Transcript Open economy macro policy Monetary policy

International Economics
By Robert J. Carbaugh
8th Edition
Chapter 17:
Macroeconomic Policy in an
Open Economy
Copyright ©2002, South-Western College Publishing
Open economy macro policy
Policy in an open economy
 Countries which are open to the world economy
cannot make domestic economic policy choices
without considering the impact on trade and
payments and their international relationships
 Nor can open economies entirely insulate
themselves from other countries’ policy choices
 As a result, nations make efforts to coordinate
their international economic policies
 Economic policies are also subject to domestic
and foreign institutional constraints
Carbaugh, Chap. 17
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Open economy macro policy
Economic objectives
 Internal balance
 Fully employed economy
 Little or no inflation
 External balance
 Current account is close enough to balance
that foreign debts can be repaid (deficit) or that
other nations can repay their debts (surplus)
Carbaugh, Chap. 17
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Open economy macro policy
Policy instruments
 Expenditure-changing policies: alter aggregate
demand for goods
 fiscal policy
 Monetary policy
 Expenditure-switching policies: shift demand
to/from imports or domestic goods
 Devaluation or revaluation (fixed rates)
 Exchange market intervention (managed float)
 Direct controls
 Tariffs, quotas, subsidies, capital controls
Carbaugh, Chap. 17
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Open economy macro policy
Economic objectives and macro policy
Carbaugh, Chap. 17
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Open economy macro policy
Exchange rate policies & overall balance
 If a nation was experiencing recession and
a BOP deficit, a currency devaluation would
encourage exports and help boost domestic
production
 If it were experiencing inflation and a BOP
surplus, a revaluation would cut back on
exports and cool domestic spending
Carbaugh, Chap. 17
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Open economy macro policy
Exchange rate & overall balance (cont’d)
 Such policy moves are not made in a
vacuum; one country’s devaluation
effectively means a revaluation for its main
trading partners
 If done without international consultation,
these policy shifts might invite retaliation
(as occurred during the Great Depression)
Carbaugh, Chap. 17
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Open economy macro policy
Fiscal & monetary policy: internal effects
 Fiscal and monetary policy are generally used to
achieve internal balance, but their effectiveness
depends on the external sector
 Under a fixed exchange rate system, fiscal policy
is more successful in promoting internal balance
than is monetary policy
 Under a floating rate system, monetary policy is
more effective than fiscal policy at achieving
internal balance
Carbaugh, Chap. 17
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Open economy macro policy
Fiscal policy: short run internal effects
Under fixed exchange rates
Aggregate
demand
rises
Increase in
government
spending
Monetary
demand and
interest
rates
increase
Output and
employment rise
Net
capital
inflows
Central bank
sells
currency and
money
supply rises
Output and
employment rise
further
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Fiscal policy: short run internal effects
Under floating exchange rates
Aggregate
demand
rises
Increase in
government
spending
Monetary
demand and
interest
rates
increase
Imports rise
and trade
account
worsens
Output and
employment
rise
Net
capital
inflows
Decrease in
aggregate
demand, output,
employment
Currency
appreciation
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Monetary policy: short run internal effects
Under floating exchange rates
Money
supply
increases
Aggregate
demand
rises
Output and
employment rise
Interest
rate
falls
Net
capital
outflows
Currency
depreciates
Exports
rise and
trade
account
improves
Output and
employment rise
further
Assumes high degree of capital mobility
For contractionary monetary policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Monetary policy: short run internal effects
Under fixed exchange rates
Money
supply
increases
Aggregate
demand
rises
Interest
rate
falls
Net
capital
outflows
Output and
employment rise
Central
bank
purchases
currency
Money
supply
decreases
Output and
employment fall
Assumes high degree of capital mobility
For contractionary monetary policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Fiscal & monetary policy: external effects
 Since floating rates foster BOP equilibrium, focus
is on fixed rates
 In short run, monetary policy has a clear effect on
BOP
 Expansion worsens BOP balance
 Contraction improves BOP balance
 Short run effects of fiscal policy are not certain they depend on capital mobility
Carbaugh, Chap. 17
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Open economy macro policy
Monetary policy: short run external effects
Aggregate
demand
rises
Money
supply
increases
Trade
account
worsens
Interest
rates
fall
Overall BOP
worsens
Net capital
outflows
Capital
account
worsens
Assumes high degree of capital mobility
For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Fiscal policy: short run external effects
Aggregate
demand
rises
Trade
account
worsens
Increase in
government
spending
Overall BOP
may
improve
Money
demand
rises
Interest
rates
rise
Net
capital
inflows
For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17
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Open economy macro policy
Policy agreement and policy conflict
 Monetary policy
 If a nation has unemployment with a BOP surplus, or
inflation with a BOP deficit, an increase/decrease in the
money supply will restore both internal and external
balances
 But if a nation has unemployment with a BOP deficit, or
inflation with a BOP surplus, a policy aimed at solving
one problem will worsen the other
 Fiscal policy - effects are unclear under those
circumstances
Carbaugh, Chap. 17
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Open economy macro policy
Policy agreement and conflict (cont’d)
 In such cases where policy aims do conflict, some
combination of fiscal and monetary policy
measures will be necessary
 Some imbalances are even more intractable,
such as the case where a nation experiences
both inflation and unemployment along with a
BOP imbalance, and require a wider range of
policy instruments
Carbaugh, Chap. 17
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Open economy macro policy
International policy coordination
 Domestic economic policy moves can spill
over to affect other countries
 Major industrial nations have worked to
coordinate economic policy so that external
balances are maintained without sacrificing
domestic objectives
Carbaugh, Chap. 17
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Open economy macro policy
International policy coordination
 Annual Group of Seven (G-7) economic
summits
 Regular meetings of central bank heads at
the Bank for International Settlements
 Major international policy agreements, such
as the Smithsonian Agreement (1971);
Bonn Summit (1978); Plaza Accord (1985);
Louvre Accord (1987)
Carbaugh, Chap. 17
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