MACROECONOMIC POLICY IN THE OPEN ECONOMY Chapter 39 - Lipsey

MACROECONOMIC VARIABLES AND THEIR RELATIONSHIPS WHY DOES OPEN MATTER? MACROECONOMIC VARIABLES AND THEIR RELATIONSHIPS NET EXPORTS MOBILE CAPITAL THE EXCHANGE RATE REGIME

MACRO POLICY IN A WORLD WITH PERFECT CAPITAL MOBILITY THE MACRO MODEL WITH CAPITAL FLOWS Two relationships must be kept in mind: Net capital flows must be of equal size and opposite sign to the current account BOP surplus Foreign demand for domestic bonds will depend upon the differential in interest rates between domestic and foreign bonds.

MACRO POLICY IN A WORLD WITH PERFECT CAPITAL MOBILITY - Cont’d Perfect capital mobility means that, with fixed exchange rates, the domestic interest rate must always equal the foreign interest rate. With floating exchange rates, any interest differential must equal the expected exchange rate change. This will be zero in full static equilibrium.

FIG.39.1 – The macroeconomic implications of perfect capital mobility With perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate in equilibrium.

POLICY CHANGES WITH FIXED EXCHANGE RATES

FIG 39.2 - MONETARY POLICY WITH FIXED EXCHANGE RATES & PERFECT CAPITAL MOBILITY Monetary policy is powerless to influence economic activity under fixed exchange rates and perfect capital mobility

FIG 39.3 - FISCAL POLICY WITH FIXED EXCHANGE RATES & PERFECT CAPITAL MOBILITY Starting from full equilibrium, an increase in government spending creates a significant stimulus to real activity in the short run, but in the long run it leads to a higher price level and a balance of payments deficit.

POLICY CHANGES WITH FLOATING EXCHANGE RATES

MONETARY POLICY An expansionary monetary policy ( MS or i ) under floating exchange rates with perfect capital mobility causes a boom in real economic activity in the short run, but the long-run effect is a higher price level and a depreciation of the nominal exchange rate , with no permanent gain in real output and an unchanged real exchange rate.

FIG 39.4 – MONETARY POLICY WITH FLOATING EXCHANGE RATES AND PERFECT CAPITAL MOBILITY Starting at full equilibrium, an increase in the money supply causes an output boom in the short run, but in the long run causes only higher prices and currency depreciation.

FISCAL POLICY An expansionary fiscal policy, under floating exchange rates with perfect capital mobility, has little impact on real national income in the short run, rather, it causes an exchange rate appreciation and a trade deficit. In the long run, there is a permanent appreciation of the real exchange rate, and the government budget deficit is equal to the trade deficit.

FIG 39.5 – FISCAL POLICY WITH FLOATING EXCHANGE RATES AND PERFECT CAPITAL MOBILITY Starting at full equilibrium, a fiscal expansion leads to a currency appreciation, which crowds out an equivalent volume of net exports, causing a current account deficit but little or no stimulus to national income.

POLICY CHANGES TO CORRECT DISEQUILIBRIUM

MONETARY POLICY Monetary policy can be used in the short term to offset a recessionary effects of a negative demand shock, but whether this can be done with enough accuracy to improve on the automatic adjustment mechanisms is controversial. FISCAL POLICY In short, starting the economy at less than potential national income and flexible ER makes it possible that both monetary and fiscal policy could be used to speed up the adjustment of national income back to its potential level.

FIG 39.6 – MACRO POLICIES TO CORRECT A DISEQUILIBRIUM Monetary and fiscal policy can help the economy recover from a negative demand shock, so long as they are appropriately timed.

SOME IMPLICATIONS The transmission of monetary policy The efficacy of fiscal policy Global transmission of cycles