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Sem 5 Prep
← Open Economy MacroInternal and external balance

Formulas for this chapter

Equilibrium with a government sector

I + X + G = S + M + T k = 1 / (MPS + MPM + MPT) Sequence: closed 1/0.25 = 4, open 1/0.40 = 2.5, with government 1/0.50 = 2

Any question involving fiscal policy. G is an injection, T a leakage, and the leakage rate now has three components.

G
Government expenditure, an injection alongside I and X
T
Taxes, a leakage alongside S and M
MPT
The marginal tax rate, the share of extra income taken in tax

Sizing an expenditure-changing policy, and its external cost

required change in autonomous spending = income gap / k induced change in imports = MPM x income gap external cost per unit of fiscal action = k x MPM

Every Zone II and Zone IV question. The first line hits the internal target, the second measures the damage to the external one.

income gap
Full-employment income minus current income; negative for an inflationary gap
k x MPM
Deficit opened per unit of fiscal expansion, e.g. 2 x 0.15 = 0.30

Reading the Swan diagram

Vertical axis R (exchange rate) Horizontal axis D (absorption) EE external balance, slopes UP YY internal balance, slopes DOWN Above EE surplus, below EE deficit Above YY inflation, below YY unemployment Zones anticlockwise from the left: I, II, III, IV

Any draw-and-explain question on internal and external balance. Name the axes first, then justify each slope, then the zones.

F
The intersection of EE and YY, where both balances hold
Zone I
Left of F: surplus with unemployment
Zone III
Right of F: deficit with inflation
Step 2 of 25
The real wordsTheory

Why policy at all

The last chapter ended with a list of side effects. The deck opens with the consequence.

The need for adjustment policies arises because the automatic adjustment mechanisms have serious unwanted side effects.

A deficit nation waiting for automatic income adjustment has to accept falling income. A surplus nation at full employment has to accept inflation. Neither is politically survivable.

James Meade is the economist who shifted the emphasis from automatic adjustment to policy-based adjustment, and that shift is what Chapter 18 is.

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