1

Global EconomicsEco 6367

Dr. Vera Adamchik

Macroeconomic Policy in an

Open EconomyChapter 16

2

Economic Objectiveso 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 ADo more AD leads to

increased GDP

5

Exchange Rate Systems

2) floating ratea) determined by market forcesb) float independently or with a group

of other currencies

1) fixed rate a) also known as pegged exchange rateb) anchored to the value of one other

currency or a group of currencies

6

Fixed Exchange Rates

Under a fixed exchange rate system governments maintaino 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

D1

S1

P

D2

S2

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

D1

S1

P

D2

S2

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

oalso known as flexible exchange ratesoequilibrium exchange rate determined by demand for and supply of home currencyochanges in exchange rate correct payments imbalance by changing the effective cost of imports and exportsowill 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

D1

S1

P

D2

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

D2

P

D1

S1

14

Expansionary Fiscal Policy with Floating Exchange Rates

domestic currencyo appreciation leads to decline in current accounto reduced impact of fiscal policy

o initial effect is move from AD0 to AD1

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 ADo policy is particularly effective in this case

o increase money supply decreases interest rates

o causes increase in ADo shift of investments

toward other nationso decreased demand for

domestic currencyo resulting depreciation

16

Summary of Effectiveness Monetary Fiscal

Policy Policy

Strengthened Weakened

Weakened Strengthened

FloatingExchange Rate

FixedExchange Rate

17

Policy Conflict-Zonerecession & current account deficito under floating exchange rate system

expansionary monetary policy causes increase in GDP as well as depreciation improving current account deficit

inflation & current account deficito 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 requires1) current account equilibrium2) full employment3) price stability

o 1971 example of inflation with unemploymento 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 capitalo 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 deficitJapan – expansionary monetary policyGermany – tax reductions

21

Examples of Policy Coordination (cont.)o 1985-88: dollar decreased 54%o decline in dollar’s value led to concern of more

drastic decrease in valueo Louvre Accord 1987

U.S. – adopt restrictive fiscal policyJapan – 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