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International Economics By Robert J. Carbaugh 9th Edition
Chapter 17: Macroeconomic Policy in an Open Economy
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Policy in an open economy
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. 17
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Economic objectives Internal balance External balance
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. 17
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Open economy macro policy
Policy instruments Expenditure-changing policies: alter aggregate demand for goods Fiscal policy (government taxes and spending) Monetary policy (money supply) 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. 17
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Economic objectives and macro policy
Open economy macro policy Economic objectives and macro policy Carbaugh, Chap. 17
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Exchange rate policies & overall balance
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. 17
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Exchange rate & overall balance (cont’d)
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. 17
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Fiscal & monetary policy: internal effects
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. 17
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Fiscal policy: short run internal effects
Open economy macro policy Fiscal policy: short run internal effects Under fixed exchange rates Aggregate demand rises Output and employment rise Increase in government spending Money demand and interest rates increase Central bank sells currency and money supply rises Net capital inflows Output and employment rise further Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes Carbaugh, Chap. 17
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Fiscal policy: short run internal effects
Open economy macro policy Fiscal policy: short run internal effects Under floating exchange rates Imports rise and trade account worsens Decrease in aggregate demand, output, employment Aggregate demand rises Output and employment rise Increase in government spending Money demand and interest rates increase Net capital inflows Currency appreciation Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes Carbaugh, Chap. 17
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Monetary policy: short run internal effects
Open economy macro policy Monetary policy: short run internal effects Under floating exchange rates Money supply increases Aggregate demand rises Output and employment rise Interest rate falls Exports rise and trade account improves Net capital outflows Output and employment rise further Currency depreciates Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes Carbaugh, Chap. 17
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Monetary policy: short run internal effects
Open economy macro policy Monetary policy: short run internal effects Under fixed exchange rates Money supply increases Aggregate demand rises Output and employment rise Interest rate falls Central bank purchases currency Net capital outflows Money supply decreases Output and employment fall Assumes high degree of capital mobility For contractionary monetary policy, reverse all changes Carbaugh, Chap. 17
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Fiscal & monetary policy: external effects
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. 17
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Monetary policy: short run external effects
Open economy macro policy Monetary policy: short run external effects Under fixed exchange rates Aggregate demand rises Trade account worsens Money supply increases Interest rates fall Overall BOP worsens Capital account worsens Net capital outflows Assumes high degree of capital mobility For contractionary fiscal policy, reverse all changes Carbaugh, Chap. 17
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Fiscal policy: short run external effects
Open economy macro policy Fiscal policy: short run external effects Under fixed exchange rates Aggregate demand rises Trade account worsens Increase in government spending Overall BOP may improve Money demand rises Interest rates rise Net capital inflows For contractionary fiscal policy, reverse all changes Carbaugh, Chap. 17
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Policy agreement and policy conflict
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. 17
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Policy agreement and conflict (cont’d)
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. 17
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International policy coordination
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. 17
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International policy coordination
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) Carbaugh, Chap. 17
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