Transcript chapter 18
Macroeconomic policy in an open economy Fiscal policy: Monetary policy definition, how conducted effect on interest rates and inflation effect on exchange rates and balance of payments definition, how conducted effect on interest rates and inflation effect on exchange rates and balance of payments We will not consider aggregate demand/aggregate supply effects Fiscal policy Keynes: the government should deliberately incur deficits when the economy is in recession, so as to stimulate demand incur surpluses when the economy is booming, so as to dampen demand His deficit prescription was very popular with politicians, business people, taxpayers – a free lunch! Surplus prescription largely forgotten Effects of fiscal stimulus on loanable funds market Increased spending must necessarily be financed by borrowing Causes outward shift in the demand curve for loanable funds If it were financed by taxation, there would be no stimulative effect, just a wealth transfer from taxpayers to politicians Raises interest rates, other things equal Crowds out marginal private borrowers The supply of loanable funds is not perfectly inelastic as Fig. 18.1 suggests: higher interest rates encourage saving Deficits do not cause inflation Deficit spending does not in itself increase the money supply, so there is no money inflation There could be a minor price deflation as people are induced to save more by higher interest rates, meaning they demand fewer consumption goods Deficits indirectly lead to price inflation when central banks soak up some of the new bond issues using newly created money Effects of expansionary fiscal policy on exchange rates Higher interest rates attract capital from abroad, e.g. UK investors who must change £ into $ In $/£ forex market, the supply of £ rises and the $/£ XR drops Also US investors are less inclined to invest in UK, therefore demand for UK£ drops, and this further suppresses the $/£ XR Lower $/£ XR due to fiscal stimulus A lower $/£ XR (appreciated $) is (in the short run) bad for US export industries since exports cost more for UK buyers (in terms of £) good for US consumers since UK imports cost less (in terms of $) good for UK producers who face reduced competition from US producers bad for UK consumers for whom imports from US cost more Public choice theory says the US producers have a louder voice & will complain to their politicians: “We are bearing an unfair burden!” Summary of effects of fiscal policy on international trade Expansionary fiscal policy Loanable funds market Increased demand (to cover deficit) raises interest rate Higher interest rate boosts capital inflow, discourages outflow Capital account improves, current account worsens Increased supply of foreign currency to buy US securities suppresses XR Reduced demand for foreign currency to acquire foreign securities further suppresses For our example, $/£ falls, meaning the US$ appreciates) Inflation No direct effect Contractionary fiscal policy Monetary policy Central banks now monopolize the business of supplying money Our money is purely fiat money meaning that it is not even indirectly related to any commodity (gold or silver) The Fed engages in discretionary monetary policy (as distinguished from a rule-based policy) The Fed chairman, Alan Greenspan, was thought to be a wizard until the 2007 collapse The Fed expands the money supply when it believes this necessary to stimulate the economy Expansionary Monetary Policy The Fed expands the money supply (money inflation) by buying Treasury securities from New York bond dealers using newly created money (“open market operations”) Fed expansionary policy constitutes an increase in the supply of loanable funds (supply curve should not be inelastic as in Fig. 18.7) Drives down interest rate Encourages business borrowing which is supposed to revive the economy Summary of effects of monetary policy on international trade Expansionary monetary policy (cont’d) Inflation Money inflation results in price inflation (falling PPM) Price inflation makes US goods less attractive to foreigners, and foreign goods more attractive to US people Supply of foreign currency drops, demand rises XR rises, US$ depreciates loanable funds market New money created by the Fed enters the bond market, supply of loanable funds rises Interest rate falls Foreigners less interested in US securities, US people more interested in foreign securities Demand for Summary of effects of monetary policy on international trade Expansionary monetary policy (cont’d) Inflation Increased supply of loanable funds (newly created Fed $) suppresses interest rates Lower interest rate means some capital goes to foreign countries Capital account worsens, current account improves Reduced supply of foreign currency from foreigners wanting US capital assets, and increased demand for foreign currency by US people, raises XR of foreign currency (e.g. $/£, falls, meaning the US$ depreciates) Inflation No direct effect Contractionary monetary policy: everything is reversed How all of this complication could vanish Replace central banking with free banking where private banks issue money in response to user demand. Try to maintain a balanced budget at all times Government monetary policy ceases to exist Government fiscal policy ceases to exist As more countries adopt free banking, market forces would push money issuers toward a common standard XR issues would cease to exist Domestic stimulus or currency war? Expansionary monetary policy as we have seen depreciates a country’s currency Open question: were recent expansionary monetary actions (Japan, U.S.) intended to stimulate the domestic economy generally or were they specifically trying to boost export industries, thus inviting retaliation? The J Curve Devaluation of a country’s currency leads to expansion of exports and an increase in its current account balance (increased surplus or decreased deficit) The short run effect may be in the opposite direction. Why? Exporters may have long-term commitments to sell at a particular price. Those terms may be renegotiated later, and increased production comes on line only later But import prices rise immediately Net short-term effect: worsened current account