Copyright ©2002, South-Western College Publishing International Economics By Robert J. Carbaugh 8th Edition Chapter 17: Macroeconomic Policy in an Open Economy

Carbaugh, Chap Open economy macro policy Policy in an open economy  Countries which are open to the world economy cannot make domestic economic policy choices without considering the impact on trade and payments and their international relationships  Nor can open economies entirely insulate themselves from other countries’ policy choices  As a result, nations make efforts to coordinate their international economic policies  Economic policies are also subject to domestic and foreign institutional constraints

Carbaugh, Chap Open economy macro policy Economic objectives  Internal balance  Fully employed economy  Little or no inflation  External balance  Current account is close enough to balance that foreign debts can be repaid (deficit) or that other nations can repay their debts (surplus)

Carbaugh, Chap Open economy macro policy Policy instruments  Expenditure-changing policies: alter aggregate demand for goods  fiscal policy  Monetary policy  Expenditure-switching policies: shift demand to/from imports or domestic goods  Devaluation or revaluation (fixed rates)  Exchange market intervention (managed float)  Direct controls  Tariffs, quotas, subsidies, capital controls

Carbaugh, Chap Economic objectives and macro policy Open economy macro policy

Carbaugh, Chap Open economy macro policy Exchange rate policies & overall balance  If a nation was experiencing recession and a BOP deficit, a currency devaluation would encourage exports and help boost domestic production  If it were experiencing inflation and a BOP surplus, a revaluation would cut back on exports and cool domestic spending

Carbaugh, Chap Open economy macro policy Exchange rate & overall balance (cont’d)  Such policy moves are not made in a vacuum; one country’s devaluation effectively means a revaluation for its main trading partners  If done without international consultation, these policy shifts might invite retaliation (as occurred during the Great Depression)

Carbaugh, Chap Open economy macro policy Fiscal & monetary policy: internal effects  Fiscal and monetary policy are generally used to achieve internal balance, but their effectiveness depends on the external sector  Under a fixed exchange rate system, fiscal policy is more successful in promoting internal balance than is monetary policy  Under a floating rate system, monetary policy is more effective than fiscal policy at achieving internal balance

Carbaugh, Chap Open economy macro policy Fiscal policy: short run internal effects Increase in government spending Aggregate demand rises Monetary demand and interest rates increase Net capital inflows Central bank sells currency and money supply rises Output and employment rise Output and employment rise further Under fixed exchange rates Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes

Carbaugh, Chap Open economy macro policy Fiscal policy: short run internal effects Increase in government spending Aggregate demand rises Monetary demand and interest rates increase Net capital inflows Currency appreciation Decrease in aggregate demand, output, employment Under floating exchange rates Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes Output and employment rise Imports rise and trade account worsens

Carbaugh, Chap Open economy macro policy Monetary policy: short run internal effects Money supply increases Aggregate demand rises Net capital outflows Currency depreciates Exports rise and trade account improves Output and employment rise Output and employment rise further Under floating exchange rates Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes Interest rate falls

Carbaugh, Chap Open economy macro policy Monetary policy: short run internal effects Money supply increases Aggregate demand rises Net capital outflows Central bank purchases currency Money supply decreases Output and employment rise Output and employment fall Under fixed exchange rates Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes Interest rate falls

Carbaugh, Chap Open economy macro policy Fiscal & monetary policy: external effects  Since floating rates foster BOP equilibrium, focus is on fixed rates  In short run, monetary policy has a clear effect on BOP  Expansion worsens BOP balance  Contraction improves BOP balance  Short run effects of fiscal policy are not certain - they depend on capital mobility

Carbaugh, Chap Open economy macro policy Monetary policy: short run external effects Interest rates fall Aggregate demand rises Net capital outflows Capital account worsens Overall BOP worsens Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes Trade account worsens Money supply increases

Carbaugh, Chap Open economy macro policy Fiscal policy: short run external effects Aggregate demand rises Money demand rises Net capital inflows Overall BOP may improve For contractionary fiscal policy, reverse all changes Trade account worsens Increase in government spending Interest rates rise

Carbaugh, Chap Open economy macro policy Policy agreement and policy conflict  Monetary policy  If a nation has unemployment with a BOP surplus, or inflation with a BOP deficit, an increase/decrease in the money supply will restore both internal and external balances  But if a nation has unemployment with a BOP deficit, or inflation with a BOP surplus, a policy aimed at solving one problem will worsen the other  Fiscal policy - effects are unclear under those circumstances

Carbaugh, Chap Open economy macro policy Policy agreement and conflict (cont’d)  In such cases where policy aims do conflict, some combination of fiscal and monetary policy measures will be necessary  Some imbalances are even more intractable, such as the case where a nation experiences both inflation and unemployment along with a BOP imbalance, and require a wider range of policy instruments

Carbaugh, Chap Open economy macro policy International policy coordination  Domestic economic policy moves can spill over to affect other countries  Major industrial nations have worked to coordinate economic policy so that external balances are maintained without sacrificing domestic objectives

Carbaugh, Chap Open economy macro policy International policy coordination  Annual Group of Seven (G-7) economic summits  Regular meetings of central bank heads at the Bank for International Settlements  Major international policy agreements, such as the Smithsonian Agreement (1971); Bonn Summit (1978); Plaza Accord (1985); Louvre Accord (1987)