1. © The McGraw-Hill Companies, 2005 Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

2. © The McGraw-Hill Companies, 2005 1 Open economy macroeconomics … is the study of economies in which international transactions play a significant role –international considerations are especially important for open economies like the UK, Germany or the Netherlands Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world –especially via the exchange rate.

3. © The McGraw-Hill Companies, 2005 2 Macroeconomic policy under fixed exchange rates Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply. When the government intervene to maintain the exchange rate, there is a direct effect on money supply. Sterilisation –an open market operation between domestic money and domestic bonds to neutralise the tendency of balance of payments surpluses and deficits to change domestic money supply.

4. © The McGraw-Hill Companies, 2005 3 Monetary policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices An increase in nominal money supply –tends to reduce interest rates –leads to a capital outflow –reducing money supply as the government seeks to maintain the exchange rate so monetary policy is powerless –the government cannot fix independent targets for both money supply and the exchange rate –domestic and foreign interest rates cannot diverge

5. © The McGraw-Hill Companies, 2005 4 Fixed exchange rates and the loss of monetary sovereignty IS A LM r* Y* Output Interest rates The need to match r* leads to a loss of monetary sovereignty To the consequent capital outflow caused by the r falling below r*, will continue until r* is restored. LM’ Beginning at A, a monetary expansion lowers r to r’, leading to capital outflows. r’

6. © The McGraw-Hill Companies, 2005 5 Fiscal policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices An increase in government expenditure, in the short run, – stimulates output –but also increases interest rates –which leads to a capital inflow –money supply expands to maintain the exchange rate –there is no crowding-out –as interest rates cannot rise in the long run, –wages and prices adjust, affecting competitiveness –the economy returns to potential output.

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8. 7 Fixed exchange rates and fiscal expansion IS A LM r* Y* Output Interest rates A fiscal expansion leads to a big short-run effect on output i.e. from Y* to Y’. IS’ Beginning at A, a fiscal expansion shifts the IS curve to IS’. B LM’ Y’ Ordinarily, interest rates would rise to dampen some of the increase in Y. Since rates cannot rise above r*, extra money supply (LM to LM’) has to accommodate the extra demand for money.

9. © The McGraw-Hill Companies, 2005 8 C Adjustment towards e 2 takes place along BC as wages and prices become more flexible. Monetary policy under floating exchange rates Time e e1e1 Suppose the economy begins in equilibrium with the nominal exchange rate at e 1. t A At time t, nominal money supply is halved... e2e2 e 2 will be the new equilibrium exchange rate once the economy has adjusted But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise. e3e3 B These higher rates push the exchange rate to e 3.

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11. 10 Monetary policy under floating exchange rates (2) This analysis suggests that with floating exchange rates monetary policy is highly effective in the short run but the effect is only transitional.

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13. © The McGraw-Hill Companies, 2005 12 Fiscal policy under floating exchange rates Following an increase in government expenditure... the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate –which dampens export demand so fiscal policy is less effective under floating exchange rates.

14. © The McGraw-Hill Companies, 2005 13 Further Reading Ercan KUMCU: “Kafamızın Karışık Olduğu Konular” August 14, 2007 http://www.hurriyet.com.tr/yazarlar/7080158.asp