an ideal opportunity to preview general equilibrium models (such as IS-LM-BOP) that would be used in a more advanced course.

With flexible exchange rates monetary policy is made more effective by the internationalization of an economy. Although derived for the case of capital mobility, this conclusion remains the same whether the financial capital markets are mobile or immobile.

Crowding Out of Fiscal Policy

The model can also be used to show the additional complications of crowding out" faced by an internationalized economy with flexible exchange rates. The instructor might then use the result to discuss the relationship between the U.S. budget deficit and the trade deficit in the 1980s. To see this, consider expansionary fiscal policy which causes an increase in the government's deficit. The crowding out phenomenon which results if government borrowing leads to increased demand in the domestic money market.

In the traditional closed economy model, the increase in demand for money puts upward pressure on the interest rate. This in turn reduces investment. So, some of the original increase in aggregate demand brought about by increased government expenditure is crowded out by the decrease in private investment.

On the international side, there is the added effect of the higher interest rate on the foreign exchange market. Again assuming mobile capital and flexible exchange rates, the rise in the U.S. interest rate triggers capital inflows, increasing foreign agents' demand for U.S. dollars. This causes the value of the dollar to rise and net exports to fall. Thus expansionary fiscal policy crowds out both private investment and net exports, and the success of fiscal policy is less in the internationalized model than in the traditional model.

As in the monetary policy case, the instructor may wish to extend the model and include some "second-round effects." In particular, the international effects on domestic interest rates may be important. If capital is very mobile, the fall in real GNP caused by the large capital inflows (and appreciation of the dollar) may reduce the demand for money in the second round sufficiently that the domestic interest rate returns to its former level. In this case the crowding out of net exports is large but the crowding out of domestic investment is negligible.

IV. CONCLUSION

The policy implications for an internationalized economy cannot be ignored at the principles level. To do otherwise would simply expose students to an isolationist fantasy. Through the popular media, many students are aware of the expanding importance of imports and exports, the growth of multinational firms, and the increased attention given to the trade deficit and value of the dollar. Policy discussions are much richer when our theory takes into account these international realities. Our method of teaching the domestic and foreign money markets together allows the instructor to emphasize internationalized macroeconomic policy.

REFERENCES

Chacholiades, Miltiades. International Monetary Theory and Policy. New York: McGraw-Hill Book Company, 1978.

Ingram, James C. International Economics. 2nd. ed. New York: John Wiley & Sons, 1986.

Yarbrough, Beth V. and Robert M. Yarbrough. The World Economy: Trade and Finance. Chicago: The Dryden Press, 1988.

It is now commonly observed that the United States economy is no longer independent of the international marketplace. While for many years U.S. imports, as a percentage of GNP, were much smaller than those of its major trading partners, this gap has narrowed significantly in recent years. In fact, by 1983 imports as a percentage of GNP were of the same order of magnitude for the U.S. as for Japan. This "internationalizing" of the macroeconomy has important implications for policymakers, since it affects their ability to conduct fiscal and monetary policy. As a result macroeconomic policy, even at the principles level, must be taught with an emphasis on international issues.

This paper argues that the essentials of international macroeconomics can be taught using simple supply and demand techniques, in conjunction with the standard Keynesian cross and/or aggregate supply/aggregate demand (AS/AD) model. The following section will introduce the method by comparing two markets for dollars-the domestic money market and the foreign exchange market-and show how capital flows tie the two markets together. The complete principles model and the effects of monetary and fiscal policy for an internationalized economy are presented in Section III.

II. THE PARALLEL BETWEEN THE INTEREST RATE AND EXCHANGE RATES

In the standard principles model of the closed economy, the relationship between the interest rate and investment is key in explaining issues in fiscal and monetary policy. The relationship between exchange rates and net exports is equally important when these issues are discussed for the open macroeconomy. Given the complexity of the open economy model, careful preparation is required to provide an effective introduction for students. Fully developing the parallels between the interest rate and exchange rates provides the foundation for this preparation.

The key is to help students understand that both the interest rate and exchange rates represent prices of money. In the domestic money market, the interest rate represents the opportunity cost of holding money-it is the "time" value of money. In the open macroeconomy, we must also consider exchange rates-the "place" value of money. Foreign agents who choose to hold U.S. currency sacrifice the opportunity to have a dollar's worth of goods at home. Assuming that exchange rates are measured in terms of the foreign currency per dollar, the exchange rate gives the foreign agents' opportunity cost of holding U.S. dollars. Just as the interest rate is the price that coordinates buying and selling across different times, exchange rates serve to coordinate buying and selling across different places. Furthermore, changes in both the interest rate and exchange rates affect aggregate demand in similar ways-the interest rate by changing the investment-savings balance and exchange rates by shifting net exports.

To help students see this parallel, the basic supply/demand model can be used. The two markets for U.S. dollars that students need to master. The left side shows the domestic money market. The right side shows the foreign exchange market for U.S. dollars with flexible exchange rates." This diagram allows students to interpret the exchange rate as the familiar phrase "the value of the dollar." This approach also helps students by developing a close parallel between the interest rate and exchange rates. The principles instructor can use his or her standard arguments to introduce these two markets. (For concreteness, the diagrams will show the U.S./Japan foreign exchange market.)

Introducing Capital Flows

After developing the supply/demand frameworks for the interest rate and exchange rates, it is natural to introduce students to the idea of capital flows. This topic establishes a bridge between the two markets which strengthens students' comprehension of the two prices of money. Furthermore, an understanding of capital flows enhances both theoretical and intuitive understanding of the internationalized economy. For example, the foreign demand for our financial assets and its effect on the value of the dollar are highlighted in a study of capital flows. Capital inflows; capital outflows can be discussed in a similar fashion.

The Fed contracts the supply of money, putting upward pressure on the interest rate. Introduce the world interest rate in the diagram and assume that Fed policy has driven the domestic interest rate above this level. Given some degree of capital mobility (i.e., international trading of financial assets), this will lead to an increase in the demand for dollars in the foreign exchange market.

The higher-than-average interest rate attracts foreign lenders with available financial capital. But to lend to the U.S. and get this interest rate (by buying our short-term treasury bills, for example), their funds must be converted to U.S. dollars. This capital inflow increases the demand for dollars in the foreign exchange market, putting upward pressure on the value of the dollar.

Thus the capital inflow drives up exchange rates. By using the domestic money market and the foreign exchange market together, we continue to develop the parallel between the interest rate and exchange rates. Upward pressure on the interest rate in turn puts upward pressure on the value of the dollar. Furthermore, with reminders about the interest rate/investment and exchange rates/net exports relationships, students can begin to see the parallel roles the two prices for money will play in macroeconomic policy.

III. FISCAL AND MONETARY POLICY

The above supply/demand model is designed to aid analysis of fiscal and monetary policy when a country has significant international involvement. At the intermediate level, this analysis would be done using the IS-LM-BOP model, or the AS/AD model derived from the IS-LM-BOP model. The same basic ideas can be introduced to principles students without this complexity by simply combining the above supply/demand analysis with the basic AS/AD or Keynesian cross model.

Assume exchange rates are flexible and capital markets are mobile. These assumptions seem to most closely approximate the international environment of the U.S., especially as trade vis-a-vis the other major industrialized countries is concerned. For the internationalized economy, we discuss two standard principles topics using the model: monetary policy and the crowding out of fiscal policy.

Monetary Policy

The use of contractionary monetary policy to lower real GNP and reduce inflation. In the traditional closed economy model, this policy is successful when the decreased supply of money causes a rise in the interest rate and a decrease in investment spending. The resulting decrease in aggregate demand and real GNP.

How to extend this analysis to the internationalized economy. Students are already familiar with the first part of the story from previous work with the supply/demand framework. The rise in the U.S. interest rate triggers a capital inflow, which increases the demand for U.S. dollars in the foreign exchange markets and drives up exchange rates. Concluding the policy analysis requires students add only two additional steps: (1) observe that the higher value of the dollar will increase the relative price of U.S. goods and thus stimulate imports and reduce exports; (2) observe that lower net exports, like lower investment, will reduce aggregate demand and put further downward pressure on real GNP and the price level.

First-round effects of the monetary policy, and some students may recognize this fact. For example, students may ask why the falling income level doesn't shift the demand for money at the top of the figure. The answer is that it does-real GNP and the price level are two of the "other factors held constant" in the two markets for dollars. In fact the instructor may wish to assign students the problem of diagramming other second-round effects, such as how falling U.S. prices increase the demand for dollars in Japan, or how falling U.S. incomes decrease the supply of dollars to the foreign exchange market. This is also an ideal opportunity to preview general equilibrium models (such as IS-LM-BOP) that would be used in a more advanced course.

With flexible exchange rates monetary policy is made more effective by the internationalization of an economy. Although derived for the case of capital mobility, this conclusion remains the same whether the financial capital markets are mobile or immobile.

Crowding Out of Fiscal Policy

The model can also be used to show the additional complications of crowding out" faced by an internationalized economy with flexible exchange rates. The instructor might then use the result to discuss the relationship between the U.S. budget deficit and the trade deficit in the 1980s. To see this, consider expansionary fiscal policy which causes an increase in the government's deficit. The crowding out phenomenon which results if government borrowing leads to increased demand in the domestic money market.

In the traditional closed economy model, the increase in demand for money puts upward pressure on the interest rate. This in turn reduces investment. So, some of the original increase in aggregate demand brought about by increased government expenditure is crowded out by the decrease in private investment.

On the international side, there is the added effect of the higher interest rate on the foreign exchange market. Again assuming mobile capital and flexible exchange rates, the rise in the U.S. interest rate triggers capital inflows, increasing foreign agents' demand for U.S. dollars. This causes the value of the dollar to rise and net exports to fall. Thus expansionary fiscal policy crowds out both private investment and net exports, and the success of fiscal policy is less in the internationalized model than in the traditional model.

As in the monetary policy case, the instructor may wish to extend the model and include some "second-round effects." In particular, the international effects on domestic interest rates may be important. If capital is very mobile, the fall in real GNP caused by the large capital inflows (and appreciation of the dollar) may reduce the demand for money in the second round sufficiently that the domestic interest rate returns to its former level. In this case the crowding out of net exports is large but the crowding out of domestic investment is negligible.

IV. CONCLUSION

The policy implications for an internationalized economy cannot be ignored at the principles level. To do otherwise would simply expose students to an isolationist fantasy. Through the popular media, many students are aware of the expanding importance of imports and exports, the growth of multinational firms, and the increased attention given to the trade deficit and value of the dollar. Policy discussions are much richer when our theory takes into account these international realities. Our method of teaching the domestic and foreign money markets together allows the instructor to emphasize internationalized macroeconomic policy.

REFERENCES

Chacholiades, Miltiades. International Monetary Theory and Policy. New York: McGraw-Hill Book Company, 1978.

Ingram, James C. International Economics. 2nd. ed. New York: John Wiley & Sons, 1986.

Yarbrough, Beth V. and Robert M. Yarbrough. The World Economy: Trade and Finance. Chicago: The Dryden Press, 1988.

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Author: | Weber, William V.; Highfill, Jannett K. |
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Publication: | Economic Inquiry |

Date: | Apr 1, 1990 |

Words: | 1805 |

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