Carbaugh, Chap. 17*Open economy macro policyPolicy in an open economyCountries which are open to the world economy cannot make domestic economic policy choices without considering the impact on trade and payments and their international relationshipsNor can open economies entirely insulate themselves from other countries policy choicesAs a result, nations make efforts to coordinate their international economic policiesEconomic policies are also subject to domestic and foreign institutional constraints

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyEconomic objectivesInternal balanceFully employed economyLittle or no inflationExternal balanceCurrent 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

Carbaugh, Chap. 17*Open economy macro policyPolicy instrumentsExpenditure-changing policies: alter aggregate demand for goodsfiscal policyMonetary policyExpenditure-switching policies: shift demand to/from imports or domestic goodsDevaluation or revaluation (fixed rates)Exchange market intervention (managed float)Direct controlsTariffs, quotas, subsidies, capital controls

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Economic objectives and macro policyOpen economy macro policy

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyExchange rate policies & overall balanceIf a nation was experiencing recession and a BOP deficit, a currency devaluation would encourage exports and help boost domestic productionIf it were experiencing inflation and a BOP surplus, a revaluation would cut back on exports and cool domestic spending

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyExchange rate & overall balance (contd)Such policy moves are not made in a vacuum; one countrys devaluation effectively means a revaluation for its main trading partnersIf done without international consultation, these policy shifts might invite retaliation (as occurred during the Great Depression)

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyFiscal & monetary policy: internal effectsFiscal and monetary policy are generally used to achieve internal balance, but their effectiveness depends on the external sectorUnder a fixed exchange rate system, fiscal policy is more successful in promoting internal balance than is monetary policyUnder a floating rate system, monetary policy is more effective than fiscal policy at achieving internal balance

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyFiscal policy: short run internal effectsIncrease in government spendingAggregate demand risesMonetary demand and interest rates increaseNet capital inflowsCentral bank sells currency and money supply risesOutput and employment riseOutput and employment rise furtherUnder fixed exchange ratesAssumes high degree of capital mobilityFor contractionary fiscal policy, reverse all changes

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyFiscal policy: short run internal effectsIncrease in government spendingAggregate demand risesMonetary demand and interest rates increaseNet capital inflowsCurrency appreciationDecrease in aggregate demand, output, employmentUnder floating exchange ratesAssumes high degree of capital mobilityFor contractionary fiscal policy, reverse all changesOutput and employment riseImports rise and trade account worsens

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyMonetary policy: short run internal effectsMoney supply increasesAggregate demand risesNet capital outflowsCurrency depreciatesExports rise and trade account improvesOutput and employment riseOutput and employment rise furtherUnder floating exchange ratesAssumes high degree of capital mobilityFor contractionary monetary policy, reverse all changesInterest rate falls

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyMonetary policy: short run internal effectsMoney supply increasesAggregate demand risesNet capital outflowsCentral bank purchases currencyMoney supply decreasesOutput and employment riseOutput and employment fallUnder fixed exchange ratesAssumes high degree of capital mobilityFor contractionary monetary policy, reverse all changesInterest rate falls

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyFiscal & monetary policy: external effectsSince floating rates foster BOP equilibrium, focus is on fixed ratesIn short run, monetary policy has a clear effect on BOPExpansion worsens BOP balanceContraction improves BOP balanceShort run effects of fiscal policy are not certain - they depend on capital mobility

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyMonetary policy: short run external effectsInterest rates fallAggregate demand risesNet capital outflowsCapital account worsensOverall BOP worsensAssumes high degree of capital mobilityFor contractionary fiscal policy, reverse all changesTrade account worsensMoney supply increases

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyFiscal policy: short run external effectsAggregate demand risesMoney demand risesNet capital inflowsOverall BOP may improveFor contractionary fiscal policy, reverse all changesTrade account worsensIncrease in government spendingInterest rates rise

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyPolicy agreement and policy conflictMonetary policyIf 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 balancesBut 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 otherFiscal policy - effects are unclear under those circumstances

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyPolicy agreement and conflict (contd)In such cases where policy aims do conflict, some combination of fiscal and monetary policy measures will be necessarySome 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

Carbaugh, Chap. 17*Open economy macro policyInternational policy coordinationDomestic economic policy moves can spill over to affect other countriesMajor industrial nations have worked to coordinate economic policy so that external balances are maintained without sacrificing domestic objectives

Carbaugh, Chap. 17

Carbaugh, Chap. 17*Open economy macro policyInternational policy coordinationAnnual Group of Seven (G-7) economic summitsRegular meetings of central bank heads at the Bank for International SettlementsMajor international policy agreements, such as the Smithsonian Agreement (1971); Bonn Summit (1978); Plaza Accord (1985); Louvre Accord (1987)

Carbaugh, Chap. 17