1 Global Economics Eco 6367 Dr. Vera Adamchik Macroeconomic Policy in an Open Economy

2 Economic Objectives o internal balance fully employed economy no inflation – or reasonable amount of inflation o external balance – neither a deficit nor a surplus in current account o overall balance – both internal and external balance o other goals: long-run economic growth and equitable income distribution

3 Policy Instruments o expenditure changing policies – alter aggregate demand for both domestic and international goods and services fiscal policy – government changes spending and taxation monetary policy – central bank changes money supply and interest rates o expenditure switching policies – modify direction of demand between domestic output and imports; example: currency depreciation and direct controls – government restrictions on economy (tariffs)

4 Expansionary Policy in Closed Economy o fiscal policy alternatives would be to increase government spending or decrease taxes o to increase output and reduce unemployment central bank increases money supply decreasing interest rates o leads to increased AD o more AD leads to increased GDP

5 Exchange Rate Systems 2) floating rate a) determined by market forces b) float independently or with a group of other currencies 1) fixed rate a) also known as pegged exchange rate b) anchored to the value of one other currency or a group of currencies

6 Fixed Exchange Rates Under a fixed exchange rate system governments maintain o par value for their currencies o an official exchange rate determined by comparing par values o an exchange rate stabilization fund to buy and sell foreign currencies in order to preserve the official exchange rate

7 Preventing Depreciation If the demand for the euro increased, the value of the euro would rise and the value of the dollar would fall. In order to maintain the fixed exchange rate, the U.S. would use its reserve of euros to buy dollars. $1.70 Q $1.50 Market for Euros D1D1 S1S1 P D2D2 S2S2

8 Preventing Appreciation If the supply of the euro increased, the value of the euro would fall and the value of the dollar would rise. In order to maintain the fixed exchange rate, the U.S. would use dollars to buy euros. $1.25 Q $1.50 Market for Euros D1D1 S1S1 P D2D2 S2S2

9 Expansionary Fiscal Policy with Fixed Exchange Rates o fixed exchange rates require government purchase foreign currency o increases money supply further increasing AD o secondary effect is an increased budget deficit which increases interest rates o attracts more foreign investment o increases demand for domestic currency

10 Expansionary Monetary Policy with Fixed Exchange Rates government use foreign currency reserves to purchase domestic currency o decrease in money supply reduces AD o to increase AD interest rates are decreased o discourages foreign investment o decreases demand for dollars o fixed exchange rate system requires

11 Floating Exchange Rates o also known as flexible exchange rates o equilibrium exchange rate determined by demand for and supply of home currency o changes in exchange rate correct payments imbalance by changing the effective cost of imports and exports o will not fluctuate erratically unless there is significant instability in financial markets

12 Depreciation Demand for the euro increases. The value of the euro would rise and the value of the dollar would fall. $1.70 Q $1.50 Market for Euros D1D1 S1S1 P D2D2

13 Appreciation Demand for the euro decreases. The value of the euro would fall and the value of the dollar would rise. $1.25 Q $1.50 Market for Euros D2D2 P D1D1 S1S1

14 Expansionary Fiscal Policy with Floating Exchange Rates domestic currency o appreciation leads to decline in current account o reduced impact of fiscal policy o initial effect is move from AD 0 to AD 1 o greater deficit leads to increased interest rates o causes inflow of foreign investment o increased demand for

15 Expansionary Monetary Policy with Floating Exchange Rates leads to further increase in AD o policy is particularly effective in this case o increase money supply decreases interest rates o causes increase in AD o shift of investments toward other nations o decreased demand for domestic currency o resulting depreciation

16 Summary of Effectiveness Monetary Fiscal Policy Policy Strengthened Weakened Weakened Strengthened Floating Exchange Rate Fixed Exchange Rate

17 Policy Conflict-Zone recession & current account deficit o under floating exchange rate system expansionary monetary policy causes increase in GDP as well as depreciation improving current account deficit inflation & current account deficit o under floating exchange rate contractionary monetary policy limits inflation but leads to appreciation increasing current account deficit o policy zone conflict – monetary policy cannot restore both internal and external balance

18 Inflation with Unemployment o more problematic because internal balance cannot be achieved by managing AD o overall balance requires 1)current account equilibrium 2)full employment 3)price stability o 1971 example of inflation with unemployment o resulting actions: expansionary policy with wage & price controls along with devaluation of the dollar

19 International Policy Coordination o mobility of goods, services, labor and capital o economic policies of one nation will have impact on economies of other nations o coordination – attempt to modify monetary, fiscal and exchange rate policies recognizing international repercussions

20 Examples of Policy Coordination o 1984: U.S. expansionary fiscal policy used to address recession o caused appreciation of dollar and current account deficit o Plaza Agreement of 1985 G-5: U.S., Japan, Germany, Great Britain, and France pledges: U.S. – reduce federal deficit Japan – expansionary monetary policy Germany – tax reductions

21 Examples of Policy Coordination (cont.) o : dollar decreased 54% o decline in dollar’s value led to concern of more drastic decrease in value o Louvre Accord 1987 U.S. – adopt restrictive fiscal policy Japan – ease monetary policy o U.S. current account deficit began to decline and reached balance by 1991 o coordination efforts may not be successful due to central banks independence and growth of global financial markets