Chapter 25 Open economy macroeconomics ©McGraw-Hill Companies, 2010

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. ©McGraw-Hill Companies, 2010 2

Open economy macroeconomics In highly connected global financial markets, regulation or taxation by a country in isolation risks driving mobile financial business to all the other countries that have not raised taxes or imposed regulations. Even if a tax on capital transactions (a Tobin tax) is desirable, it would require simultaneous introduction in most important financial centres. ©McGraw-Hill Companies, 2010 3

According to the IMF’s Chief Economist Perfect international capital mobility is an idealized benchmark against which to compare actual capital mobility, which would differ in different countries. Countries can pursue expected rates of return on assets that might differ slightly from the world average. But when major strains emerge – as in the case of Greece in 2010 – the extent of national autonomy from speculation is quickly eroded. ©McGraw-Hill Companies, 2010 4

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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 intervenes to maintain the exchange rate, there is a direct effect on money supply. Sterilization an open market operation between domestic money and domestic bonds to neutralize the tendency of balance of payments surpluses and deficits to change domestic money supply. ©McGraw-Hill Companies, 2010 6

Monetary policy under fixed exchange rates Assume: 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 ©McGraw-Hill Companies, 2010 7

Fixed exchange rates and the loss of monetary sovereignty The exchange rate is fixed to a foreign currency LM LM’ Beginning at A, a monetary expansion lowers r to r’, leading to capital outflows. r’ r* is the foreign interest rate A r* Interest rates This is caused by the interest rate falling below r*, and will continue until r* is restored. IS Y* The need to match r* leads to a loss of monetary sovereignty Output ©McGraw-Hill Companies, 2010 8

Fiscal policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices An increase in government expenditure, in the short run, stimulates output money supply expands 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 ©McGraw-Hill Companies, 2010 9

Fixed exchange rates and fiscal expansion Beginning at A, a fiscal expansion shifts the IS curve to IS’. LM 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. A r* Interest rates IS Y* Output A fiscal expansion leads to a big short-run effect on output, i.e. from Y* to Y’. ©McGraw-Hill Companies, 2010 10

Monetary policy under floating exchange rates The long run equilibrium nominal exchange rate is e* e To be constant this requires no inflation differential cross countries. e0 e* The Fisher hypothesis then means that interest rate differentials are also eliminated in the long run For a country with temporary high Interest rates, the exchange rate begins at e0 and moves to e* over time, Time similarly for too low interest rates beginning at e1. In either case expected exchange rate differentials offset interest differentials. ©McGraw-Hill Companies, 2010 11

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. ©McGraw-Hill Companies, 2010 12

Fiscal policy under 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. ©McGraw-Hill Companies, 2010 13

©McGraw-Hill Companies, 2010 PPP and the short run The purchasing power parity (PPP) path of the nominal exchange rate is the path that offsets differential inflation rates across countries, maintaining a constant real exchange rate. However, in the short run, the real exchange rate can fluctuate a lot. If the vast stock of internationally mobile funds were all to move in a short period between two currencies: this could not possibly be offset by the small net flows that occur on the current account during that time. Under freely floating exchange rates there is no government intervention and no official financing. The forex market could not clear. ©McGraw-Hill Companies, 2010 14

©McGraw-Hill Companies, 2010 But clear it does! UK interest rates rise and are 4% above US interest rates. If people think that the UK exchange rate will fall at 2% a year, the extra UK interest rate more than compensates for capital losses on sterling. Everyone tries to move into pounds. Almost instantly, this bids up the $/£ exchange rate until it reaches such a high level that people expect the pound then to fall by 4% a year. The capital losses expected on funds lent in pounds offsets the 4% interest differential. This restores interest parity and ends one-way traffic. ©McGraw-Hill Companies, 2010 15

©McGraw-Hill Companies, 2010 Devaluation A devaluation (revaluation) reduces (increases) the par value of a pegged (fixed) exchange rate. With sluggish price adjustment, devaluation raises competitiveness and –eventually – impacts on the current account. In the long run, devaluation is unlikely to have much effect. In passing on higher import prices and seeking cost-of-living wage increases, firms and workers offset the competitive advantage of devaluation. ©McGraw-Hill Companies, 2010 16

Devaluation: Impact on real exchange rate Devaluation leads to an immediate increase in competitiveness and decline in the real exchange rate from e1 to e2 . e e1 But firms may respond by raising prices and hence not all the impact may be on competitiveness. Devaluation leads to a temporary but not a permanent rise in competitiveness. Time In the long run, changes in one nominal variable eventually induce offsetting changes in others to restore real variables to their equilibrium values. But devaluation may be the simplest way to change competitiveness quickly. ©McGraw-Hill Companies, 2010 17

Devaluation: Impact on current account balance Initially, the devaluation is effectively a price cut – until quantities can respond, making exports cheaper actually harms export revenue. The current account worsens. Current account In the medium run, the induced quantity rise in exports benefits the current account in value terms, provided quantities respond sufficiently to price incentives. Time Eventually, since the real exchange rate is restored to its original level, so is the current account. ©McGraw-Hill Companies, 2010 18