Chapter 25: Economic Policy in the Open Economy

1
Chapter 25 Economic Policy in the Open Economy

• Fixed exchange rates

2
Opening blurb

• The hot currency topic today, as it has been for
  several years, is the renminbi (aka yuan)
• there has been great debate concerning whether
  the yuan is undervalued, how much and what is the
  best policy to deal with it.
• There is also great debate about whether a
  floating yuan would be better for the world, or
  whether it would destabilize world markets.
• Is there one answer to these questions? No. But,

3
Opening blurb

• Is there one answer to what is the right policy
  at this point in time? No.
• But, in this chapter and the next, we will learn
  about how countries can effectuate monetary and
  fiscal policy under fixed and floating exchange
  rates.
• This will provide a conceptual framework for
  thinking about these issues.

4
Targets instruments

• In most cases, if policy-makers wish to achieve
  two targets, they need two instruments to do so.
• In the last chapter, we mentioned the use of
  expansionary and contractionary policy to achieve
  internal and external balance.
• We noted that if the imbalances required contrary
  policy direction then we might not be able to
  easily achieve both targets (balances)

5
Robert Mundell (nobel 1999)

• The most influential contributor to modelling
  policy in the open economy is Robert Mundell.
• born in Kingston, Ontario, Mundell argued that
  under the Bretton-Woods system, the Federal
  Reserve maintained stability, not the existence
  of a fixed currency
• analyzed policy in a small, open economy
• he also argued that progressive taxes could not
  be maintained under flexible exchange rates.
• father of supply-side economics and the monetary
  approach to the Balance of Payments

6
Mundell-Fleming Model

• Robert Mundell developed a model where monetary
  and fiscal policy could be combined to reach both
  an internal and external balance.
• The trick is to aim one policy at one target and
  another at a second.
• Note Mundell defined External balance as
  overall balance, the model is not designed to
  achieve current account balance.

7
Mundell-Fleming Model

• In this model, both monetary and fiscal policy
  affect both the internal and external balances
• interest rates affect the external balance much
  more than the internal balance.
• Therefore, monetary policy should be directed at
  the external balance
• Fiscal policy also affects the internal balance
  more than the external balance
• therefore fiscal policy should be aimed at the
  internal balance

8
Mundell-Fleming Model

• In the diagrammatic presentation of the model,
  interest rates summarize monetary policy.
• The relationship between interest rates and
  fiscal policy (G T ) that will maintain a
  balance is positive

9
Mundell-Fleming Model

• Starting at internal balance
• If (G T) rises, this causes excess demand,
  therefore, a contractionary monetary policy (rise
  in interest rate) is needed to return to balance.
• therefore, the Internal Balance curve is upward
  sloping
• Starting at external balance
• If (G T) rises, this causes imports to rise,
  and a deficit, therefore an increase in interest
  rates is needed to attract foreign funds
• therefore the External Balance curve is also
  upward sloping

10
Mundell-Fleming Model

• As noted above, the external market responds
  quickly and greatly to a change in interest rates
• therefore a small increase in interest rates
  would require a large increase in net government
  spending (G T) to restore the external balance.
• Or, from another point of view, a high increase
  in (G T) requires only a small upward
  adjustment in interest rates to restore external
  balance.

11
Mundell-Fleming Model

• In the next slide, we have the Mundell-Fleming
  diagram.
• The IB curve is steeper than the EB curve for
  reasons noted above.
• To the left (above) IB, fiscal policy and
  monetary policy are too restrictive for internal
  balance to the right of IB, they are both too
  expansionary for internal Balance
• To the left (above) EB, fiscal and monetary
  policy are too restrictive for external balance.

12
Mundell-Fleming diagram
IB
II
i
I
EB

• a

• d

i
III

• c

• b

IV
G - T
G - T
13
Internal and external imbalances

• Once again, we have four cases for imbalances
  (they are numbered differently than in the last
  chapter)
• I (unacceptably) high unemployment balance of
  payments surplus
• II rapid inflation balance of payments surplus
• III rapid inflation balance of payments deficit
• IV high unemployment balance of payments deficit

14
Internal and external imbalances

• In this case, however, we also have clear policy
  prescriptions
• I (unacceptably) high unemployment balance of
  payments surplus
• expansionary fiscal policy accompanied by
  expansionary monetary policy
• II unacceptably rapid inflation balance of
  payments surplus
• contractionary fiscal policy accompanied by
  expansionary monetary policy.

15
Internal and external imbalances

• III unacceptably rapid inflation balance of
  payments deficit
• contractionary fiscal policy contractionary
  monetary policy
• IV unacceptably high unemployment balance of
  payments deficit
• expansionary fiscal policy contractionary
  monetary policy

16
Building a macroeconomic model for the open
economy

• General equilibrium in the open economy
• The IS/LM/BP model

17
First, review the construction of IS/LM ---
starting with LM curve

• Recall from Chapter 22
• Equilibrium in the money market is defined by
• Money Supply
• Ms a(DRIR) a(BR C)
• Money supply can be defined using domestic
  reserves plus international reserves (both held
  by central bank)
• or bank reserves plus currency held by non-bank
  public

18
LM curve

• Recall from Chapter 22
• Money Demand
• Md L f(Y, i , P, W, E(p), O)
• Money demand depends on income (), interest rate
  (-), price level (), wealth (), expected
  inflation (-) and other factors (?)

19
LM curve

• We begin by drawing the money market, with the
  interest rate as the price of money.
• Assuming the money supply is set by the central
  bank, Ms is vertical
• Demand for money is a decreasing function of the
  interest rate.
• All else equal, if the interest rate is too high,
  there is an excess supply of money (demand A,
  supply B)
• if the interest rate is too low, there is an
  excess demand for money (demand A, supply
  B)

20
Money supply and demand Building the LM curve
Ms
i
.
.
A
B
i1
.
q
ie
.
.
A
i2
Lf(i)
B
Money
21
LM curve

• To construct an LM curve, however, we need to
  examine how the demand for money changes with
  income Y , as well as interest rates.
• Because income is not on the axes of this graph,
  a change in income will shift the relevant curve
• If income increases, demand for money rises.
• The demand curve shifts up, or right.

22
Money supply and demand Building the LM curve
Ms
i
.
i1
.
i0
.
Lf(Y1,i)
i2
Lf(Y0,i)
Lf(Y2,i)
Money
23
LM curve

• Transferring this graph to i-Y space interest
  rate and income
• we see that there is a positive relationship
  between the interest rate and the exchange rate.
• We also see that, the stronger the demand
  reaction to a change in income, the steeper the
  LM curve.
• In other words, if an increase in income leads to
  a big jump in the demand for money, then, given
  fixed supply, a big increase in the price of
  money (interest rate) is needed to return to
  equilibrium.

24
LM curve

• Finally,
• to the right of the LM curve, there is excess
  demand for money (income is too high for the
  prevailing interest rate)
• to the left of the LM curve, there is an excess
  supply of money (income is too low the for
  prevailing interest rate)

25
LM curve
Ms
i
LM
i
i1
i1
i0
Lf(Y1,i)
i0
Lf(Y0,i)
i2
i2
Lf(Y2,i)
Money
Y
Y1
Y0
Y2
26
You do

• Start with an LM curve (just draw one)
• Now show a new curve for each of the following
  cases
• money supply increases
• the response of liquidity demand for money based
  on income increases

27
Next class

• IS curve
• BP curve
• Putting it all together.

28
IS curve

• this curve represents the
• Injections Leakages
• Recall, injections leakages is simply a
  rearranging of the income expenditure
  equations.
• but, the IS curve it is named for
• Investment Savings
• because they are the major components, (and
  because we assume, even in the simplest model,
  that investment is affected by the interest rate)

29
IS curve

• Review Injections leakages
• I X G S M T
• Saving and imports depend on income, so
• I X G S(Y) M(Y) T

IGX SMT
SMT
IGX
0
Y
Y0
30
IS curve

• The IS curve is built by varying the rate of
  interest and examining the effect of this on the
  equilibrium income.
• As interest rates fall, investment increases, the
  IGX curve shifts up.
• investment and interest rates move in opposite
  directions from each other.
• As interest rates increase, investment falls.
  The IGX curve shifts down.
• The level of equilibrium income is higher when
  interest rates are lower.

31
IS curve

• Assume i1 lt i0 and i2 gt i0
• Result Y1 gt Y0 and Y2 lt Y0

IGX SMT
SMT
I(i1) GX
I(i0) GX
I(i2) GX
0
Y
Y0
Y2
Y1
32
IS curve

• We can now move the injections leakages curve
  to (Y, i ) space.
• This yields the traditional IS curve.
• Each rate of interest and income level along the
  IS curve represents an equilibrium in the real
  market.
• That is income expenditure along the IS curve.

33
IS curve

• Assume i1 lt i0 and i2 gt i0

i
IGX SMT
SMT
i2
I(i1) GX
i0
I(i0) GX
I(i2) GX
i1
IS
0
Y
Y0
Y2
Y1
Y
Y1
Y0
Y2
34
IS curve

• Notice how the shape of the IS curve is affected
  by the slope of S(Y) TM(Y)
• if savings and/ or imports are more responsive to
  income, the IS curve is steeper.
• Notice also how the shape of the IS curve depends
  on the size of the shift in IGX when interest
  rate changes.
• if Investment is very responsive to a change in
  the interest rate, IS is flatter.

35
IS curve

• To the right of the IS curve, the interest rate
  is too high for the level of income
• Therefore, S(Y)TM(Y) gt I(i) GX
• The level of income is generating too much
  savings for the injections into the economy. The
  interest rate will fall because of the excess
  savings and return the economy to equilibrium.
• If the interest rate does not rise, then income
  will fall as the leakages lower income to
  equilibrium

36
IS curve

• From the other perspective to the right of the
  IS curve, the income level is too high for the
  level of interest
• Therefore, S(Y)TM(Y) gt I(i)GX
• The level of income is generating too much
  savings for the injections into the economy. The
  interest rate will fall because of the excess
  savings and return the economy to equilibrium.
• If the interest rate does not fall, then income
  will fall as the leakages lower income to
  equilibrium
• Or both these will cause a return to equilibrium

37
IS Curve You do

• Draw an IS curve, label it IS0
• Draw a second IS curve, assuming autonomous
  savings are higher than the level in the first IS
  curve. label it IS1
• Draw a third IS curve, assuming that the marginal
  propensity to import is higher than it is in your
  first IS curve. label it IS2
• Draw an IS curve,assuming that investment is less
  responsive to a change in interest rates than the
  case in IS0 , label it IS3

38
IS-LM Closed economy equilibrium

• The equilibrium in the IS-LM diagram represents
  the simultaneous determination of income and
  interest rate when the monetary sector and real
  sector of the economy are in equilibrium.
• If the economy is not in equilibrium, market
  forces push it toward equilibrium.

39
IS-LM Closed economy equilibrium
i
LM
A
G
ie
IS
Ye
Y

• At point A, the interest rate is too high for
  both markets.
• Lower investment pushes i down while reducing Y
• The demand for money is too low for monetary
  equilibrium, the excess supply of money also
  lowers interest rates.

40
Equilibrium in the Balance of Payments the BP
curve

• The BP curve represents the combinations of
  income and interest rates that yield equilibrium
  in the Balance of Payments.
• By equilibrium, we mean both current account plus
  capital account (or overall balance)
• For this chapter, the BP curve is drawn for a
  fixed exchange rate

41
BP curve

• The shape of the BP curve will depend on how the
  balance of payments are affected by income and
  interest rates.
• Income affects imports
• as income increases, so do imports.
• as imports increase, the Balance of Payments
  deteriorates
• to offset the effect of imports, an increase in
  the interest rate is needed. It will cause
  capital flows to enter the country, and return
  the country to BoP equilibrium

42
BP curve

• The shape of the BP curve will depend on how the
  balance of payments are affected by income and
  interest rates.
• We can see from the above, that the
  responsiveness of capital flows will affect the
  slope of the BP curve.
• If capital is perfectly mobile,
• a small increase in the interest rate causes an
  infinite increase in capital inflows,
• the BP curve is horizontal

43
BP curve

• If capital is perfectly immobile,
• no capital is allowed to flow into or out of the
  country.
• then an increase in the interest rate will have
  no effect on capital flows and the BoP,
• the BP curve is vertical
• In between these two extremes, capital is
  imperfectly mobile
• an increase in the interest rate causes an inflow
  of capital
• the BP curve is upward sloping.

44
BP curve
i
i
i
BP
BP
BP
0
Y
0
Y
Y
0
perfectly immobile capital
perfectly mobile capital
imperfectly mobile capital
45
Putting it all together Fixed Exchange rates

• Equilibrium in the open economy occurs when all
  three markets are in equilibrium.
• We need
• money market equilibrium
• real economy equilibrium (income expenditure)
• balance of payments equilibrium

46
Putting it all together Fixed Exchange rates

• To analyze movement to equilibrium, we will
  examine how the markets react to a shock
• A shock is an exogenous change in some variable
  in the economy
• it is usually represented by a shift in the
  curves
• it may sometimes represent a change in slope
• We will then examine the effects of
• fiscal policy
• monetary policy

47
First shock

• There is an increase in exogenous exports.
• Effects
• there is more foreign exchange flowing into the
  country.
• At the old equilibrium, there is a BoP surplus.
• The BoP curve shifts right.
• each interest rate can support a higher income
  (and import) level. for BoP equilibrium

48
First shock Increase in exports

• Effects
• The BoP curve shifts right.
• each interest rate can support a higher income
  (and import) level. for BoP equilibrium
• The IS curve shifts right
• Injections have increased, therefore at every
  interest rate, a higher level of income (and
  leakages) can occur for real economy equilibrium.
• NOTE these two shifts are directly caused by the
  increase in exports.

49
First shock Increase in exports

• Effects
• The BoP curve shifts right.
• The IS curve shifts right
• The LM curve will also shift right
• Under fixed exchange rates, the BoP surplus
  causes an increase in the money supply.
• the money supply will only be in balance when the
  BoP is in balance.
• The LM curve shifts to accommodate the BoP
  imbalance.

50
Important to remember

• Under fixed exchange rates
• The IS curve and / or the BP curve may shift due
  to an initial shock or policy change
• The LM curve ALWAYS shifts to return the economy
  to equilibrium at the new intersection of the IS
  and BP curve.
• This is because an imbalance in the balance of
  payments affect the Money Supply

51
You do Autonomous increase in Savings.

• Effects
• IS curve shifts . Why?
• BP curve shifts Why?
• LM curve shifts Why?

52
Fiscal policy

• The government increases spending
• This shock is analogous to the increase in
  exports for the IS curve,
• But it causes no independent shift in the BP
  curve.
• So, what happens?

53
Fiscal policy

• Fiscal policy is the use of spending and taxes to
  affect the economy.
• Example
• The government increases spending, hoping to
  increase income.
• This affects the real internal economy directly.
• Therefore, the only curve to shift as a direct
  result of the policy is the IS curve.
• The BP curve does not shift.
• The LM curve will shift to adjust the economy
  back to equilibrium (under fixed exchange rates)

54
Fiscal policy

• Whether or not fiscal policy affects the level of
  income in the economy depends on the degree of
  capital mobility.
• The effect on the interest rate will also depend
  on the degree of capital mobility

55
Fiscal policy

• We can consider 4 cases
• capital is completely immobile internationally
  (BP curve vertical)
• capital is very immobile internationally (BP
  curve is steeper than LM curve)
• capital is fairly mobile internationally (such
  that international capital reacts more to a
  change in exchange rates than internal money
  demand) (BP curve is flatter than LM curve)
• capital is perfectly mobile (BP curve is flat)

56
Fiscal policy

• Cases 1. and 2.
• In cases where capital is immobile, either
  completely or partly,
• the increase in spending causes imports to rise
  (recall M M(Y) )
• this causes a BoP deficit
• which results in a decrease in the money supply.
• The LM curve shifts left, and the interest rate
  rises further.
• This chokes off some or all of the increase in
  income that would result from fiscal expansion.

57
Fiscal policy

• Cases 3. and 4.
• In cases where capital is mobile, completely or
  partly,
• the increase in spending causes imports to rise
  (recall M M(Y) )
• this causes an increase in the interest rate
• which causes an inflow of capital
• which leads to a balance of payments surplus
• which results in an increase in the money supply.
• The LM curve shifts right and the interest rate
  falls.
• This increases income more than the closed
  economy case.

58
Fiscal policy graphical analysis
BP
BP
LM
LM
i
i
LM
LM
IS
IS
IS
IS
Y
Y
LM
LM
i
LM
i
LM
BP
BP
IS
IS
IS
IS
Y
Y
59
Fiscal policy

• In the case of fixed exchange rates
• fiscal policy is most effective at increasing
  income when capital is perfectly mobile.
• in this case there is no effect on interest rates
• the BoP deficit caused by imports is completely
  offset by capital flows
• fiscal policy is least effective at increasing
  income when capital is perfectly immobile
• the BoP deficit caused by imports causes a
  decrease in money supply, completely choking off
  any income effect.

60
Fiscal policy

• You do
• The government increases autonomous taxes
• What is the effect if capital is relatively
  immobile (inelastic compared to money demand)?
• What is the effect if capital is perfectly
  mobile?

61
Monetary policy under fixed exchange rates

• Given the analysis of shocks and fiscal policy,
  we can predict the effectiveness of monetary
  policy under fixed exchange rates
• NONE.
• The money supply is determined by the Balance of
  Payments.
• if there is a surplus, money supply increases
• if there is a deficit, money supply falls
• Money supply change will change neither the
  interest rate nor income.

62
Monetary policy graphical analysis
BP
BP
LM
i
i
LM
LM
LM
IS
IS
Y
Y
LM
LM
i
LM
i
LM
BP
BP
IS
IS
Y
Y
63
Effect of a change in the official exchange rate

• A change in the official exchange rate will have
  a real effect in all four cases.
• Example devaluation
• imports decrease
• exports increase
• there is a BoP surplus, BoP curve shifts right
• there is also an increase in injections into the
  economy and a decrease in leakages, IS curve
  shifts right
• LM curve shifts to accomodate

64
Effect of a change in the official exchange rate

• Case 1 and 2 completely immobile or relatively
  immobile capital
• IS and BP curves shift right
• there is a BoP surplus
• there are little or no capital inflows, and so
  the surplus causes an increase in money supply
• the LM curve shifts right

65
Effect of a change in the official exchange rate

• Case 3 and 4 mobile or completely mobile capital
• IS and BP curves shift right
• there is a BoP surplus
• at the point of internal equilibrium (new IS, old
  LM curve) the interest rate is also too high for
  external balance.
• both capital flows and expenditure switching
  contribute to the surplus, causing an increase in
  money supply
• the LM curve shifts right

66
Devaluation graphical analysis
BP
BP
BP
BP
LM
LM
i
i
LM
LM
i2
IS
IS
IS
IS
Y
Y2
Y0
Y2
Y
Y0
LM
LM
i
LM
i
LM
BP
BP
BP
IS
IS
IS
IS
Y2
Y
Y
Y0
Y0
Y2
67
You do

• Revaluation of currency (increase in value)
• if capital is completely immobile
• if capital is very, but not completely mobile.

68
In sum

• We first learned that, with a foreign sector,
  internal equilibrium is not a guarantee of
  external equilibrium
• We then introduced a model where the three
  markets were in equilibrium.
• In this model, monetary policy is completely
  ineffective within the country
• that is, the external sector balance is
  maintained by adjustments to the money supply
  caused by inflows and outflows of reserves

69
In sum

• On the other hand, fiscal policy has varying
  levels of effectiveness depending on the mobility
  of capital
• the higher the mobility of capital, the more
  effective is fiscal policy
• Shocks to the real economy or the external
  economy cause changes in income, the money market
  adjusts to those shocks
• Shocks to the money market are offset by the
  reactions of the external markets. The LM curve
  always adjusts to accomodate the IS-BP
  equilibrium under fixed exchange rates.