Transcript Chater 29 Open economy macroeconomics

Chapter 29
Open economy macroeconomics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward
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Open economy macroeconomics
• … is the study of economies in which
international transactions play a significant
role
– international considerations are especially
important for open economies like the UK,
Germany or the Netherlands
• Domestic macroeconomic policy in such
countries cannot ignore the influence of the
rest of the world
– especially via the exchange rate.
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Macroeconomic policy under fixed
exchange rates
• Under fixed exchange rates, there is a crucial link
between external imbalance and domestic money
supply.
• When the government intervene to maintain the
exchange rate, there is a direct effect on money
supply.
• Sterilisation
– an open market operation between domestic money and
domestic bonds to neutralise the tendency of balance of
payments surpluses and deficits to change domestic money
supply.
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Monetary policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in nominal money supply
– tends to reduce interest rates
– leads to a capital outflow
– reducing money supply as the government seeks
to maintain the exchange rate
• so monetary policy is powerless
– the government cannot fix independent targets for
both money supply and the exchange rate
– domestic and foreign interest rates cannot diverge
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Fixed exchange rates and the
loss of monetary sovereignty
Interest rates
LM LM’
To the consequent capital
outflow caused by the r falling
below r*, will continue until r* is
restored.
A
r*
r’
The need to match r* leads
to a loss of monetary
sovereignty
IS
Y*
Beginning at A, a monetary
expansion lowers r to r’, leading
to capital outflows.
Output
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Fiscal policy under fixed exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in government expenditure,
• in the short run,
– stimulates output
– but also increases interest rates
– which leads to a capital inflow
– money supply expands to maintain the exchange rate
– there is no crowding-out
– as interest rates cannot rise
• in the long run,
– wages and prices adjust, affecting competitiveness
– the economy returns to potential output.
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Fixed exchange rates and
fiscal expansion
Interest rates
LM LM’
A
B
r*
IS
Y*
Y’
IS’
Output
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Beginning at A, a fiscal
expansion shifts the IS curve
to IS’.
Ordinarily, interest rates
would rise to dampen some
of the increase in Y. Since
rates cannot rise above r*,
extra money supply (LM to
LM’) has to accommodate the
extra demand for money.
A fiscal expansion leads to
a big short-run effect on
output i.e. from Y* to Y’.
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Monetary policy
under floating exchange rates
Suppose the economy begins in equilibrium
with the nominal exchange rate at e1.
e
At time t, nominal money
supply is halved...
B
e3
e2 will be the new equilibrium
exchange rate once the
economy has adjusted
C
e2
e1
A
t
Time
But prices are sluggish, so
in the short run, real money
supply falls and domestic
interest rates rise.
These higher rates push the
exchange rate to e3.
Adjustment towards e2 takes place along BC as wages and prices
become more flexible.
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Monetary policy
under floating exchange rates (2)
• This analysis suggests that with floating
exchange rates
• monetary policy is highly effective in the short
run
• but the effect is only transitional.
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Fiscal policy
under floating exchange rates
• Following an increase in government
expenditure ...
• the crowding-out effect of higher interest
rates is enhanced by appreciation of the
exchange rate
– which dampens export demand
• so fiscal policy is less effective under floating
exchange rates.
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Further Reading
• Ercan KUMCU: “Kafamızın Karışık
Olduğu Konular” August 14, 2007
http://www.hurriyet.com.tr/yazarlar/7080158.asp
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