Download monetary policy

Chapter 4
Macroeconomic
Policy in an Open
Economy
1
4.1 Introduction


From chapter 3, it was noted that the
ultimate impact of a devaluation will in
large part be dependent upon the
economic policies that accompany the
devaluation.
In this chapter, we shall be examining
how both exchange-rate changes and
macroeconomic policies impact upon an
open economy.
2
A fundamental difference between an open
economy and a close economy is that over
time a country has to ensure that there is an
approximate balance in its current account:
No country can continuously keep deficit;
It is no sense to continuously keep surplus.
Policy-makers need to pay attention to the
effects of the changes in fiscal and monetary
policies on the balance of payments to fulfill
internal and external balance.
3
Ensuring a sustainable BOP position

over time is an important economic
objective to go along with high
economic growth, low unemployment
and low inflation.
This chapter concentrates on how fiscal
and monetary policies operate under
both regimes.
4
4.2 The Problem of Internal
and External Balance

Although economic policy-makers generally
have many macroeconomic aims, the
discussion in the 1950s and 1960s was
primarily concerned with two objectives:
Internal balance: full employment along
with a stable level of prices;
External balance: running an equilibrium
in the balance of payments.
5
Policy instruments:
Expenditure changing policy: policies such
as fiscal and monetary policies which
aim to influence the level of the
aggregate demand in the economy;
Expenditure switching policy: policies
such as devaluation/revaluation of the
exchange rate which attempt to
influence the composition of spending
between domestic and foreign goods.

6

The policy problem of achieving both
was conceptualized by Trevor Swan
(1955) in what is known as the Swan
diagram.
The vertical axis: the real exchange rate.
Er↑→foreign currency real appreciate
→domestic currency real depreciate
→international competitiveness↑;
The horizontal axis: the amount of real
domestic absorption. A=C+I+G.
7
Real
Exchange
(4)
EB
Rate
inflation D
D
(3) surplus
(1)
unemployment A
inflation
surplus C
B
deficit
(2)
A
unemployment
deficit
IB
0
domestic absorption
Figure 4.1 The Swan diagram
8
The IB schedule: represents
combinations of the real exchange rate
and domestic absorption for which the
economy is in internal balance.
It is downward-sloping from left to right.
(Er↓→X↓&M↑maintain full employment
→A↑)
To the right of IB: inflation.
To the left of IB: unemployment.

9
The EB schedule: represents
combinations of the real exchange rate
and domestic absorption for which the
economy is in external balance.
It is upward-sloping from left to right.
(Er↑→X↑&M↓ maintain current account
balance →A↑)
To the right of EB: deficit;
To the left of EB: surplus;

10
Four different possible states for an
economy:




Zone
Zone
Zone
Zone
1
2
3
4
–
–
–
–
a
a
a
a
deficit and inflationary pressures.
deficit and deflationary pressures.
surplus and deflationary pressures.
surplus and inflationary pressures.
At point A, the economy is in both internal
and external equilibrium.
11

Suppose economy at point B(inflation,
deficit):
M↓→EB fulfilled
If A↓ E↕
(at point C)
U↑→IB unfulfilled
X↑,M↓→EB fulfilled
If E↑ A↕
(at point D)
I↑→IB unfulfilled
the use of one instrument to achieve two
targets is most unlikely to be successful.
12

To move from point B to point A:
Deflate→control inflation
two targets
Devalue→ improve current account can met
Tinbergen’s instrument-targets rule:
a country generally requires as many
instruments as it has targets to fulfill
both internal and external equilibrium.
13
Tinbergen's rule is a useful conceptual



framework for economic policy discussion, but
rather simplistic:
The underlying economic relationships are not
explicitly defined;
No role for international capital movements;
No distinction made between monetary and
fiscal policies;
Mundell-Fleming model to integrate such
features into a formal open economy
macroeconomic models.
18
4.3 the Mundell-Fleming
model
Their major contribution: incorporate
international capital movement into
formal macroeconomic models based on
the Keynesian IS-LM framework and led
to some dramatic implications
concerning the effectiveness of fiscal
and monetary policy for the attainment
of internal and external balance.
19
4.4 The Derivation of the IS
Schedule for an Open Economy
The IS curve: shows various combinations
of the level of output(Y) and rate of
interest(r) that make leakages equal to
injections.


Open economy: Y=C+I+G+X-M
Since: Y-C=S, rewrite (4.1):
S+M=I+G+X
(4.1)
(4.2)
20


For simplicity, assume:
S=Sa+sY
(4.3)
M=Ma+mY
(4.4)
I=I(r), dI/dr<0
(4.5)
G & X: autonomous with respect to
the rate of interest and level of national
income.
The preceding relationships are
depicted in figure 4.2.
21
r
IS
Y
Figure 4.2 The IS schedule
22
The IS curve is downward-sloping
from left to right.
S+M=I+G+X
Y↑→(S+M)↑to make L=In
(I+G+X)↑→r↓

23
4.5 The Derivation of the LM
Schedule for an Open Economy
The LM schedule: shows various
combinations of the level of income(Y)
and rate of interest(r) for which the
money market is in equilibrium.
24
Demand for money: for transaction or
speculative purposes.
Assume Mt is a positive function of Y:
Mt=Mt(Y)
(4.6)

Where: Mt--the transaction demand for
money.
Assume Msp is negative function of r:
Msp=Msp(r)
(4.7)
Where: Msp—the speculative demand for
money.
25


In equilibrium:
Md=Msp(r)+Mt(Y)=Ms
The derivation of the LM curve is
depicted in figure 4.3.
(4.8)
r
LM
Y
Figure 4.3 The LM schedule
26
The LM schedule is upward-sloping
from left to right.
Md=Msp+Mt=Ms
Y↑→Mt↑to make Md=Ms Msp↓→r↑

27
4.6 The Derivation of the BP
Schedule for an Open Economy
The BP schedule: shows different
combinations of r and Y that are
compatible with equilibrium in the
balance of payments.

Current account balance(CA)=X-M
X: independent of Y and r;
M=Ma+mY
(4.9)
28



Capital account balance(K) is positive
function of the domestic interest rate.
K=K(r-r*)
(4.10)
In equilibrium:
CA+K=-dR=0=(X-M)+K=0
(4.11)
The derivation of the BP schedule is
depicted in figure 4.4.
29
r
BP
Y
Figure 4.4 The BP schedule
30
The BP schedule is upward-sloping from
left to right.
X-M+K=0
Y↑→M↑→(X-M)↓to make CA=-K K↑→r↑
 Points to the left of the BP schedule:
in surplus
 Points to the right of the BP schedule:
in deficit

31

Note:
The slope of the BP schedule is determined by
the degree of capital mobility internationally.
the higher the degree of capital mobility then
the flatter the BP schedule.
1)When capital is perfectly mobile, the BP
schedule is horizontal;
2)When capital is perfectly immobile, the BP
schedule is vertical;
3)When capital is imperfectly mobile, the BP
schedule is upward-sloping.
32
4.7 Equilibrium of the Model
Equilibrium of the model is determined
by the interaction of the three
schedules at a common point A.
Note:
 The BP schedule is steeper than the
LM schedule, but this need not always
be the case.

33
r
BP
r1
A
LM
IS
Y1 Yf
Y
Figure 4.5 Equilibrium of the model
34


Equilibrium income(Y1)< full
employment level of income(Yf), the
economy is not in internal balance, but
in external balance.
Figures 4.6(a) and 4.6(b) depict
scenarios where there is a surplus and
deficit respectively in the BOP.
35
r
r
BP
LM
r1
BP
LM
r2
IS
Y1
IS
Y
Y2
Y
Figure 4.6 Surplus(a) and deficit(b) in the BOP
36
4.8 Factors Shifting the ISLM-BP Schedules
To consider how changes in the
exchange rate and monetary and
fiscal policies affect the position of
the various schedules.
37
1. Factors shifting the IS schedule



L=S+M=I+G+X=In
Sa+sY+Ma+mY=I(r)+G+X
Sa+Ma+(s+m)Y=I(r)+G+X
I↑ or G↑or X↑→In↑ to make L=In L↑ r↕
→Y↑→shift rightward
Sa↓ or Ma↓→L↓ to make L=In L↑ r↕
→Y↑→shift rightward
S↑ M-L hold X↑ and M↓→In>L to make L=In
and r↕ L↑→Y↑→shift rightward
38
2. Factors shifting the LM schedule
Ms=Md=Mt(Y+)+Msp(r-)

Ms↑ to make Ms=Md Md↑ r↕ Mt↑→
Y↑→shift rightward

S↑→Pi↑→real money balance↓→Md↑
to make Ms=Md Md↓ r↕ Mt↓→Y↓→
shift leftward
39
3. Factors shifting the BP schedule
BOP=CA+K+dR=X-M+K=0
X-Ma-mY+K(r-r*)=0
 Xa↑or Ma↓→CA↑ r↕ and to make CA=-K
mY↑→Y↑→shift rightward;
 S↑ M-L hold →Xa↑or Ma↓→CA↑ r↕ and to
make CA=-K mY↑→Y↑→shift rightward.
40
4.9 Internal and External
Balance
The swan diagram do not distinguish fiscal and
monetary policies as quite different and
independent types of expenditure-changing
policies
begs the question as to
whether or not it is feasible to achieve the
twin objectives by combining fiscal and
monetary policies without the need to adjust
the exchange rate
to consider how the
two policies influence economic activities.
41

Monetary policy
Expansionary monetary policy(purchase
bonds)→the price of bonds↑ and r↓
→ I↑→Y↑→CA↓ →BOP deficit
K↓

Fiscal policy
Expansionary fiscal policy(G↑ financed by selling
bonds) →the price of bonds↓ and r↑
→ G↑→ Y↑→CA↓
r↑→ I↓→Y↓→CA↑
→K↑
→BOP↑or↓
42
Sterilized and non-sterilized intervention
Sterilized intervention: the authorities
offset the money-base implications of
their exchange market interventions to
ensure that the reserve changes due to
intervention do not affect the domestic

money base;
Non-sterilized intervention: the authorities
allow the reserve changes resulting from
their interventions to affect the money
base.
43

Illustrate the distinction with an example:
money expansion under fixed exchange rates.
Money expansion→ LM1→LM2 →r↓(r1→r2),
Y↑(Y1→Y2) →BOP deficit →excess supply of
home currency →to maintain fixed exchange
rates →purchase home currency with reserves
→ Ms↓→LM2→LM1(non-sterilized)
Ms↓offset by further expansion of the
Ms(sterilized intervention) →LM remains at
LM2 →suffer continuous BOP deficit and R↓
→such a policy is only feasible in the short run.
44
r
BP
LM1
LM2
r1
r2
IS
Y1 Y2
Y
Figure 4.7 A monetary expansion under fixed
exchange rates
45
4.10 Internal and External Balance
Under Fixed Exchange Rates
Assume economy is initially at point A, in
external balance, but Y1<Yf:
Bond-financed fiscal expansion→G↑→IS1→IS2
→ Y↑(Y1→Y2)
r↑(r1→r2) →BOP deficit→purchase home
currency→ Ms↓→LM1→LM2→ Y↑(Y2→Yf)
r↑(r2→r3)
BOP balance
→achieve both internal and external objectives
(point C).
46

r
BP
r3
r2
r1
LM2
LM1
C
B
A
IS2
IS1
Y1 Yf Y2
Y
Figure 4.8 Internal and external balance under
a fixed exchange rate
47
Both objectives can be achieved
without changing the exchange rate,
because having two policies for two
targets.
48
4.11 Internal and External Balance
Under Floating Exchange Rates
1. Monetary expansion under floating
exchange rates
Expansionary monetary policy→Ms↑→
LM1→LM2 → Y↑→CA↓ →BOP
r↓→K↓
deficit(B)
X↑& M↓
IS1→IS2
Y↑
→S↑→ X↑& M↓→ BP1→BP2 → r ↓(point C)
P↑→Md↑ LM2→LM3
S↑
49
r
BP1
BP2
LM1
r1
r3
r2
A
C
LM3
LM2
B
IS1 IS2
Y1 Y2 Y3
Y
Figure 4.9 A monetary expansion under floating
exchange rates
50
2. Fiscal expansion under floating
exchange rates
Case 1: BP steeper than LM.
capital flows insensitive to r, Md elastic to r.
Expansionary fiscal policy→G↑→ IS1→IS2
→ Y↑ → CA↓ →BOP
r↑
K↑
deficit(B)
IS2→IS3
Y↑
→S↑→ BP1→BP2 → r↑(point C)
LM1→LM2
S↑
51
r
r3
r2
r1
BP1 BP2
LM2
C
LM1
B
A
IS3
IS1 IS2
Y1 Y2 Y3
Y
Figure 4.10 Case 1: a fiscal expansion under
floating exchange rates
52
Case 2: BP flatter than LM.
Expansionary fiscal policy→G↑→ IS1→IS2
→ Y↑ → CA↓ →BOP
r↑
K↑
surplus(B)
IS2→IS3
Y↑
→S↓→ BP1→BP2 → r↑(point C)
LM1→LM2
S↓
53
r
r2
r3
r1
LM1 LM2
BP2
B
BP1
C
A
IS2
IS1 IS3
Y1 Y3 Y2
Y
Figure 4.11 Case 2: a fiscal expansion under
floating exchange rates
54
4.12 A Small Open Economy
with Perfect Capital Mobility


To examine the implication of high
capital mobility for a small country that
had no ability to influence world interest
rates.
Their paper showed that the choice of
exchange-rate regime would have a
radical implications concerning the
effectiveness of monetary and fiscal
policy.
55

Assume a small country facing perfect
capital mobility
the BP schedule
becomes a horizontal line at a domestic
interest rate that is the same as the
world interest rate.
56
1. Fixed exchange rates and perfect
capital mobility.
 Monetary expansion:
Monetary expansion(Ms↑)→ LM1→LM2
→downward pressure on r →massive
capital outflow →pressure for S↑
→intervene →buy home currency
→Ms↓ till LM2→LM1 →r=r*,Y↕
→monetary policy ineffective at
influencing Y.
57
Fiscal expansion:
Fiscal expansion(G↑) → IS1→IS2 →
upward pressure for r →massive capital
inflow →pressure for S↓ →intervene →
sell home currency →Ms↑ → LM1→LM2
till intersect IS2 at the initial r→r=r*,
Y↑→ active fiscal policy alone has the

ability to achieve both IB and EB.
58
r
LM1
LM2
r1
BP
Y1
IS1
Y2
IS2
Y
Figure 4.12 Fixed exchange rates and perfect
capital mobility
59
2. Floating exchange rates and perfect
capital mobility.
 Monetary expansion:
Monetary expansion(Ms↑)→ LM1→LM2
→downward pressure on r →massive
capital outflow →S↑ →X↑& M↓ →
IS1→IS2 →r=r*,Y↑
LM2→LM3
→monetary policy effective at
influencing Y.
60
Fiscal expansion:
Fiscal expansion(G↑) → IS1→IS2 →
upward pressure for r →massive capital
inflow →S↓ →X↓& M↑ → IS2→IS1
→r=r*, Y↕→ fiscal policy ineffective at
influencing Y.

61
r
LM1 LM3 LM2
r1
BP
Y1
IS1
Y2
IS2
Y
Figure 4.13 Floating exchange rates and
perfect capital mobility
62

The contrast between the effectiveness
of fiscal and monetary policy with
perfect capital mobility under different
exchange rate regimes is one of the
most famous results in international
economics.
63
Box 4.1
The macroeconomic trilemma
The macroeconomic trilemma is that the
authorities have to make a choice out of
two of the following three goals. Some
have termed the trilemma the
“impossible trinity”, reflecting the fact
that is not possible to achieve all three
goals simultaneously.
64
The impossible three are:
2.Fixed exchange rates
1.Monetary
Independence
3.Free movement of
international capital.
65
4.13 The Principle of
Effective Market Classification

Tinbergen’s rule does not tell us which
instrument should be assigned to which
target
the principle of effective
market classification stated that
“policies should be paired with the
objectives on which they have the most
influence”.
66



The problem for economic policymakers to determine which instruments
to assign to which targets, is termed the
“assignment problem”.
Mundell suggested that under fixed
exchange rates, monetary policy should
be assigned to external balance and
fiscal policy to internal balance.
Illustrated in figure 4.14.
67
Monetary policy
E
E
Unemployment
deficit
D
Nm
C
A
B C
unemployment
surplus
inflation
deficit
inflation
surplus
EB
Nf
IB
Contractionary expansionary Fiscal policy
Figure 4.15 The assignment problem
68
Vertical axis: monetary policy;
 Horizontal axis: fiscal policy.
 The IB schedule: negative slop.
Contractionary monetary policy
to maintain full employment
Expansionary fiscal policy
To the right of the IB schedule: inflation
To the left of the IB schedule:

unemployment.
69
The EB schedule: positive or negative slop.
If expansionary fiscal policy→BOP deficit
→to maintain EB→contractionary
monetary policy →negative slop;
If expansionary fiscal policy→BOP surplus
→to maintain EB→expansionary
monetary policy →positive slop;
Assume the EB schedule has negative slop.
To the right of the EB schedule: deficit
To the left of the EB schedule: surplus

70
The IB schedule is drawn steeper than
the EB schedule.
Expansionary fiscal policy(G↑) →
Y↑→M↑→CA↓ →BOP deficit
r↑→K↑
but small;
Expansionary monetary policy(Ms↑) →
r↓→ K↓
→BOP deficit
I↑→Y↑→M↑→CA↓
but great;
deficitM>deficitF & surplusM>surplusF;
EBM>EBF or IBF>IBM.

71


Point A →contractionary monetary policy
→point B →expansionary fiscal policy
→point C →converge the economy to
the intersection of the IB and EB
schedules →the assignment is stable;
Point A → contractionary fiscal policy
→point D →expansionary monetary
policy →point E →move the economy
away from the simultaneous
achievement of the IB and EB →the
assignment is unstable.
72
Unfortunately, there is no unambiguous
answer to the assignment problem.
Depending upon the structural parameters:

1)the degree of capital mobility;
2)marginal propensity to save and import;
3)income and interest elasticity of demand for
money;
4)the price elasticity of demand for imports and
exports;
5)responsiveness of investment to interest rate
variations.
73
4.14 Limitations of the
Mundell-Fleming Model
A number of the criticisms relate to
the short-run nature of the model:
1.The Marshall-Lerner condition.
2.Interaction of stocks and flows.
3. Neglect of long-run budget constraints.
4. Wealth effect.
5. Neglect of supply-side factors.

74
6. Treatment of capital flow.
7. Exchange-rate expectations.
8. Flexibility of policy instruments.
75
4.15 Conclusions


Economic policy formulation in an open
economy has to take into account many
important additional considerations compared
to a simple closed economy;
The most important lessons are that they
generally need as many independent policy
instruments as they have targets, and they
have to decide which instrument to assign to
which target;
76



In real world the achievement of internal and
external balance will be far more difficult than
our theoretical analysis has suggested;
The relative effectiveness of fiscal and
monetary policies is very much dependent
upon the choice of exchange-rate regime;
The most significant contribution of the model
is that it focuses on the important role that
international capital flows can play in
determining the effectiveness of
macroeconomic policies under alternative
exchange rate regimes.
77
Further reading:
 李文川，《香港货币局制度还能走多
远——浅析货币局制度的利与弊》，
《财经界》，2007年6月。
 徐舜，《香港货币局制度理论综述》，
《广东财经职业学院学报》，2005年02
期。
 王书伟，《汇率制度的选择及对中国汇
率制度改革的新探索》，财经界(下半
月), 2006年09期。
78