Transcript 9.1 Internal Balance and External Balance

International Economics
Chapter 9
Macroeconomic Policies
in Open Economy
Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance
 9.2 Policy Mix to Achieve Internal Balance and
External Balance
 9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates
 9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates
9.1 Internal Balance and External Balance

Internal Balance and External Balance

Internal balance means (1) full employment, (2) no
inflation, or more realistically, low inflation, and (3)
steady economic growth.
External balance is the achievement of neither BP
deficits nor BP surpluses.
9.1 Internal Balance and External Balance
BP Surplus
II
Unemployment
I
O
III
Inflation
IV
BP Deficit
9.1 Internal Balance and External Balance

Policy Instruments

Expenditure-changing policies include fiscal policy
and monetary policy, altering the level of aggregate
demand for goods and services which are either
produced domestically or imported.
Expenditure-switching policies refer to exchange-rate
policies, including appreciation or depreciation of a
currency, which shifts the direction of demand between
domestic output and imports.
9.1 Internal Balance and External Balance
When
an economy is located in the disequilibrium
zones of Quadrant I and III in Figure 9-1, expenditureswitching policies can restore the economy to overall
balance.
 In Quadrant I: An appreciation of its currency
decreases the international competitiveness of its
goods and leads to a fall in export, which, on the
one hand, decreases its BP surplus, and on the other
hand, reduces its aggregate demand and thus output,
lessening its inflation.
 In Quadrant III: A depreciation can restore the
overall balance.
9.1 Internal Balance and External Balance
Tinbergen
Rule
 One economic goal could be attained by at least one
effective policy tool. Thus, to achieve n independent
goals, we need no less than n effective policy tools.
9.1 Internal Balance and External Balance
Meade
Conflict
 Under fixed exchange rate system, a country cannot
change its exchange rate and thus it loses
expenditure switching policy tools. In this condition,
the goals of internal balance and external balance
may become conflicting since the government now
can only resort to expenditure changing policies.
9.1 Internal Balance and External Balance
– In Quadrant I, the economy will meet the conflict
between internal balance and external balance.
» A contractionary expenditure changing policy will
reduce output and income, decreasing the inflation
and restoring internal balance. But reduced national
income then weakens imports, enlarging its BP
surplus and worsening its external imbalance.
» If the government uses an expansionary
expenditure-changing policy, the external balance
can be achieved but the internal economy will be
imbalanced with more severe inflation.
– In Quadrant III, the economy will also meet the
conflict between internal balance and external balance.
9.1 Internal Balance and External Balance

In a fixed exchange rate system where
expenditure-switching policies cannot be fulfilled,
we need two independent policy tools to achieve
both internal balance and external balance and
thus solve Meade Conflict.
Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance
 9.2 Policy Mix to Achieve Internal Balance and
External Balance
 9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates
 9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates
9.2 Policy Mix to Achieve Internal Balance and
External Balance

Mundell Assignment Rule
 Fiscal
policy and monetary policy have different effects on
internal economy and external economy. So even under fixed
exchange rate system, it is likely to utilize fiscal policy and
monetary policy to achieve both internal and external balance.
 Fiscal policy and monetary policy may affect national income
and the current account to the same extent. But they have
different influence on the interest rate and the capital and
financial account.
 Contractionary fiscal policy can reduce the interest rate,
causing capital outflows and worsening the capital and
financial account.
 Contractionary monetary policy will increase the interest rate,
causing capital inflows and improving the capital and
financial account.
9.2 Policy Mix to Achieve Internal Balance and
External Balance
r
II
I
E
C
B
B’
A
III
EB
IV
IB
O
 IB
T−G
slopes downward: (T-G)↑=> Y↓, requiring r↓ =>I↑.
 Right to IB: Unemployment; Left to IB: Inflation.
 EB slopes downward: (T-G)↑=> Y↓ =>M↓, requiring r↓
=>capital outflow.
 Above EB: BP surplus; Below IB: BP deficit.
9.2 Policy Mix to Achieve Internal Balance and
External Balance
r
II
I
E
C
B
B’
A
III
EB
IV
IB
O
 Point A:
T−G
BP deficit with unemployment.
 Ms↓=> (1) r↑ => capital inflow => KA↑; (2) Y↓=> M↓=>
CA↑ =>B: EB + unemployment.
 G↑ => Y↑ => C: IB + BP deficit.
 Finally, Ms↓ + G↑ => E: IB + EB
9.2 Policy Mix to Achieve Internal Balance and
External Balance
Conclusion:
 Fiscal
policy should be assigned to solve internal
imbalance while monetary policy should be
assigned to solve external imbalance.
 If policies are wrongly assigned, the economy will
diverge from the overall balance.
9.2 Policy Mix to Achieve Internal Balance and
External Balance

Swan Model
Mundell Assignment
Rule solves Meade Conflict
under fixed exchange rate system by assigning fiscal
policy and monetary policy effectively.
Swan Model aims to achieve both internal balance and
external balance by combining expenditure-changing
policies and expenditure-switching policies when the
exchange rate can be changed.
9.2 Policy Mix to Achieve Internal Balance and
External Balance
eP*/P
EB
I
E
II
IV
A
III
O
 IB
IB
A
slopes downward: eP*/P↑=>NX↑, requiring A↓=>Y↓.
 Right to IB: inflation; Left to IB: unemployment.
 EB slopes upward: eP*/P↑=> NX↑, requiring A↑=>M↑.
 Above EB: BP surplus; Below EB: BP deficit.
9.2 Policy Mix to Achieve Internal Balance and
External Balance
eP*/P
EB
I
E
II
IV
A
III
O
 Point A:
IB
A
BP deficit with unemployment.
 Expansionary expenditure-changing policy to deal with the
internal unemployment;
 Depreciation of domestic currency to restore its balance of
payments.
Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance
 9.2 Policy Mix to Achieve Internal Balance and
External Balance
 9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates
 9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates
9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates

IS-LM-BP Model
r
LM
E
IS
O
 IS
Y
curve slopes downward.
 G↑=> IS shifts rightward; G↓=> IS shifts leftward.
 LM curve slopes upward.
 Ms↑=> LM shifts rightward; Ms↓=> LM shifts leftward.
9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates
r
r
r
BP
BP
BP
O
Y
(a)
Right
O
Y O
(b)
Y
(c)
to BP: BP deficit; Left to BP: BP surplus.
 (a): Perfect capital immobility;
 (b): Imperfect capital mobility;
 (c): Perfect capital mobility.
9.3 Effects of Macroeconomic Policies
under Fixed Exchange Rates

Effects of Fiscal Policy under Fixed Exchange Rate

Fiscal policy has no effect on economy under fixed
exchange rate when capital is perfectly immobile, only to
find a higher interest rate.
 Fiscal policy has some effect on economy under fixed
exchange rate when capital is imperfectly mobile. But the
extent of effect relies on the sensibility of capital flow to
changes of the interest rate. The more sensible the capital
flow is, the larger the effect of fiscal policy is.
 Fiscal policy has perfect effect on economy under fixed
exchange rate when capital is perfectly mobile.
A. Case of Perfect
Capital Immobility
r
BP
LM’
LM
r2
E2
r1
r0
E1
E0
IS’
IS
O
Y0 Y1
e +K:
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K  KA
CA− > KA  BP−  e↑   f↑  Ms↓  LM  E2: Y↓(Y0) ; r↑(r2)
Y
B. Case of Imperfect
Capital Immobility
(BP>LM)
r
r2
r1
r0
BP LM’
E2
LM
E1
E0
IS’
IS
O
Y0 Y2 Y 1
(a)
Y
e + K̂ (BP>LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
CA− > KA+  BP−  e↑   f↑  Ms↓  LM  E2: Y↓(Y2>Y0) ; r↑(r2)
r
B. Case of Imperfect
Capital Immobility
(BP=LM)
LM, BP
r1
r0
E1
E0
IS’
IS
O
Y0 Y 1
(b)
Y
e + K̂ (BP=LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
(CA− = KA+  BP )
r
B. Case of Imperfect
Capital Immobility
(BP<LM)
LM LM’
r1
r2
r0
E1
E0
BP
E2
IS’
IS
O
Y0 Y 1 Y 2
(c)
e + K̂ (BP<LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
CA− < KA+  BP+  e↓   f↓  Ms↑  LM  E2: Y↑; r↓(r2>r0)
Y
r
LM
C. Case of Perfect
Capital Mobility
r0
E0
LM’
E1
BP
IS’
IS
O
Y0
Y1
Y
e +K:
G↑  AD↑  IS  Y↑
r↑  K↑  BP+  e↓   f↓  Ms↑  LM  E1: Y↑; r↓(r0)
9.3 Effects of Macroeconomic Policies
under Fixed Exchange Rates

Effects of Monetary Policy under Fixed Exchange Rate
 Monetary policy
has no effect on economy under fixed
exchange rate regardless of the extent of capital mobility.
r
A. Case of Perfect
Capital Immobility
BP
LM
LM’
r0
r1
E0
E1
IS
O
Y0 Y1
(a)
e +K:
Ms↑  LM  E1: Y↑(Y1)  M↑  CA−
r↓(r1)  K  KA
CA− > KA  BP−  e↑   f↑  Ms↓  LM  E0: Y↓(Y0); r↑(r0)
Y
r
B. Case of
Imperfect Capital
Immobility
LM
r0
r1
LM’
BP
E0
E1
IS
O
Y0 Y 1
(b)
Y
e + K̂ :
Ms↑  LM  E1: Y↑(Y1)  M↑  CA−
r↓(r1)  K↓  KA−
CA− + KA−  BP−  e↑   f↑  Ms↓  LM  E0: Y↓(Y0); r↑(r0)
r
C. Case of Perfect
Capital Mobility
LM
r0
E0
LM’
BP
IS
O
Y0
(c)
Y
e +K:
Ms↑  LM  Y↑
r↓  K↓  BP−  e↑   f↑  Ms↓  LM  E0: Y↓(Y0); r↑(r0)
Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance
 9.2 Policy Mix to Achieve Internal Balance and
External Balance
 9.3 Effects of Macroeconomic Policies under
Fixed Exchange Rates
 9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates

Under floating exchange rate, changes of the exchange
rate will cause shifts of BP curve.
 A depreciation of
domestic currency leads to a rightward shift
of BP curve.
 An appreciation leads to a leftward shift of BP curve.
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates
r
BP’’
BP
e↓
r0
O




e↑
C
A
B
Y2
Y0
Y1
BP’
Y
On BP curve, r0 and Y0 keeps the economy in external balance.
A depreciation results in more export and less import, leading to a surplus
of the balance of payments.
To digest the surplus of the balance of payments, national income needs to
grow in order to encourage more import.
At any other interest rates, the same thing happens.
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates

Effects of Fiscal Policy under Floating Exchange Rate
 The
effect of fiscal policy under floating exchange rate is
inversely proportional to the extent of capital mobility. The
less mobile capital is, the stronger effect fiscal policy has.
A. Case of Perfect
Capital Immobility
r
BP’
BP
LM
r2
E2
r1
r0
E1
E0
IS’’
IS’
IS
O
Y0 Y1 Y2
e+K :
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K  KA
CA− > KA  BP−  e↑  X↑, M↓  IS' , BP  E2: Y↑(Y2); r↑(r2)
Y
r
B. Case of Imperfect
Capital Immobility
(BP>LM)
BP BP’
LM
r2
r1
r0
E2
E0
E1
IS
O
IS’’
IS’
Y0 Y1 Y 2
(a)
e + K̂ (BP>LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
CA− > KA+  BP−  e↑  X↑, M↓  IS' , BP  E2: Y↑(Y2); r↑(r2)
Y
r
B. Case of Imperfect
Capital Immobility
(BP=LM)
LM, BP
r1
r0
E1
E0
IS’
IS
O
Y0 Y1
(b)
Y
e + K̂ (BP=LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
(CA− = KA+  BP )
B. Case of Imperfect
Capital Immobility
(BP<LM)
r
LM
BP’
BP
E1
r1
E2
r2
r0
E0
IS
O
Y 0 Y2 Y 1
(c)
IS’
IS’’
Y
e + K̂ (BP<LM):
G↑  AD↑  IS  E1: Y↑(Y1)  M↑  CA−
r↑(r1)  K↑  KA+
CA− < KA+  BP+  e↓  X↓, M↑  IS ' , BP  E2: Y↓(Y2>Y0); r↓(r0)
r
C. Case of Perfect
Capital Mobility
r0
LM
E0
BP
IS’
IS
O
Y0
e+K :
G↑  AD↑  IS  Y↑
r↑  K↑  BP+  e↓  X↓, M↑  IS  E0: Y↓ (Y0)
Y
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates

Effects of Monetary Policy under Floating Exchange Rate

Monetary policy has perfect effect on economy under floating
exchange rate regardless of the extent of capital mobility.
r
A. Case of Perfect
Capital Immobility
BP’
BP
LM
LM’
r0,r2
r1
E0
E2
E1
IS’
IS
O
Y0 Y1 Y2
(a)
e+K :
Ms↑  LM  E1: Y↑(Y1)  M↑  CA−
r↓(r1)  K  KA
CA− > KA  BP−  e↑  X↑, M↓  BP , IS  E2: Y↑(Y2); r↑(r2=r0)
Y
r
B. Case of
Imperfect Capital
Immobility
LM
LM’
BP
r0,r2
r1
O
E0
E2
BP’
E1
Y0 Y1 Y2
(b)
IS IS’
Y
e + K̂ :
Ms↑  LM  E1: Y↑(Y1)  M↑  CA−
r↓(r1)  K↓  KA−
CA− + KA−  BP−  e↑  X↑, M↓  BP , IS  E2: Y↑(Y2); r↑(r2= r0)
r
C. Case of Perfect
Capital Mobility
LM
r0
E0
LM’
E1
BP
IS’
IS
O
Y0
(c)
Y1
Y
e+K :
Ms↑  LM  Y↑
r↓  K↓  BP−  e↑  X↑, M↓  IS  E1: Y↑ (Y1)
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates

A Summary of Mundell-Flemming Model
9.4 Effects of Macroeconomic Policies
under Floating Exchange Rates

Mundell Incompatible Trinity
 One
country cannot have a fixed exchange rate, free capital
movement and an independent monetary policy at the same
time.
Fixed Exchange Rate
Free Capital Movement
Independent Monetary Policy