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INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Third Edition
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.
Chapter 14
Domestic
Economic
Policymaking
in a Global
Economy
Policy Assignment Problem
• Once policymakers commit to an external
objective, they confront a fundamental
problem: Domestic and international
objectives often clash.
• Assignment Problem: The problem of
determining whether the central bank or the
finance ministry should assume responsibility
for achieving a nation’s domestic or
international policy objectives.
2
Monetary and Fiscal Policy Combinations for External
Balance with High Capital Mobility and a Floating
Exchange Rate
3
Monetary and Fiscal Policy Combinations for Internal
Balance with High Capital Mobility and a Floating
Exchange Rate
4
Policy Assignment and Internal and External Balance
with High Capital Mobility and a Floating Exchange
Rate
5
Exchange Rate Responses
• Short-run wage stickiness causes the aggregate price
level to adjust less completely to changes in
aggregate demand than it would otherwise.
• This has an important consequence for the response
of the exchange rate to policy actions that affect
aggregate demand.
• Exchange Rate Overshooting is a situation in which
the short-run effect for an increase in aggregate
demand is a rise in the nominal exchange rate above
its long-run equilibrium value.
6
Long-Run Adjustment of the Exchange
Rate to an Increase in the Money Stock
7
Openness and the Output-Inflation
Relationship
• The openness of an nation’s economy is
another potentially important factor that affects
the responsiveness of a nation’s real output to
changes in the price level.
• It turns out, however, the openness can have
conflicting effects on the output –inflation
relationship.
• Openness is often measured using imports as a
share of total expenditure.
8
Imports as a Share of Total
Expenditures in Selected Nations
9
Competition in Domestic Product
Markets
• Many nations restrain competition through
elaborate systems of domestic regulations and
protect firms from competition using trade
barriers.
• Imperfect Competition is a market
environment in which there are only a few
firms, each of which individually can influence
the market price by varying its production.
10
Index Measure of the Extent of Product-Market
Regulation in selected Industrialized Nations
11
The Sacrifice Ratio
• The Sacrifice Ratio is the short-run fall in a
nation’s real output generated by a reduction in
inflation divided by the associated decline in
the inflation rate.
• If a rise in openness in a nation is observed to
be associated with a larger sacrifice ratio, this
would provide evidence that greater openness
raises the sensitivity of real output to a change
in the price level.
12
Central Bank Independence and the Net Effect of
Openness on the Sacrifice Ratio
13
Openness and Inflation
14
New Open Economy
Macroeconomics
• Open Economy Macroeconomics is the study
of factors affecting the overall economic
performance of a country that permits crossboarder exchanges of goods, services, and
financial assets.
• New Open Economy Macroeconomics focuses
on how nominal wage stickiness, sluggish
prices, and imperfect competition affect the
transmission of policy actions.
15