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Global Economics Eco 6367 Dr. Vera Adamchik

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Title: Global Economics Eco 6367 Dr. Vera Adamchik


1
Global EconomicsEco 6367Dr. Vera Adamchik
  • Macroeconomic Policy in an Open Economy

2
Economic Objectives
  • internal balance
  • fully employed economy
  • no inflation or reasonable amount of inflation
  • external balance neither a deficit nor a
    surplus in current account
  • overall balance both internal and external
    balance
  • other goals long-run economic growth and
    equitable income distribution

3
Policy Instruments
  • 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
  • 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
  • to increase output and reduce unemployment
    central bank increases money supply decreasing
    interest rates
  • leads to increased AD
  • more AD leads to increased GDP
  • fiscal policy alternatives would be to increase
    government spending or decrease taxes

5
Exchange Rate Systems
1) fixed rate a) also known as pegged exchange
rate b) anchored to the value of one
other currency or a group of currencies
2) floating rate a) determined by market
forces b) float independently or with a
group of other currencies
6
Fixed Exchange Rates
  • Under a fixed exchange rate system governments
    maintain
  • par value for their currencies
  • an official exchange rate determined by
    comparing par values
  • 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.
P
1.50
Q
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.
P
1.50
Q
9
Expansionary Fiscal Policy with Fixed Exchange
Rates
  • secondary effect is an increased budget deficit
    which increases interest rates
  • attracts more foreign investment
  • increases demand for domestic currency
  • fixed exchange rates require government purchase
    foreign currency
  • increases money supply further increasing AD

10
Expansionary Monetary Policy with Fixed Exchange
Rates
  • to increase AD interest rates are decreased
  • discourages foreign investment
  • decreases demand for dollars
  • fixed exchange rate system requires
  • government use foreign currency reserves to
    purchase domestic currency
  • decrease in money supply reduces AD

11
Floating Exchange Rates
  • also known as flexible exchange rates
  • equilibrium exchange rate determined by demand
    for and supply of home currency
  • changes in exchange rate correct payments
    imbalance by changing the effective cost of
    imports and exports
  • will 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.
P
1.50
Q
13
Appreciation
Market for Euros
Demand for the euro decreases. The value of the
euro would fall and the value of the dollar
would rise.
P
1.50
D1
D2
Q
14
Expansionary Fiscal Policy with Floating Exchange
Rates
  • initial effect is move from AD0 to AD1
  • greater deficit leads to increased interest rates
  • causes inflow of foreign investment
  • increased demand for
  • domestic currency
  • appreciation leads to decline in current account
  • reduced impact of fiscal policy

15
Expansionary Monetary Policy with Floating
Exchange Rates
  • increase money supply decreases interest rates
  • causes increase in AD
  • shift of investments toward other nations
  • decreased demand for domestic currency
  • resulting depreciation
  • leads to further increase in AD
  • policy is particularly effective in this case

16
Summary of Effectiveness
Monetary Fiscal Policy
Policy Strengthened Weakened
Weakened Strengthened
Floating Exchange Rate
Fixed Exchange Rate
17
Policy Conflict-Zone
  • recession current account deficit
  • under floating exchange rate system expansionary
    monetary policy causes increase in GDP as well as
    depreciation improving current account deficit
  • inflation current account deficit
  • under floating exchange rate contractionary
    monetary policy limits inflation but leads to
    appreciation increasing current account deficit
  • policy zone conflict monetary policy cannot
    restore both internal and external balance

18
Inflation with Unemployment
  • more problematic because internal balance cannot
    be achieved by managing AD
  • overall balance requires
  • current account equilibrium
  • full employment
  • price stability
  • 1971 example of inflation with unemployment
  • resulting actions expansionary policy with wage
    price controls along with devaluation of the
    dollar

19
International Policy Coordination
  • mobility of goods, services, labor and capital
  • economic policies of one nation will have impact
    on economies of other nations
  • coordination attempt to modify monetary, fiscal
    and exchange rate policies recognizing
    international repercussions

20
Examples of Policy Coordination
  • 1984 U.S. expansionary fiscal policy used to
    address recession
  • caused appreciation of dollar and current account
    deficit
  • Plaza Agreement of 1985
  • G-5 U.S., Japan, Germany, Great Britain, and
    France
  • pledges
  • U.S. reduce federal deficit
  • Japan expansionary monetary policy
  • Germany tax reductions

21
Examples of Policy Coordination (cont.)
  • 1985-88 dollar decreased 54
  • decline in dollars value led to concern of more
    drastic decrease in value
  • Louvre Accord 1987
  • U.S. adopt restrictive fiscal policy
  • Japan ease monetary policy
  • U.S. current account deficit began to decline and
    reached balance by 1991
  • coordination efforts may not be successful due to
    central banks independence and growth of global
    financial markets
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