Macroeconomic Policies in Open Economy International Economics Chapter 9

Macroeconomic Policiesin Open Economy

International Economics

Chapter 9

Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance 9.2 Policy Mix to Achieve Internal Balance and

External Balance 9.3 Effects of Macroeconomic Policies under

Fixed Exchange Rates 9.4 Effects of Macroeconomic Policies under

Floating Exchange Rates

9.1 Internal Balance and External Balance

Internal Balance and External Balance Internal balance means (1) full employment, (2) no

inflation, or more realistically, low inflation, and (3) steady economic growth.

External balance is the achievement of neither BP deficits nor BP surpluses.

9.1 Internal Balance and External Balance

InflationUnemployment

BP Surplus

BP Deficit

III

IVIII

O

9.1 Internal Balance and External Balance

Policy Instruments Expenditure-changing policies include fiscal policy

and monetary policy, altering the level of aggregate demand for goods and services which are either produced domestically or imported.

Expenditure-switching policies refer to exchange-rate policies, including appreciation or depreciation of a currency, which shifts the direction of demand between domestic output and imports.

9.1 Internal Balance and External Balance

When an economy is located in the disequilibrium zones of Quadrant I and III, expenditure-switching policies can restore the economy to overall balance. In Quadrant I: An appreciation of its currency

decreases the international competitiveness of its goods and leads to a fall in export, which, on the one hand, decreases its BP surplus, and on the other hand, reduces its aggregate demand and thus output, lessening its inflation.

In Quadrant III: A depreciation can restore the overall balance.

9.1 Internal Balance and External Balance

Tinbergen RuleOne economic goal could be attained by at least one

effective policy tool. Thus, to achieve n independent goals, we need no less than n effective policy tools.

9.1 Internal Balance and External Balance

Meade ConflictUnder fixed exchange rate system, a country cannot

change its exchange rate and thus it loses expenditure switching policy tools. In this condition, the goals of internal balance and external balance may become conflicting since the government now can only resort to expenditure changing policies.

9.1 Internal Balance and External Balance

– In Quadrant I, the economy will meet the conflict between internal balance and external balance.

» A contractionary expenditure changing policy will reduce output and income, decreasing the inflation and restoring internal balance. But reduced national income then weakens imports, enlarging its BP surplus and worsening its external imbalance.

» If the government uses an expansionary expenditure-changing policy, the external balance can be achieved but the internal economy will be imbalanced with more severe inflation.

– In Quadrant III, the economy will also meet the conflict between internal balance and external balance.

9.1 Internal Balance and External Balance

In a fixed exchange rate system where expenditure-switching policies cannot be fulfilled, we need two independent policy tools to achieve both internal balance and external balance and thus solve Meade Conflict.

Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance 9.2 Policy Mix to Achieve Internal Balance and

External Balance 9.3 Effects of Macroeconomic Policies under

Fixed Exchange Rates 9.4 Effects of Macroeconomic Policies under

Floating Exchange Rates

9.2 Policy Mix to Achieve Internal Balance and External Balance Mundell Assignment Rule

Fiscal policy and monetary policy have different effects on internal economy and external economy. So even under fixed exchange rate system, it is likely to utilize fiscal policy and monetary policy to achieve both internal and external balance.

Fiscal policy and monetary policy may affect national income and the current account to the same extent. But they have different influence on the interest rate and the capital and financial account. Contractionary fiscal policy can reduce the interest rate,

causing capital outflows and worsening the capital and financial account.

Contractionary monetary policy will increase the interest rate, causing capital inflows and improving the capital and financial account.

9.2 Policy Mix to Achieve Internal Balance and External Balance

IB slopes downward: (T-G)↑=> Y↓, requiring r↓ =>I↑. Right to IB: Unemployment; Left to IB: Inflation.

EB slopes downward: (T-G)↑=> Y↓ =>M↓, requiring r↓ =>capital outflow. Above EB: BP surplus; Below IB: BP deficit.

r

T − G

IB

EB

O

E

A

III

III IV

BC

B’

9.2 Policy Mix to Achieve Internal Balance and External Balance

Point A: BP deficit with unemployment. Ms↓=> (1) r↑ => capital inflow => KA↑; (2) Y↓=> M↓=>

CA↑ =>B: EB + unemployment. G↑ => Y↑ => C: IB + BP deficit.Finally, Ms↓ + G↑ => E: IB + EB

r

T − G

IB

EB

O

E

A

III

III IV

BC

B’

9.2 Policy Mix to Achieve Internal Balance and External Balance

Conclusion:Fiscal policy should be assigned to solve internal

imbalance while monetary policy should be assigned to solve external imbalance.

If policies are wrongly assigned, the economy will diverge from the overall balance.

9.2 Policy Mix to Achieve Internal Balance and External Balance

Swan ModelMundell Assignment Rule solves Meade Conflict

under fixed exchange rate system by assigning fiscal policy and monetary policy effectively.

Swan Model aims to achieve both internal balance and external balance by combining expenditure-changing policies and expenditure-switching policies when the exchange rate can be changed.

9.2 Policy Mix to Achieve Internal Balance and External Balance

IB slopes downward: eP*/P↑=>NX↑, requiring A↓=>Y↓.Right to IB: inflation; Left to IB: unemployment.

EB slopes upward: eP*/P↑=> NX↑, requiring A↑=>M↑.Above EB: BP surplus; Below EB: BP deficit.

eP*/P

A

IB

O

E

EBI

II

III

IV

A

9.2 Policy Mix to Achieve Internal Balance and External Balance

Point A: BP deficit with unemployment.Expansionary expenditure-changing policy to deal with the

internal unemployment; Depreciation of domestic currency to restore its balance of

payments.

eP*/P

A

IB

O

E

EBI

II

III

IV

A

Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance 9.2 Policy Mix to Achieve Internal Balance and

External Balance 9.3 Effects of Macroeconomic Policies under

Fixed Exchange Rates 9.4 Effects of Macroeconomic Policies under

Floating Exchange Rates

9.3 Effects of Macroeconomic Policies under Fixed Exchange Rates IS-LM-BP Model

IS curve slopes downward.G↑=> IS shifts rightward; G↓=> IS shifts leftward.

LM curve slopes upward.Ms↑=> LM shifts rightward; Ms↓=> LM shifts leftward.

r

Y

IS

O

E

LM

9.3 Effects of Macroeconomic Policies under Fixed Exchange Rates

Right to BP: BP deficit; Left to BP: BP surplus.(a): Perfect capital immobility;(b): Imperfect capital mobility;(c): Perfect capital mobility.

r

Y

BP

O

r

O Y

r

O Y

BP

BP

(a) (b) (c)

9.3 Effects of Macroeconomic Policies under Fixed Exchange Rates

Effects of Fiscal Policy under Fixed Exchange Rate Fiscal policy has no effect on economy under fixed

exchange rate when capital is perfectly immobile, only to find a higher interest rate.

Fiscal policy has some effect on economy under fixed exchange rate when capital is imperfectly mobile. But the extent of effect relies on the sensibility of capital flow to changes of the interest rate. The more sensible the capital flow is, the larger the effect of fiscal policy is.

Fiscal policy has perfect effect on economy under fixed exchange rate when capital is perfectly mobile.

e +K :

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K KA

CA− >KA BP− e↑ f↑ Ms↓ LM�

E2: Y↓(Y0) ; r↑(r2)

A. Case of Perfect Capital Immobility

r

Y

IS

O

E0

LMBP

IS’

LM’

E1

Y0 Y1

r0

r1

r2 E2

B. Case of Imperfect Capital Mobility

(BP>LM)

e + K̂ (BP>LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+

CA− > KA+ BP− e↑ f↑ Ms↓ LM�

E2: Y↓(Y2>Y0) ; r↑(r2)

r

Y

BP

O

(a)Y0 Y1

r0

r1 E1

IS

LMLM’

E0

IS’

E2

Y2

r2

B. Case of Imperfect Capital Mobility

(BP=LM)

e + K̂ (BP=LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+ (CA− = KA+ BP )

r

O Y

LM, BP

(b)

IS

Y0 Y1

r0

r1E0

E1

IS’

B. Case of Imperfect Capital Mobility

(BP<LM)

e + K̂ (BP<LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+

CA− < KA+ BP+ e↓ f↓ Ms↑ LM��������������

E2: Y↑; r↓(r2>r0)

r

O Y(c)

IS

E0

Y0

r0

BP

LM LM’

IS’

E1

E2

r1r2

Y1 Y2

C. Case of Perfect Capital Mobility

e +K :

G↑ AD↑ IS��������������

Y↑

r↑ K↑ BP+ e↓ f↓ Ms↑ LM��������������

E1: Y↑; r↓(r0)

r

Y

IS

O

E0

LM

BP

IS’

LM’

E1

Y0 Y1

r0

9.3 Effects of Macroeconomic Policies under Fixed Exchange Rates

Effects of Monetary Policy under Fixed Exchange Rate Monetary policy has no effect on economy under

fixed exchange rate regardless of the extent of capital mobility.

A. Case of Perfect Capital Immobility

e +K :

Ms↑ LM��������������

E1: Y↑(Y1) M↑ CA−

r↓(r1) K KA

CA− > KA BP− e↑ f↑ Ms↓ LM�

E0: Y↓(Y0); r↑(r0)

r

Y

BP

O

(a)Y0 Y1

r0

r1 E1

IS

LMLM’

E0

B. Case of Imperfect Capital Mobility

e + K̂ :

Ms↑ LM��������������

E1: Y↑(Y1) M↑ CA−

r↓(r1) K↓ KA−

CA− + KA− BP− e↑ f↑ Ms↓ LM�

E0: Y↓(Y0); r↑(r0)

r

O Y

LM

(b)

IS

Y0 Y1

r0

r1

E0

E1

BP

LM’

C. Case of Perfect Capital Mobility

r

O Y(c)

IS

E0

Y0

r0 BP

LM LM’

e +K :

Ms↑ LM��������������

Y↑

r↓ K↓ BP− e↑ f↑ Ms↓ LM�

E0: Y↓(Y0); r↑(r0)

Chapter 9 Macroeconomic Policies in Open Economy

9.1 Internal Balance and External Balance 9.2 Policy Mix to Achieve Internal Balance and

External Balance 9.3 Effects of Macroeconomic Policies under

Fixed Exchange Rates 9.4 Effects of Macroeconomic Policies under

Floating Exchange Rates

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates Under floating exchange rate, changes of the exchange

rate will cause shifts of BP curve. A depreciation of domestic currency leads to a

rightward shift of BP curve.An appreciation leads to a leftward shift of BP curve.

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates

On BP curve, r0 and Y0 keeps the economy in external balance. A depreciation results in more export and less import, leading to a surplus

of the balance of payments. To digest the surplus of the balance of payments, national income needs to

grow in order to encourage more import. At any other interest rates, the same thing happens.

r

YO

BPBP’

BP’’

r0

Y0 Y1Y2

A BC

e↑e↓

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates Effects of Fiscal Policy under Floating Exchange Rate

The effect of fiscal policy under floating exchange rate is inversely proportional to the extent of capital mobility. The less mobile capital is, the stronger effect fiscal policy has.

A. Case of Perfect Capital Immobility

e +K :

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K KA

CA− >KA BP− e↑ X↑, M↓ IS'��������������

, BP��������������

E2: Y↑(Y2); r↑(r2)

r

Y

IS

O

E0

LMBP

IS’

E1

Y0 Y1

r0

r1

r2 E2

BP’

IS’’

Y2

B. Case of Imperfect Capital Mobility

(BP>LM)

e + K̂ (BP>LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+

CA− > KA+ BP− e↑ X↑, M↓ IS'��������������

, BP��������������

E2: Y↑(Y2); r↑(r2)

r

Y

BP

O

(a)Y0 Y1 Y2

r0

r1

r2

E1

E2

ISIS’

LM

E0

IS’’

BP’

B. Case of Imperfect Capital Mobility

(BP=LM)

e + K̂ (BP=LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+ (CA− = KA+ BP )

r

O Y

LM, BP

(b)

IS

IS’

Y0 Y1

r0

r1

E0

E1

B. Case of Imperfect Capital Mobility

(BP<LM)

e + K̂ (BP<LM):

G↑ AD↑ IS��������������

E1: Y↑(Y1) M↑ CA−

r↑(r1) K↑ KA+

CA− < KA+ BP+ e↓ X↓, M↑ 'IS�

, BP�

E2: Y↓(Y2>Y0); r↓(r0)

r

O Y(c)

IS

IS’E0

E1

E2

Y0 Y1Y2

r0

r1

r2

BP

LM

IS’’

BP’

C. Case of Perfect Capital Mobility

e +K :

G↑ AD↑ IS��������������

Y↑

r↑ K↑ BP+ e↓ X↓, M↑ IS�

E0: Y↓ (Y0)

r

Y

IS

O

E0

LM

BP

IS’

Y0

r0

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates Effects of Monetary Policy under Floating Exchange Rate

Monetary policy has perfect effect on economy under floating exchange rate regardless of the extent of capital mobility.

A. Case of Perfect Capital Immobility

e +K :

Ms↑ LM��������������

E1: Y↑(Y1) M↑ CA−

r↓(r1) K KA

CA− >KA BP− e↑ X↑, M↓ BP��������������

, IS��������������

E2: Y↑(Y2); r↑(r2=r0)

r

Y

BP

O

(a)Y0 Y1

r0,r2

r1

E1

IS

LMLM’

E0

BP’

E2

IS’

Y2

B. Case of Imperfect Capital Immobility

e + K̂ :

Ms↑ LM��������������

E1: Y↑(Y1) M↑ CA−

r↓(r1) K↓ KA−

CA− + KA− BP− e↑ X↑, M↓ BP��������������

, IS��������������

E2: Y↑(Y2); r↑(r2= r0)

r

O Y

LM

(b)

ISY0 Y1

r1

E0

E1

BP

LM’

E2

Y2

BP’

IS’

r0,r2

C. Case of Perfect Capital Mobility

e +K :

Ms↑ LM��������������

Y↑

r↓ K↓ BP− e↑ X↑, M↓ IS��������������

E1: Y↑ (Y1)

r

O Y(c)

IS

E0

Y0

r0 BP

LM LM’

IS’

Y1

E1

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates A Summary of Mundell-Flemming Model

9.4 Effects of Macroeconomic Policies under Floating Exchange Rates Mundell Incompatible Trinity

One country cannot have a fixed exchange rate system, free capital movement and an independent monetary policy at the same time.

Fixed Exchange Rate System

Free Capital Movement Independent Monetary Policy