Download Lecture Slides 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 AD0 to AD1
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