© 2003 McGraw-Hill Ryerson Limited. International Dimensions of Monetary and Fiscal Policy Chapter 17

© 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u Macroeconomics’ international goals are less straightforward than its domestic goals.

© 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u There is great debate about how Canada should maintain its position in the world economy.

© 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u Do we want a high or a low value for our currency? u Do we want a balance of trade surplus or a trade deficit? u Should we even pay attention to the balance of trade?

© 2003 McGraw-Hill Ryerson Limited. The Exchange Rate Goal u A high value for a currency has advantages and disadvantages. u Depending on the state of the economy, there are arguments both for high and low exchange rates.

© 2003 McGraw-Hill Ryerson Limited. Advantages of a High Value for the Dollar u It makes foreign currencies cheaper. u It lowers the price of imports.

© 2003 McGraw-Hill Ryerson Limited. Advantages of a High Value for the Dollar u Lower import prices puts competitive pressure on domestic firms and helps to keep down inflation. u Canadian residents’ living standards are enhanced.

© 2003 McGraw-Hill Ryerson Limited. Advantages of a High Exchange Rate u A low value for the dollar has the opposite effect.

© 2003 McGraw-Hill Ryerson Limited. Disadvantages of a High Value for the Dollar u A high value for a currency encourages imports and discourages exports. u It can cause a trade deficit that can have a contractionary effect of the economy by decreasing aggregate demand for domestic output.

© 2003 McGraw-Hill Ryerson Limited. Disadvantages of a High Value for the Dollar u A low exchange rate has the opposite effect.

© 2003 McGraw-Hill Ryerson Limited. The Exchange Rate Goal u Because of the divergent views, some economists argue that government should simply accept whatever exchange rate exists and not consider it in its conduct of monetary and fiscal policies.

© 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u A deficit in the trade balance means that, as a country, we are consuming more than we are producing. l Trade balance – the difference between imports and exports.

© 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u There is a debate about whether we should worry about a trade deficit or not. u A trade deficit is not without costs. u We pay for a trade deficit by selling off Canadian assets to foreigners.

© 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u All the future interest and profits on those assets will flow to foreigners, not Canadian citizens.

© 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u Eventually, we will have to produce more than we consume so that we can pay them their profit and interest on their assets.

© 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u In the short-run a trade deficit allows more current consumption, in the long run it presents problems.

© 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u Domestic goals generally dominate international goals. u International goals are ambiguous.

© 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u International goals affect a country’s population indirectly. u In politics, indirect effects take a back seat.

© 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u When a nation is forced to face certain economic facts (threats by other countries that they must limit their imports), international goals can become its primary goals.

© 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u As countries become more economically integrated, these pressures from other countries become more important.

© 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u An economy with fixed exchange rates is much more restricted in its monetary and fiscal policies than one with flexible exchange rates.

© 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u The reason is that the amount of currency stabilization that can be achieved with direct intervention is quite small, since a country's foreign reserves are limited.

© 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u If foreign reserves are limited, a country must adjust its economy to maintain the value of its currency.

© 2003 McGraw-Hill Ryerson Limited. Raising the Value of the Euro Using Monetary and Fiscal Policy u There are three options for raising the value of the euro: l Increase the private demand for euros via contractionary monetary policy. l Decrease the private supply of euros via contractionary monetary and fiscal policy. l Use some combination of both.

© 2003 McGraw-Hill Ryerson Limited. Increase the Private Demand for Euros u The primary way to increase the demand for euros in the short run is through contractionary monetary policy. u The interest rate will increase which increases the demand for the countries’ interest-bearing assets.

© 2003 McGraw-Hill Ryerson Limited. Increase the Private Demand for Euros u The problem? u The area can achieve an interest rate target or an exchange rate target, but not both at the same time.

© 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u The private supply of euros can be decreased via contractionary monetary and fiscal policy.

© 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u Contractionary monetary and fiscal policy will create a recession. u The demand for imports will decrease, thereby decreasing the private supply of euros.

© 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u The problem? u A purposely induced recession for political reasons is not a very popular decision.

© 2003 McGraw-Hill Ryerson Limited. S0S0 D0D0 Price of euros (in dollars) $ Quantity of euros D1D1 S1S1 Targeting an Exchange Rate with Monetary and Fiscal Policy, Fig. 17-1, p 419

© 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Flexible or Partially Flexible Exchange Rates u Many countries choose flexible or partially flexible exchange rate regimes to avoid the constraints that a fixed exchange rate regime places on domestic monetary and fiscal policy.

© 2003 McGraw-Hill Ryerson Limited. Monetary Policy’s Effect on Exchange Rates u Monetary policy's effect on exchange rates is felt in three ways: l Through its effect on the interest rate. l Through its effect on income. l Through its effect on price levels and inflation.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u An expansionary monetary policy pushes down the Canadian interest rate. u Lower interest rates decrease foreign capital inflow into Canada.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Less foreign capital inflow decreases the demand for dollars. u Lower demand for Canadian dollars decreases the exchange.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u A contractionary monetary policy does the opposite. u It raises Canadian interest rate, bringing in the capital from abroad, increasing the demand for dollars and increasing the value of the dollar.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Monetary policy affects income in a country. l As money supply rises, income expands. l When money supply falls, income contracts.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Rising Canada’s income increases the demand for imported goods. u To buy imported goods, Canadian citizens need foreign currency that they must buy with dollars.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u The supply of dollars in the foreign exchange market increases as Canadian citizens sell dollars to buy foreign currencies to pay for the imports. u The increase in the supply of dollars causes its value to decrease.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Expansionary monetary policy pushes up the Canadian price level. u As the prices rise relative to foreign prices, Canadian exports become more expensive and goods Canadian imports become cheaper.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u The demand for foreign currencies increases and the demand for dollars decreases, pushing the value of the dollar down.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Contractionary monetary policy puts downward pressure on Canadian price level and slows down any existing inflation.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u As a result, contractionary monetary policy pushes the value of the dollar up via the price path.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on Exchange Rates u Expansionary monetary policy lowers exchange rates. u It decreases the relative value of a currency.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on Exchange Rates u Contractionary monetary policy increases exchange rates. u It increases the relative value of a country's currency.

© 2003 McGraw-Hill Ryerson Limited. M Competi- tiveness Expansionary monetary policy i P Y Net Effect of Monetary Policy on Exchange Rates Value of domestic currency Value of domestic currency L-R effect Value of domestic currency Imports

© 2003 McGraw-Hill Ryerson Limited. M Competi- tiveness Imports Contractionary monetary policy i P Y Net Effect of Monetary Policy on Exchange Rates Value of domestic currency Value of domestic currency L-R effect Value of domestic currency

© 2003 McGraw-Hill Ryerson Limited. Monetary Policy’s Effect on the Trade Balance u Monetary policy affects the trade balance in three ways. l Through income. l Through price levels. l Through the exchange rate.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u Expansionary monetary policy increases income. u When incomes rise, imports rise; exports are unaffected.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u As imports rise, the trade balance shifts in the direction of deficit. u As a result, the trade balance shifts toward a deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u Contractionary monetary policy works in the opposite direction. u As a result, the trade balance shifts toward a surplus.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Expansionary monetary policy pushes a country’s price level up. u This decreases it competitiveness. u Trade deficits go up as residents substitute imported for domestic goods.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Contractionary monetary policy works in the opposite direction. u As a result, contractionary monetary policy decreases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Monetary policy’s effect on the price level is a long-run effect.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Expansionary monetary policy decreases the interest rate. u This tends to push the dollar exchange rate down. u This increases Canadian competitiveness which decreases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Contractionary monetary policy works in the opposite direction. u As a result, contractionary monetary policy increases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Like the price level effect, the effect of the exchange rate on the trade deficit is a long-term effect.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on the Trade Balance u Expansionary monetary policy makes a trade deficit larger. u Contractionary monetary policy makes a trade deficit smaller.

© 2003 McGraw-Hill Ryerson Limited. M Value of domestic currency Expansionary monetary policy Net Effect of Monetary Policy on the Trade Deficit Imports Trade deficit YP i Competi- tiveness

© 2003 McGraw-Hill Ryerson Limited. M Contractionary monetary policy Net Effect of Monetary Policy on the Trade Deficit Imports Competi- tiveness Trade deficit Y i Competi- tiveness P Value of domestic currency

© 2003 McGraw-Hill Ryerson Limited. Fiscal Policy’s Effect on Exchange Rates u Fiscal policy affects exchange rates in three ways. l Through income. l Through price. l Through interest rates.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Expansionary fiscal policy increases income. u When incomes rise, imports rise; exports are unaffected. u As imports rise, the trade deficit increases and the currency value drops.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Contractionary fiscal policy works in the opposite direction. u Imports decrease and the currency value increases.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Expansionary fiscal policy increases aggregate demand. u The prices of a country’s exports increases. u The competitiveness of a country’s exports decreases and the currency value drops.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Contractionary fiscal policy works in the opposite direction. u The price path is a long-run effect.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Expansionary fiscal policy increases interest rates because the government sells bonds to finance the deficit. u Higher Canadian interest rates cause foreign capital to flow into Canada. u The dollar value goes up.

© 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Contractionary fiscal policy works in the opposite direction. u Interest rates decrease, capital flows out of Canada and the value of the dollar decreases.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on Exchange Rates u The interest rate effect and the income effect are both short-term effects. u The two work in opposite directions, so the net effect of fiscal policy is ambiguous.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on Exchange Rates u It is unclear what the effect of expansionary or contractionary fiscal policy will be on exchange rates.

© 2003 McGraw-Hill Ryerson Limited. Net Effect of Fiscal Policy on Exchange Rates Competi- tiveness Expansionary fiscal policy i P Y Value of domestic currency Value of domestic currency L-R effect Imports ?

© 2003 McGraw-Hill Ryerson Limited. Net Effect of Fiscal Policy on Exchange Rates Competi- tiveness Imports Contractionary fiscal policy iP Y Value of domestic currency L-R effect ?

© 2003 McGraw-Hill Ryerson Limited. Fiscal Policy’s Effect on the Trade Deficit u Fiscal policy works on the trade deficit through its effects on income and prices.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Income u Expansionary fiscal policy increases income. u Imports go up, as does the trade deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Income u Contractionary fiscal policy works in the opposite direction. u It decreases the size of the trade deficit. u These are the same effects as those of monetary policy.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Prices u Expansionary fiscal policy increases the price level. u This increases the price of a country’s exports and decreases it competitiveness. u This increases the trade deficit.

© 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Prices u Contractionary fiscal policy works in the opposite direction. u It decreases the size of the trade deficit. u These are the same effects as those of monetary policy.

© 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on the Trade Deficit u Expansionary fiscal policy increases a trade deficit. u Contractionary fiscal policy decreases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited. Expansionary fiscal policy The Net Effect of Fiscal Policy on the Trade Deficit Imports Trade deficit Y P Competi- tiveness

© 2003 McGraw-Hill Ryerson Limited. Contractionary fiscal policy The Net Effect of Fiscal Policy on the Trade Deficit Imports Competi- tiveness Trade deficit Y P

© 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy’s Effect on International Goals

© 2003 McGraw-Hill Ryerson Limited. International Phenomena and Domestic Goals u Monetary and fiscal policy can work the other way around. u The monetary and fiscal policies of other countries can have significant effects on Canadian domestic economy.

© 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Governments try to coordinate their monetary and fiscal policies because their economies are interdependent.

© 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Because of this interdependence, many economists argue that all countries must work together to coordinate their monetary and fiscal policies.

© 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Because of the fear of retaliatory measures, nations take their trading partners’ desires into account when making their monetary and fiscal policies.

© 2003 McGraw-Hill Ryerson Limited. Coordination Is a Two-Way Street u If other nations are to take the needs of Canadian economy into account, Canada must take the needs of other countries into account in determining its goals.

© 2003 McGraw-Hill Ryerson Limited. Coordination Is a Two-Way Street u Each country will likely do what is best for the world economy as long as it is also best for itself.

© 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u There is another way to avoid crowding out that results from financing the debt. u Foreigners could buy the debt at the existing interest rate. u This is called internationalizing the debt.

© 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u Internationalizing a country’s debt may help in the short run.

© 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u In the long run it presents potential problems since foreign ownership of a country’s debts means the country must pay interest to those foreign countries and that debt may come due.

© 2003 McGraw-Hill Ryerson Limited. Selecting Policies to Achieve Goals, Table17-1, p 429

© 2003 McGraw-Hill Ryerson Limited. Selecting Policies to Achieve Goals, Table17-1, p 429

© 2003 McGraw-Hill Ryerson Limited. International Dimensions of Monetary and Fiscal Policy End of Chapter 17