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C h a p t e r
1 8
Macroeconomic
Policy and
Floating
Exchange Rates
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
CHAPTER ORGANIZATION
•
•
•
•
•
•
•
Introduction
Fiscal and Monetary Policy
Changes in Fiscal Policy
Changes in Monetary Policy
Monetary and Fiscal Policy in an Open
Economy
Trade Flow Adjustment and Current Account
Dynamics
Summary
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18 – 2
INTRODUCTION
• Fiscal and monetary policies are two
macroeconomic policies that governments
employ to affect domestic output, maintain
full employment and price stability
• These are the 2 macroeconomic policies used
to achieve the 3 goals of any economic policy
• These polices have an effect on the exchange
rate, the current account, interest rates, and
short-run capital flows within an
environment of floating exchange rates
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18 – 3
FISCAL AND MONETARY POLICY
• Fiscal policy entails using changes in
government taxation and/or spending to
affect the level of economic activity GDP
• Monetary policy uses changes in the money
supply and/or interest rates to affect a
county’s GDP
• Changes in these policies have predictable
effects on the exchange rate, the current
account balance, and short-run capital flows
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18 – 4
FISCAL AND MONETARY POLICY
• In this chapter (Ch18) we’ll assume these
policies are conducted in a floating exchange
rate regime ERR (effects in a fixed ERR are in
Ch19)
• The assumption is that the government does
not employ fiscal and/or monetary policy in
an attempt to generate a balanced current
account, but to affect the output and price
level
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18 – 5
FISCAL AND MONETARY POLICY
• It used to be common practice for governments to
•
•
•
focus fiscal and/or monetary policy on obtaining
what is known as an external balance
Governments now tend to use monetary and fiscal
policy to focus on a country’s internal balance
Internal balance refers to the levels of
unemployment and inflation that fit the preferences
of the citizens of various economies
The focus on internal balance comes at the expense
of external balance considerations
• Policies designed to achieve a desired internal balance
may have large consequences for a country’s external
balance
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18 – 6
CHANGES IN FISCAL POLICY
• In most countries, government spending is
such a large part of the GDP that any changes
can have a critical impact on an economy
• Substantial amounts spent on transfer
payments mean tax revenues add to this
amount
• A portion of total government spending is
usually financed through borrowing, thereby
having a significant impact on country’s
domestic financial markets and interest rates
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CHANGES IN FISCAL POLICY
• The demand for loanable funds is the total
•
•
demand for loans in the economy
It includes private sector demand from the
public’s consumption activities that must be
financed and business demand for funds for
investment
The public sector demand is generated by the
government’s need for funds which is the
difference between total government spending
and total taxes collected
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18 – 8
CHANGES IN FISCAL POLICY
• The supply of loanable funds represents the
•
•
total amount of money available to be borrowed
by the private and public sectors of the
economy
This is represented as perfectly inelastic; the
amount of loanable funds is not related to the
interest rate
In the short-run, the amount of money held in
savings by the public determines the supply of
loanable fund
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18 – 9
CHANGES IN FISCAL POLICY
Figure 18.1
Supply and Demand for Loanable Funds and
Expansionary Fiscal Policy
Interest Rate (i)
ie
S
E
D
Loanable Funds (L)
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18 – 10
CHANGES IN FISCAL POLICY
• Expansionary Fiscal Policy
• The government adopts an expansionary fiscal
policy by choosing to lower tax revenues and/or
have higher government spending
• This leads to a government budget deficit (or
larger deficit)
• Assume government borrows to finance and
does not print money
• This will have a predicable effect on interest
rates as in Fig 18.1
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CHANGES IN FISCAL POLICY
• An expansionary fiscal policy causes an increase
•
•
•
in the demand for loanable funds (from D to D’)
In a closed economy, this would cause interest
rates to rise (from ie to i’)
In an open economy with freely flowing
international capital, the rise in interest rates
causes an inflow of capital and an increase in the
supply of loanable funds (from S to S’)
This inflow of capital lowers domestic interest
rates (from i’ back to ie)
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18 – 12
CHANGES IN FISCAL POLICY
Figure 18.1
Supply and Demand for Loanable Funds and
Expansionary Fiscal Policy
Interest Rate (i)
i’
ie
S
S’
F
E
G
D’
D
Loanable Funds (L)
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18 – 13
CHANGES IN FISCAL POLICY
• The net result of an expansionary fiscal policy in
•
•
•
an open economy is that less upward pressure is
put on interest rates than would be the case in a
closed economy
A larger federal government budget deficit tends
to increase domestic interest rates which causes
an inflow of foreign capital into the country
The capital flows have an effect on the
equilibrium exchange rate (as described in Ch15)
This effect is shown in Fig. 18.2
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18 – 14
CHANGES IN FISCAL POLICY
Figure 18.2
Effects of Expansionary Fiscal Policy on the Exchange Rate
S
Exchange Rate
(XR)
S’
XRe
XR’
E
X
M
D
Foreign Exchange (FX)
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18 – 15
CHANGES IN FISCAL POLICY
• In an economy with a balanced current account, if
•
•
the government adopts an expansionary fiscal
policy and domestic interest rates rise, the inflow
of foreign capital requires foreign investors to sell
foreign currency to buy dollars
The supply of foreign exchange increases (from S
to S’) and the nominal exchange rate appreciates
(from XRe to XR’)
The capital inflows encouraged by the higher
interest rates will result in a capital account
surplus and a current account deficit (M-X at XR’)
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18 – 16
CHANGES IN FISCAL POLICY
• Therefore, an expansionary fiscal policy puts
•
•
upward pressure on domestic interest rates
which leads to an increase in the flow of capital
from abroad into the domestic financial markets
leading to an appreciating currency and a current
account deficit
However, we need to consider the effect of an
expansionary fiscal policy on the domestic
economy (using tools of AD and AS from Ch17)?
In a closed economy, this would lead to an
increase in domestic output and price level
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18 – 17
CHANGES IN FISCAL POLICY
Figure 18.3
Effects of Fiscal Policy on Equilibrium Output and Price Level
Price Level (P)
AS
P’
F
Pe
E
AD’
AD
Ye
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Y’
Real GDP (Y)
18 – 18
CHANGES IN FISCAL POLICY
• In an open economy, the effects are less
clear as an expansionary fiscal policy has
two conflicting effects
• The policy increases AD as the government
reduces taxes and/or increases spending –
the direct effect
• On the other hand, the policy reduces AD
as the exchange rate appreciates and the
current account balance deteriorates – the
indirect effect
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18 – 19
CHANGES IN FISCAL POLICY
Figure 18.3
Effects of Fiscal Policy on Equilibrium Output and Price Level
Price Level (P)
AS
Direct Effect: AD’
Indirect Effect: AD’’/AD’’’
P’
Pe
AD’
AD’’
AD
AD’’’
Ye
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Y’
Real GDP (Y)
18 – 20
CHANGES IN FISCAL POLICY
• The net effect depends on the magnitude
of the two effects
• Conclusion: Expansionary fiscal policy in
an open economy is less effective at
changing equilibrium output and price
levels than in a closed economy
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18 – 21
CHANGES IN FISCAL POLICY
• Contractionary Fiscal Policy
• A contractionary fiscal policy would entail some
combination of higher taxes and/or lower
government spending
• This reduces a government budget deficit or
increases size of a surplus
• Adopting a contractionary fiscal policy causes
the overall demand for loanable funds to shrink
(from D to D’) and lowers the interest rate
(from ie to i’)
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18 – 22
CHANGES IN FISCAL POLICY
Figure 18.4
Supply and Demand for Loanable Funds and Contractionary
Fiscal Policy
Interest Rate (i)
ie
i’
S’
S
G
E
D
F
D’
Loanable Funds (L)
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18 – 23
CHANGES IN FISCAL POLICY
• The lower domestic interest rate affects capital
•
•
flow into the country as domestic and foreign
investors would tend to invest less domestically
and domestic investors would tend to invest
more capital abroad
The net result would be an outflow of capital
from domestic economy and the supply of
loanable funds would decrease (from S to S’)
raising interest rates (from i’ back to ie)
A contractionary fiscal policy puts less downward
pressure on domestic interest rates in an open
economy than in a closed economy
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18 – 24
CHANGES IN FISCAL POLICY
Figure 18.5
Effects of Contractionary Fiscal Policy on the Exchange Rate
Exchange Rate
(XR)
XR’
S
M
XRe
X
E
D’
D
Foreign Exchange (FX)
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18 – 25
CHANGES IN FISCAL POLICY
• A contractionary fiscal policy lowers the federal
•
•
government budget deficit which decreases
domestic interest rates and causes an outflow of
capital
This increases the demand for foreign exchange
(from D to D’) and the exchange rate rises or the
domestic currency depreciates (from XRe to XR’)
This causes the capital account to become
negative which causes the current account to
become positive (X-M at XR’)
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18 – 26
CHANGES IN FISCAL POLICY
• Therefore, a contractionary fiscal policy puts
downward pressure on domestic interest rates
which leads to an decrease in the flow of capital
from abroad into the domestic financial markets
leading to an depreciating currency and a current
account surplus
• What about the effects in a closed vs. open
economy?
• In a closed economy, this would lead to an
decrease in domestic output and price level
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18 – 27
CHANGES IN FISCAL POLICY
Figure 18.6
Effects of Fiscal Policy on Equilibrium Output and Price Level
Price Level (P)
AS
Pe
P’
AD
AD’
Y’
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Ye
Real GDP (Y)
18 – 28
CHANGES IN FISCAL POLICY
• In an open economy with free international
•
•
capital flows, a contractionary fiscal policy causes
AD to decrease and the domestic currency to
depreciate as the government increases taxes
and/or reduces spending—the direct effect
The contractionary fiscal policy increases AD as
the currency depreciates and the current account
balance improves—the indirect effect
A contractionary fiscal policy in an open economy
is less effective in changing equilibrium output
than it is in a closed economy
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CHANGES IN FISCAL POLICY
Figure 18.6
Effects of Fiscal Policy on Equilibrium Output and Price Level
Price Level (P)
AS
Direct Effect: AD’
Indirect Effect: AD’’/AD’’’
Pe
P’
AD’’
AD
AD’’’
AD’
Y’
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Ye
Real GDP (Y)
18 – 30
CHANGES IN FISCAL POLICY
• The net effect depends on the magnitude of the
•
•
two effects
Conclusion: In open economies with international
capital mobility, contractionary fiscal policy is not
as particularly effective in changing the
equilibrium levels of output & prices
Fiscal policy can still, however, affect interest
rates, exchange rates, capital flows and current
account balances and the effects are noticeable in
the economy and have an effect on business
decision making
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18 – 31
CHANGES IN MONETARY POLICY
• Most central banks in developed countries
use discretionary monetary policy in an
attempt to affect the short-run
performance of the economy by changing
the growth rate of the money supply
and/or interest rates
• Our interest is in explaining the effects of
changes in monetary policy on exchange
rates, the current account and by
extension on a country’s overall economy
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CHANGES IN MONETARY POLICY
• Expansionary Monetary Policy
• An expansionary monetary policy results when a
central bank increases the money supply or
money supply growth rate
• Increases in the money supply increase the supply
of loanable funds (from S to S’) initially causing a
decrease in the interest rate (from ie to i’)
• The decrease in interest rates causes a capital
outflow
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CHANGES IN MONETARY POLICY
Figure 18.7
Supply and Demand for Loanable Funds and
Expansionary Monetary Policy
Interest Rate (i)
ie
i’
S
S’
E
F
D
Loanable Funds (L)
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CHANGES IN MONETARY POLICY
• Capital outflows cause demand for foreign
•
•
exchange to increase (from D to D’) and the
currency depreciates (from XRe to XR’) which
worsens the capital account causing a deficit
This translates into a current account surplus as
exports increase and imports decrease (X-M at
XR’)
An expansionary monetary policy indirectly leads
to a current account surplus when capital is
mobile between countries
• What about the effects in a closed vs. open
economy?
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CHANGES IN MONETARY POLICY
Figure 18.8
Effects of Expansionary Monetary Policy on the
Exchange Rate
Exchange Rate
(XR)
XR’
S
M
XRe
X
E
D’
D
Foreign Exchange (FX)
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18 – 36
CHANGES IN MONETARY POLICY
• In a closed economy, monetary policy is generally
•
•
•
effective because lower interest rates increase
both consumption and investment spending—the
direct effect
AD increases (shifts from AD to AD’)
In an open economy, the fall in interest rates
induces depreciation of the domestic currency
and capital outflow improving the current
account as exports increase and imports
decrease—the indirect effect
The AD curve shifts even further to the right
(from AD’ to AD’’)
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CHANGES IN MONETARY POLICY
Figure 18.9
Effects of Monetary Policy on Equilibrium Output and
Price Level
Price Level
(P)
AS
P”
Direct Effect: AD’
Indirect Effect: AD’’
G
P’
F
Pe
E
AD”
AD’
AD
Ye
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Y’ Y”
Real GDP (Y)
18 – 38
CHANGES IN MONETARY POLICY
• These movements in the exchange rate, the
financial account and the current account
tend to reinforce the initial effects of
monetary policy on the domestic economy
• Conclusion: The net result is that in an
open economy with capital mobility,
monetary policy is effective in increasing
the level of economic activity (influencing
output and price levels)
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CHANGES IN MONETARY POLICY
• Contractionary Monetary Policy
• In contractionary monetary policy, the central
bank decreases the money supply or reduces the
money supply growth rate
• The most notable effect is an increase in
domestic interest rates
• In developed countries, decreasing money
supply is done through selling government
bonds, which decreases the supply of loanable
funds (from S to S’) causing a rise in interest
rates (from ie to i’)
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CHANGES IN MONETARY POLICY
Figure 18.10
Supply and Demand for Loanable Funds and
Contractionary Monetary Policy
Interest Rate (i)
i’
ie
S’
S
F
E
D
Loanable Funds (L)
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18 – 41
CHANGES IN MONETARY POLICY
• This increase in domestic interest rates attracts
•
•
•
foreign capital
In order to buy domestic financial assets, foreign
investors must sell foreign currency and buy
domestic currency in the foreign exchange
market
The capital inflow will increase the supply of
foreign exchange (from S to S’) causing a
decrease in the exchange rate (from XRe to XR’)
This creates an exchange rate appreciation
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CHANGES IN MONETARY POLICY
Figure 18.11
Effects of Contractionary Monetary Policy on the
Exchange Rate
Exchange Rate
(XR)
S
S’
XRe
XR’
E
X
M
D
Foreign Currency (FX)
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18 – 43
CHANGES IN MONETARY POLICY
• The capital inflows and appreciating exchange
rate create a capital account surplus and a
current account deficit (M-X at XR’)
• What about the effects in a closed vs. open
economy?
• In a closed economy, a contractionary monetary
•
policy is effective because the increased interest
rate reduces the growth rate of consumption
and/or investment
The reduction in total spending causes a decrease
in AD lowering output and the price level
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18 – 44
CHANGES IN MONETARY POLICY
• In an open economy, the effects are larger. Why?
• The initial effect of a contractionary monetary
•
•
•
policy is to decrease AD – the direct effect
The increase in interest rate induces capital flows
into the country and an appreciation of the
currency
The current account deteriorates as exports fall
and imports rise—the indirect effect
Conclusion: In an open economy with free
international capital mobility, contractionary
monetary policy is highly effective in changing
equilibrium levels of output and price
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CHANGES IN MONETARY POLICY
Figure 18.12
Effects of Monetary Policy on Equilibrium Output and
Price Level
Price Level
(P)
AS
Pe
Direct Effect: AD’
Indirect Effect: AD’’
E
P’
F
P”
G
AD
AD’
AD”
Y”
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Y’ Ye
Real GDP (Y)
18 – 46
CHANGES IN MONETARY POLICY
Figure 18.13
Crowding Out in a Closed Economy
Interest Rate (i)
i’
S
G
F
E
ie
D’
D
L’
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L
Loanable Funds (L)
18 – 47
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effects of government policies are often
•
•
•
described in terms of effects on a country’s
external and internal balances
The current account balance represents the
external balance while the equilibrium level of
output and price level is the internal balance
At any point in time, there is an optimal balance
of output level and price level implying full
employment and stable prices
This is rarely observed
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Governments frequently use fiscal and monetary
•
•
•
policy to achieve an acceptable balance between
output and price level
Fiscal and/or monetary policy can be used to
influence internal or external balance
In many cases, governments cannot balance both
and have to choose which is more important
Typically internal balance is seen as most
important and fiscal and/or monetary policy is
focused on achieving an optimal internal balance
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Although both fiscal and monetary policy affect
•
•
•
the current account and exchange rates, they are
usually not the primary focus of policy
The public and the press tend to think the
exchange rate and the current account are the
primary targets of macroeconomic policies
While this may be the case, macroeconomic
policy is often focused on a country’s internal
balance
The policy mix of a country is the effects of
various combinations of fiscal and monetary
policy
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18 – 50
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Table 18.1
Effects of Different Fiscal and Monetary Policies Under
Flexible Exchange Rates and Free Capital Mobility
Effect on
Equilibrium
Output
Fiscal Policy
Expansionary
Contractionary
Equilibrium Price
Level
Internal Balance
Exchange
Rate
Current
Account
External Balance
–Direct
Increase
Increase
–Indirect
Decrease
Decrease
Appreciates
Deteriorates
–Net
Little or no Effect
Little or no Effect
Appreciates
Deteriorates
–Direct
Decrease
Decrease
–Indirect
Increase
Increase
Depreciates
Improves
–Net
Little or no Effect
Little or no Effect
Depreciates
Improves
–Direct
Increase
Increase
–Indirect
Increase
Increase
Depreciates
Improves
–Net
Large Increase
Large Increase
Depreciates
Improves
–Direct
Decrease
Decrease
–Indirect
Decrease
Decrease
Appreciates
Deteriorates
–Net
Large Decrease
Large Decrease
Appreciates
Deteriorates
Monetary Policy
Expansionary
Contractionary
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Consistent Policy Mixes
• In a recession, the real GDP is below the full
employment level
• The government wants to increase output by
adopting an expansionary monetary policy
and/or expansionary fiscal policy
• A combination of both would tend to increase
output and price level
• The potential for rising prices may be deemed an
acceptable risk
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18 – 52
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effect on the exchange rate is unclear
•
•
•
depending on magnitude of change in the two
policies on domestic interest rates
The effect on the current account is also unclear
depending on the effect on interest rates
From a policy perspective, battling a recession
and letting the external balance adjust as needed
is a safe option
The domestic economy would improve and the
external balance is unlikely to change by a large
amount in either direction
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18 – 53
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• A similar scenario emerges if the problem is
•
•
•
•
inflation
The economy is temporarily producing output at
greater than full employment levels
The government would employ a combination of
contractionary monetary and fiscal policies
The effects on internal balance are that both
equilibrium output and the price level would fall
The effects on the external balance (exchange
rate and current account) are unclear since
policies move in opposite directions
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18 – 54
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• This policy mix does not appear to be a problem
as the internal balance moves in the desired
direction without dramatic changes in the
external balance
• When governments adopt similar fiscal and
monetary policies, the equilibrium level of
output and the price level (internal
balance) can be changed without making
drastic changes in the exchange rate or
current account balance (external balance)
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18 – 55
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Inconsistent Policy Mixes
• Mixtures of fiscal and monetary policies that are
inconsistent with one another (one expansionary,
the other contractionary) are inconsistent with
internal balance objectives
• Why would a government adopt such a mixture
when the effects are unclear?
• Often different policy makers are in control of
fiscal and monetary policy
• In the U.S., elected officials control the fiscal
policy while the independent Federal Reserve
determines the monetary policy
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18 – 56
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effect of inconsistent policies can be
•
•
•
ambiguous on the domestic economy (internal
balance)
However, the effect on the external balance is
explicit (see Table 18.1)
An expansionary fiscal policy and contractionary
monetary policy leads to an appreciation of the
currency and decreased current account
The policies reinforce one another and the effect
on the external balance can be significant
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18 – 57
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Similarly, a contractionary fiscal policy coupled
•
•
with an expansionary monetary policy leads to a
depreciation of the domestic currency and an
improvement in the current account balance
The point of our discussion is that inconsistent
policy mixes can have extreme effects on a
country’s external balance
The effect of changes in the country’s exchange
rate can have a dramatic impact on the
competitiveness of individual firms with tradable
goods
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18 – 58
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.14
Federal Budget Deficit and the Balance on Current
Account for the U.S., 1980-1996
50 –
In Billions of Dollars
0–
–50 –
–100 –
–150 –
–200 –
–250 –
–300 –
1980
1985
1990
1995
Year
Federal Deficit
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Current Account
18 – 59
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.15a
U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
Long-Run Real Interest Rate
9–
6–
3–
0–
–3 –
1980
1985
1990
1995
Year
Real Interest Rate
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18 – 60
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.15b
U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
Real Exchange Rate 1973 = 100
140 –
130 –
120 –
110 –
100 –
90 –
80 –
1980
1985
1990
1995
Year
Real Exchange Rate
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18 – 61
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• Implicit in our analysis was an assumption of
no lag in the effects of monetary and fiscal
policies on macroeconomic variables
• If financial markets are relatively efficient,
then interest rates are affected quickly
• Moreover, high capital mobility allows the
exchange rate to change relatively quickly
• However, the response of trade flows to
changes in exchange rates may not always
happen quickly
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TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• The price of imports and exports may not
change instantly as the exchange rate
changes
• International trade may respond slowly to
changes in prices compared to the
response of financial markets
• The time it takes for the exchange rate to
affect a country’s exports and imports and
the current account balance may be as
long as six months to a year
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TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• In the long-run, as a country’s currency
depreciates, its exports expand and imports
contract (and vice versa)
• In the short-run, as a country’s exchange
rate changes, the response of exports and
imports and current account balance could
very easily be in the opposite direction
• In part, this is because international trade is
often conducted between parties on a
contract basis
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TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• Also, in the short-run, demand for the more
•
•
expensive imports (and demand for exports, which
are cheaper to foreign buyers using foreign
currencies) remain price inelastic
This is due to time lags in the consumer's search for
acceptable, cheaper alternatives
The net effect is that the current account may
initially worsen after a depreciation and only
improve after a lag
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TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• The effect on the current account balance has
•
•
•
been called the J-curve
This reflects the tendency for the current account
balance to initially worsen when a currency
depreciates
Only after contracts are renewed to reflect the
new exchange rate will the current account begin
to improve
It is important for policy makers to take the lag
effect into account
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TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
Figure 18.16
The J Curve
Current Account
Balance
Current Account Surplus
0
t0
t1
Time
Current Account Deficit
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SUMMARY
1. Governments use fiscal policy to change the level
of taxation and/or government spending at the
national level to affect the level of economic
activity (GDP). Governments use monetary policy
to change the money supply or interest rates to
affect a country’s level of economic activity.
2. A country’s exchange rate and its current account
balance represent its external balance
3. Expansionary fiscal policy occurs when a
government chooses to adopt some combination
of lower tax revenue and/or higher government
spending
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SUMMARY
4. In an open economy with international capital
mobility, expansionary fiscal policy leads to a rise
in interest rates which causes and inflow of
foreign capital
5. A contractionary fiscal policy in an open economy
is not very effective in reducing the price level or
real GDP
6. Expansionary monetary policy occurs when a
government chooses to increase the money
supply or the money supply’s growth rate
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SUMMARY
7. In an open economy with international capital
mobility, expansionary monetary policy leads to a
fall in interest rates which causes an outflow of
foreign capital
8. A contractionary monetary policy would lead to
higher interest rates, lower output, and a lower
price level
9. Consistent policy mixes can be effective in solving
internal balance problems
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SUMMARY
10. Mixtures of fiscal and monetary policy that are
inconsistent with one another are also
inconsistent with internal balance objectives
11. In the long run, as a country’s currency
depreciates, its exports expand and imports
contract. In the short run, its current account
balance could very easily move in the opposite
direction.
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