Macroeconomic Policy in an Open Economy Chapter 16

Macroeconomic Policy in an Open Economy Chapter 16 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Economic Objectives o internal balance • fully employed economy • no inflation – or reasonable amount of inflation o external balance – neither a deficit nor a surplus in current account o overall balance – both internal and external balance o other goals: long-run economic growth and equitable income distribution

Policy Instruments o expenditure changing policies – alter aggregate demand for both domestic and international goods and services • fiscal policy – government changes spending and taxation • monetary policy – central bank changes money supply and interest rates o expenditure switching policies – modify direction of demand between domestic output and imports; example: currency depreciation o direct controls – government restrictions on economy; example: tariffs

Expansionary Policy in Closed Economy o to increase output and reduce unemployment central bank increases money supply decreasing interest rates o leads to increased AD o more AD leads to increased GDP o fiscal policy alternatives would be to increase government spending or decrease taxes

Expansionary Fiscal Policy with Fixed Exchange Rates o secondary effect is an increased budget deficit which increases interest rates o attracts more foreign investment o increases demand for domestic currency o fixed exchange rates require government purchase foreign currency o increases money supply further increasing AD

Expansionary Monetary Policy with Fixed Exchange Rates o to increase AD interest rates are decreased o discourages foreign investment o decreases demand for dollars o fixed exchange rate system requires government use foreign currency reserves to purchase domestic currency o decrease in money supply reduces AD

Expansionary Fiscal Policy with Floating Exchange Rates o initial effect is move from AD 0 to AD 1 o greater deficit leads to increased interest rates o causes inflow of foreign investment o increased demand for domestic currency o appreciation leads to decline in current account o reduced impact of fiscal policy

Expansionary Monetary Policy with Floating Exchange Rates o increase money supply decreases interest rates o causes increase in AD o shift of investments toward other nations o requires sale of domestic currency o resulting depreciation leads to further increase in AD o policy is particularly effective in this case

Summary of Effectiveness Monetary Policy Fiscal Policy Floating Exchange Rate Strengthened Weakened Fixed Exchange Rate Weakened Strengthened

Policy Conflict-Zone recession & current account deficit o under floating exchange rate system expansionary monetary policy causes increase in GDP as well as depreciation improving current account deficit inflation & current account deficit o under floating exchange contractionary monetary policy limits inflation but leads to appreciation increasing current account deficit o policy zone conflict – monetary policy cannot restore both internal and external balance

Inflation with Unemployment o more problematic because internal balance cannot be achieved by managing AD o overall balance requires 1) current account equilibrium 2) full employment 3) price stability o 1971 example of inflation with unemployment o resulting actions: expansionary policy with wage & price controls along with devaluation of the dollar

International Policy Coordination o mobility of goods, services, labor and capital o economic policies of one nation will have impact on economies of other nations o coordination – attempt to modify monetary, fiscal and exchange rate policies recognizing international repercussions

Examples of Policy Coordination o 1984: U. S. expansionary fiscal policy used to address recession o caused appreciation of dollar and current account deficit o Plaza Agreement of 1985 • G-5: U. S. , Japan, Germany, Great Britain, and France • pledges: U. S. – reduce federal deficit Japan – expansionary monetary policy Germany – tax reductions

Examples of Policy Coordination (cont. ) o 1985 -88: dollar decreased 54% o decline in dollar’s value led to concern of more drastic decrease in value o Louvre Accord 1987 U. S. – adopt restrictive fiscal policy Japan – ease monetary policy o U. S. current account deficit began to decline and reached balance by 1991 o coordination efforts may not be successful due to central banks independence and growth of global financial markets