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Transcript
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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 7 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 11 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 29 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’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 32 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 33 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 34 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? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 35 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 37 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 39 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’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 40 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 42 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 45 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” Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 48 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 49 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 51 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 62 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 63 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 64 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 65 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 66 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 67 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 68 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 69 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 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 70 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. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – 71