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Chapter 29Open economy

macroeconomics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005

PowerPoint presentation by Alex Tackie and Damian Ward

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Open economy macroeconomics

• … is the study of economies in which international transactions play a significant role– international considerations are especially

important for open economies like the UK, Germany or the Netherlands

• Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world– especially via the exchange rate.

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Macroeconomic policy under fixed exchange rates

• Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply.

• When the government intervene to maintain the exchange rate, there is a direct effect on money supply.

• Sterilisation– an open market operation between domestic money and

domestic bonds to neutralise the tendency of balance of payments surpluses and deficits to change domestic money supply.

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Monetary policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices

• An increase in nominal money supply– tends to reduce interest rates– leads to a capital outflow– reducing money supply as the government

seeks to maintain the exchange rate

• so monetary policy is powerless– the government cannot fix independent targets

for both money supply and the exchange rate– domestic and foreign interest rates cannot

diverge

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Fixed exchange rates and the loss of monetary

sovereignty

IS

A

LM

r*

Y*Output

Inte

rest

rat

es

The need to match r* leads to a loss of monetary sovereignty

To the consequent capital outflow caused by the r falling below r*, will continue until r* is restored.

LM’Beginning at A, a monetary expansion lowers r to r’, leading to capital outflows.

r’

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Fiscal policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices

• An increase in government expenditure,

• in the short run,– stimulates output

– but also increases interest rates

– which leads to a capital inflow

– money supply expands to maintain the exchange rate

– there is no crowding-out

– as interest rates cannot rise

• in the long run,– wages and prices adjust, affecting competitiveness

– the economy returns to potential output.

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8©The McGraw-Hill Companies, 2005

Fixed exchange rates and fiscal expansion

IS

A

LM

r*

Y*Output

Inte

rest

rat

es

A fiscal expansion leads to a big short-run effect on output i.e. from Y* to Y’.

IS’

Beginning at A, a fiscal expansion shifts the IS curve to IS’.

B

LM’

Y’

Ordinarily, interest rates would rise to dampen some of the increase in Y. Since rates cannot rise above r*, extra money supply (LM to LM’) has to accommodate the extra demand for money.

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C

Adjustment towards e2 takes place along BC as wages and pricesbecome more flexible.

Monetary policy under floating exchange

rates

Time

e

e1

Suppose the economy begins in equilibrium with the nominal exchange rate at e1.

t

A

At time t, nominal moneysupply is halved...

e2

e2 will be the new equilibriumexchange rate once the economy has adjusted

But prices are sluggish, soin the short run, real money supply falls and domestic interest rates rise.

e3B

These higher rates push theexchange rate to e3.

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Monetary policy under floating exchange rates

(2)

• This analysis suggests that with floating

exchange rates

• monetary policy is highly effective in

the short run

• but the effect is only transitional.

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13©The McGraw-Hill Companies, 2005

Fiscal policyunder floating exchange rates

• Following an increase in government expenditure ...

• the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate– which dampens export demand

• so fiscal policy is less effective under floating exchange rates.

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Further Reading

• Ercan KUMCU: “Kafamızın Karışık Olduğu Konular” August 14, 2007

http://www.hurriyet.com.tr/yazarlar/7080158.asp