Download Monetary policy

Robert Carbaugh
INTERNATIONAL
ECONOMICS, 15E
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Macroeconomic Policy
in an Open Economy
Chapter 16
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Chapter Outline
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Economic Objectives of Nations
Policy Instruments
Aggregate Demand and Aggregate Supply: A Brief
Review
Monetary and Fiscal Policy in a Closed Economy
Monetary and Fiscal Policy in an Open Economy
Macroeconomic Stability and the Current
Account: Policy Agreement vs Policy Conflict
Inflation with Unemployment
International Economic Policy Coordination
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service or otherwise on a password-protected website for classroom use.
Economic Objectives of Nations
(1 of 2)
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Objectives of macroeconomic policy
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Internal balance
External balance
Overall balance
Long-term economic growth
Reasonably equitable distribution of national
income
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Economic Objectives of Nations
(2 of 2)

Objectives of macroeconomic policy (cont.)
◦ Internal balance
 Economic stability at full employment
 A fully employed economy
 No inflation
◦ External balance
 When it realizes neither deficits nor surpluses in its
current account
◦ Overall balance
 The combination of internal balance and external
balance
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Policy Instruments (1 of 3)
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Expenditure changing policies
◦ Alter the level of total spending (aggregate
demand) for goods and services which are
either produced domestically or imported
◦ Fiscal policy
 Changes in government spending and taxes
 Responsibility of President & the U.S. Congress
◦ Monetary policy
 Changes in the money supply and interest rates
 Responsibility of the Central bank (Federal Reserve)
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service or otherwise on a password-protected website for classroom use.
Policy Instruments (2 of 3)
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Expenditure-switching policies
◦ Modify the direction of demand
 Use policies that shift between domestic output and
imports
◦ Under fixed exchange rates and trade deficit
 Devalue currency
◦ Under managed floating exchange-rate and to
increase its competitiveness
 Depreciate currency
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service or otherwise on a password-protected website for classroom use.
Policy Instruments (3 of 3)
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Direct controls (such as tariffs)
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Government restrictions in a market economy
Control particular items in the current account
Restrain capital outflows
Stimulate capital inflows
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Aggregate Demand & Aggregate
Supply: A Brief Review (1 of 3)
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Aggregate demand-Aggregate supply model
◦ Aggregate demand curve (AD)
 Level of real output (real GDP) purchased at various
price levels during a given year
 Spending by domestic consumers, businesses, government, and
foreign buyers (net exports)
 On an Aggregate Demand curve, as the price level falls
 The quantity of real output demanded increases
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Figure 16.1- Macro Equilibrium:
Aggregate Demand… Supply
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service or otherwise on a password-protected website for classroom use.
Aggregate Demand & Aggregate
Supply: A Brief Review (2 of 3)
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Aggregate demand-aggregate supply model
◦ Aggregate supply curve (AS)
 Relation between the level of prices and amount of
real output that will be produced by the economy
during a given year
 Upward sloping
 Per-unit production costs and prices increase as real output
increases
◦ Macroeconomic Equilibrium: AD = AS
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service or otherwise on a password-protected website for classroom use.
Aggregate Demand & Aggregate
Supply: A Brief Review (3 of 3)
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Shifts in aggregate demand curve
◦ Changes in the determinants of AD
 Consumption, investment, government purchases, or
net exports
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Shifts in aggregate supply curve
◦ Changes in the price of resources, technology,
business expectations
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Monetary and Fiscal Policy
in a Closed Economy (1 of 2)
Monetary & Fiscal Policies Tools to Influence
Performance of Economy
 If aggregate output is too low & if the
unemployment is high, then the government
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◦ Increases aggregate demand which may result in
higher output by engaging in:
 Expansionary monetary and/or fiscal policies
 Increase in domestic consumption, investment, or
government spending resulting in an increase in the
country’s real GDP
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service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in a Closed Economy (2 of 2)
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To control inflation, the government will:
◦ Reduce the level of aggregate demand for real
output by engaging in
 Contractionary monetary and/or fiscal policies
 Upward pressure on prices is softened and inflation
moderates
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service or otherwise on a password-protected website for classroom use.
Figure 16.2- Effect of Expansionary
Monetary or Fiscal Policy…GDP
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Monetary and Fiscal Policy
in an Open Economy (1 of 7)

Expansionary monetary or fiscal policy
◦ Initial effect (only effect in closed economy)
 Increase in aggregate demand
 Increase in domestic consumption, investment, or
government spending
◦ Secondary effects in open economies
◦ Conflicting impacts: increase or decrease in
aggregate demand by
 Changing net exports and other determinants of
aggregate demand
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service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in an Open Economy (2 of 7)
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If the initial and secondary effects both
result in increases in aggregate demand,
then it
◦ Strengthens the effect of expansionary policy
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If the initial and secondary effects have
conflicting impacts
◦ Expansionary effects are weakened
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service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in an Open Economy (3 of 7)
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Effect of Fiscal & Monetary Policy under
Fixed Exchange Rates
◦ Expansionary fiscal policy more successful and
an expansionary monetary policy is less
successful in open economy than in closed
economy at stimulating the economy
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Table 16.1- Effectiveness of
Monetary & Fiscal Policy…Mobility
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Monetary and Fiscal Policy
in an Open Economy (4 of 7)
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Fiscal Policy is Strengthened Under Fixed
Exchange Rates
◦ Initial effect: Increase aggregate demand
◦ Secondary effect: Increase aggregate demand
 Budget deficit; Higher interest rate
 Increased demand for domestic currency in foreigncurrency market
 Purchase foreign currency with domestic currency
 Increase in the domestic money supply
 Increase the amount of loanable funds
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service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in an Open Economy (5 of 7)

Monetary Policy is Weakened Under Fixed
Exchange Rates
◦ Initial effect: Increase aggregate demand
 Money Supply increases, domestic interest rate reduces
 Increased consumption and investment
◦ Secondary effects: Reduced aggregate demand
 Decreasing demand for domestic currency due to low
interest rates
 To maintain fixed exchange rate, authorities purchase
domestic currency with foreign currency which result in
 Decrease in money supply and loanable funds
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in an Open Economy (6 of 7)
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Effect of Fiscal & Monetary Policy Under
Floating Exchange Rates
◦ Initial effect: Increase aggregate demand
 Reduce the domestic interest rate
 Increased consumption and investment
◦ Secondary effect: Increase aggregate demand
 Domestic currency depreciates
 Increase in exports, decrease in imports, improvement in
current account
◦ Monetary policy – strengthened under floating
exchange rates
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or
service or otherwise on a password-protected website for classroom use.
Monetary and Fiscal Policy
in an Open Economy (7 of 7)

Effect of Fiscal & Monetary Policy Under Floating
Exchange Rates (cont.)
◦ Fiscal policy is weakened under floating exchange
rates
 Initial effect: Increase aggregate demand
 Secondary effect: Decrease aggregate demand
 Budget deficit; Higher interest rate
 Increased demand for domestic currency in the
foreign-exchange market
 Domestic currency appreciates; Falling exports
 Rising imports, Deteriorating current account
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service or otherwise on a password-protected website for classroom use.
Macroeconomic Stability & Current
Account: Policy Agreement vs Conflict
(1 of 2)

Recession + current account deficit
◦ Floating exchange rates
◦ Expansionary monetary policy to combat
recession
 Currency depreciation
 Rise in exports and fall in imports
◦ Reduce the current account deficit
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A single economic policy promotes overall
balance
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service or otherwise on a password-protected website for classroom use.
Macroeconomic Stability & Current
Account: Policy Agreement vs Conflict
(2 of 2)

Inflation + current account deficit
◦ Contractionary monetary policy to combat
inflation
 Increase in domestic interest rate
 Currency appreciation
 Fall in exports and rise in imports
◦ Larger current-account deficit
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Policy conflict: monetary policy (or fiscal
policy) alone will not restore both internal
and external balance
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Inflation with Unemployment
(1 of 2)
Assumed that as economy advances to full
employment, domestic prices unchanged until
full employment reached
 Once nation’s production capacity achieved,
further increases in aggregate demand pull
prices upward
 This is demand-pull inflation
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Inflation with Unemployment
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(2 of 2)
Inflation with unemployment
◦ Internal balance cannot be achieved just by
manipulating aggregate demand
 Reduce AD to decrease inflation
 Increase AD to decrease unemployment
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Overall balance - three separate targets
◦ Current-account equilibrium
◦ Full employment
◦ Price stability (Wage & Price controls)
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International Economic
Policy Coordination (1 of 5)
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Economic relations among nations
◦ Conflict -- Independence -- Integration
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Policy cooperation
◦ Officials from different nations meet to evaluate
world economic conditions
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International economic policy
coordination
◦ Formal agreement among nations to initiate
particular policies to modify national monetary,
fiscal & exchange rate policies
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service or otherwise on a password-protected website for classroom use.
Figure 16.3- Relations
among National Governments
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service or otherwise on a password-protected website for classroom use.
International Economic
Policy Coordination (2 of 5)
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Policy Coordination in Theory
◦ Some nations give higher priority to price stability,
or to full employment, than others
◦ Some nations have a stronger legislature
 Or weaker trade unions, than others
◦ The party pendulums in different nations
 Shift with elections occurring in different years
◦ One nation may experience economic recession
 While another nation experiences rapid inflation
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International Economic
Policy Coordination (3 of 5)
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Does Policy Coordination Work?
◦ Plaza Agreement of 1985, Group of Five (G-5)
nations - The United States, Japan, Germany, Great
Britain, and France
 Overvalued U.S. dollar
 Twin U.S. deficits (trade & federal budget) were too large
◦ Each country
 Specific pledges on macroeconomic policy
 Agreed to initiate coordinated sales of the dollar
◦ By 1986, dollar had dramatically depreciated
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International Economic
Policy Coordination (4 of 5)
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Does Policy Coordination Work? (cont.)
◦ But New concern: uncontrolled dollar plunge
◦ Louvre Accord of 1987, Group of Five (G-5)
 Intervention policies – curbing the pace of the dollar’s
depreciation
 Other macroeconomic adjustments
◦ By 2000s, more difficult to coordinate
 Rise of independent central banks
 Makes coordination more difficult
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International Economic
Policy Coordination (5 of 5)
Does Policy Coordination Work? (cont.)
 2000, Group of Seven (G-7)
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◦ The United States, Canada, Japan, the United
Kingdom, Germany, France, and Italy
◦ Coordinated purchases of the euro to boost its
value
◦ From $0.84 per euro to more than $0.88 per euro
◦ Within two weeks following the intervention, the
euro’s value slid to an all-time low
◦ Economists considered intervention a failure
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