Macroeconomic Policies

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International Economics
Chapter 9

• Macroeconomic Policies
• in Open Economy

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Chapter 9 Macroeconomic Policies in Open Economy

• 9.1 Internal Balance and External Balance
• 9.2 Policy Mix to Achieve Internal Balance and
  External Balance
• 9.3 Effects of Macroeconomic Policies under Fixed
  Exchange Rates
• 9.4 Effects of Macroeconomic Policies under
  Floating Exchange Rates

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9.1 Internal Balance and External Balance

• Internal Balance and External Balance
• Internal balance means (1) full employment, (2)
  no inflation, or more realistically, low
  inflation, and (3) steady economic growth.
• External balance is the achievement of neither BP
  deficits nor BP surpluses.

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9.1 Internal Balance and External Balance
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9.1 Internal Balance and External Balance

• Policy Instruments
• Expenditure-changing policies include fiscal
  policy and monetary policy, altering the level of
  aggregate demand for goods and services which are
  either produced domestically or imported.
• Expenditure-switching policies refer to
  exchange-rate policies, including appreciation or
  depreciation of a currency, which shifts the
  direction of demand between domestic output and
  imports.

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9.1 Internal Balance and External Balance

• When an economy is located in the disequilibrium
  zones of Quadrant I and III in Figure 9-1,
  expenditure-switching policies can restore the
  economy to overall balance.
• In Quadrant I An appreciation of its currency
  decreases the international competitiveness of
  its goods and leads to a fall in export, which,
  on the one hand, decreases its BP surplus, and on
  the other hand, reduces its aggregate demand and
  thus output, lessening its inflation.
• In Quadrant III A depreciation can restore the
  overall balance.

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9.1 Internal Balance and External Balance

• Tinbergen Rule
• One economic goal could be attained by at least
  one effective policy tool. Thus, to achieve n
  independent goals, we need no less than n
  effective policy tools.

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9.1 Internal Balance and External Balance

• Meade Conflict
• Under fixed exchange rate system, a country
  cannot change its exchange rate and thus it loses
  expenditure switching policy tools. In this
  condition, the goals of internal balance and
  external balance may become conflicting since the
  government now can only resort to expenditure
  changing policies.

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9.1 Internal Balance and External Balance

• In Quadrant I, the economy will meet the conflict
  between internal balance and external balance.
• A contractionary expenditure changing policy will
  reduce output and income, decreasing the
  inflation and restoring internal balance. But
  reduced national income then weakens imports,
  enlarging its BP surplus and worsening its
  external imbalance.
• If the government uses an expansionary
  expenditure-changing policy, the external balance
  can be achieved but the internal economy will be
  imbalanced with more severe inflation.
• In Quadrant III, the economy will also meet the
  conflict between internal balance and external
  balance.

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9.1 Internal Balance and External Balance

• In a fixed exchange rate system where
  expenditure-switching policies cannot be
  fulfilled, we need two independent policy tools
  to achieve both internal balance and external
  balance and thus solve Meade Conflict.

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Chapter 9 Macroeconomic Policies in Open Economy

• 9.1 Internal Balance and External Balance
• 9.2 Policy Mix to Achieve Internal Balance and
  External Balance
• 9.3 Effects of Macroeconomic Policies under Fixed
  Exchange Rates
• 9.4 Effects of Macroeconomic Policies under
  Floating Exchange Rates

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• Mundell Assignment Rule
• Fiscal policy and monetary policy have different
  effects on internal economy and external economy.
  So even under fixed exchange rate system, it is
  likely to utilize fiscal policy and monetary
  policy to achieve both internal and external
  balance.
• Fiscal policy and monetary policy may affect
  national income and the current account to the
  same extent. But they have different influence on
  the interest rate and the capital and financial
  account.
• Contractionary fiscal policy can reduce the
  interest rate, causing capital outflows and
  worsening the capital and financial account.
• Contractionary monetary policy will increase the
  interest rate, causing capital inflows and
  improving the capital and financial account.

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• IB slopes downward (T-G)?gt Y?, requiring r?
  gtI?.
• Right to IB Unemployment Left to IB
  Inflation.
• EB slopes downward (T-G)?gt Y? gtM?, requiring
  r? gtcapital outflow.
• Above EB BP surplus Below IB BP deficit.

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• Point A BP deficit with unemployment.
• Ms?gt (1) r? gt capital inflow gt KA? (2) Y?gt
  M?gt CA? gtB EB unemployment.
• G? gt Y? gt C IB BP deficit.
• Finally, Ms? G? gt E IB EB

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• Conclusion
• Fiscal policy should be assigned to solve
  internal imbalance while monetary policy should
  be assigned to solve external imbalance.
• If policies are wrongly assigned, the economy
  will diverge from the overall balance.

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• Swan Model
• Mundell Assignment Rule solves Meade Conflict
  under fixed exchange rate system by assigning
  fiscal policy and monetary policy effectively.
• Swan Model aims to achieve both internal balance
  and external balance by combining
  expenditure-changing policies and
  expenditure-switching policies when the exchange
  rate can be changed.

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• IB slopes downward eP/P?gtNX?, requiring
  A?gtY?.
• Right to IB inflation Left to IB unemployment.
  
• EB slopes upward eP/P?gt NX?, requiring A?gtM?.
• Above EB BP surplus Below EB BP deficit.

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9.2 Policy Mix to Achieve Internal Balance and
External Balance

• Point A BP deficit with unemployment.
• Expansionary expenditure-changing policy to deal
  with the internal unemployment
• Depreciation of domestic currency to restore its
  balance of payments.

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Chapter 9 Macroeconomic Policies in Open Economy

• 9.1 Internal Balance and External Balance
• 9.2 Policy Mix to Achieve Internal Balance and
  External Balance
• 9.3 Effects of Macroeconomic Policies under Fixed
  Exchange Rates
• 9.4 Effects of Macroeconomic Policies under
  Floating Exchange Rates

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9.3 Effects of Macroeconomic Policies under Fixed
Exchange Rates

• IS-LM-BP Model
• IS curve slopes downward.
• G?gt IS shifts rightward G?gt IS shifts
  leftward.
• LM curve slopes upward.
• Ms?gt LM shifts rightward Ms?gt LM shifts
  leftward.

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9.3 Effects of Macroeconomic Policies under Fixed
Exchange Rates

• Right to BP BP deficit Left to BP BP surplus.
• (a) Perfect capital immobility
• (b) Imperfect capital mobility
• (c) Perfect capital mobility.

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9.3 Effects of Macroeconomic Policies under Fixed
Exchange Rates

• Effects of Fiscal Policy under Fixed Exchange
  Rate
• Fiscal policy has no effect on economy under
  fixed exchange rate when capital is perfectly
  immobile, only to find a higher interest rate.
• Fiscal policy has some effect on economy under
  fixed exchange rate when capital is imperfectly
  mobile. But the extent of effect relies on the
  sensibility of capital flow to changes of the
  interest rate. The more sensible the capital flow
  is, the larger the effect of fiscal policy is.
• Fiscal policy has perfect effect on economy under
  fixed exchange rate when capital is perfectly
  mobile.

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A. Case of Perfect Capital Immobility
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B. Case of Imperfect Capital Immobility
(BPgtLM)
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B. Case of Imperfect Capital Immobility (BPLM)
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B. Case of Imperfect Capital Immobility (BPltLM)
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C. Case of Perfect Capital Mobility
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9.3 Effects of Macroeconomic Policies under Fixed
Exchange Rates

• Effects of Monetary Policy under Fixed Exchange
  Rate
• Monetary policy has no effect on economy under
  fixed exchange rate regardless of the extent of
  capital mobility.

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A. Case of Perfect Capital Immobility
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B. Case of Imperfect Capital Immobility
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C. Case of Perfect Capital Mobility
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Chapter 9 Macroeconomic Policies in Open Economy

• 9.1 Internal Balance and External Balance
• 9.2 Policy Mix to Achieve Internal Balance and
  External Balance
• 9.3 Effects of Macroeconomic Policies under Fixed
  Exchange Rates
• 9.4 Effects of Macroeconomic Policies under
  Floating Exchange Rates

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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• Under floating exchange rate, changes of the
  exchange rate will cause shifts of BP curve.
• A depreciation of domestic currency leads to a
  rightward shift of BP curve.
• An appreciation leads to a leftward shift of BP
  curve.

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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• On BP curve, r0 and Y0 keeps the economy in
  external balance.
• A depreciation results in more export and less
  import, leading to a surplus of the balance of
  payments.
• To digest the surplus of the balance of payments,
  national income needs to grow in order to
  encourage more import.
• At any other interest rates, the same thing
  happens.

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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• Effects of Fiscal Policy under Floating Exchange
  Rate
• The effect of fiscal policy under floating
  exchange rate is inversely proportional to the
  extent of capital mobility. The less mobile
  capital is, the stronger effect fiscal policy
  has.

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A. Case of Perfect Capital Immobility
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B. Case of Imperfect Capital Immobility (BPgtLM)
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B. Case of Imperfect Capital Immobility (BPLM)
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B. Case of Imperfect Capital Immobility (BPltLM)
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C. Case of Perfect Capital Mobility
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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• Effects of Monetary Policy under Floating
  Exchange Rate
• Monetary policy has perfect effect on economy
  under floating exchange rate regardless of the
  extent of capital mobility.

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A. Case of Perfect Capital Immobility
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B. Case of Imperfect Capital Immobility
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C. Case of Perfect Capital Mobility
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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• A Summary of Mundell-Flemming Model

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9.4 Effects of Macroeconomic Policies under
Floating Exchange Rates

• Mundell Incompatible Trinity
• One country cannot have a fixed exchange rate,
  free capital movement and an independent monetary
  policy at the same time.