Macroeconomic Policy in an Open Economy

Macroeconomic Policy in an Open Economy How is macroeconomic international influences?

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policy

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Do domestic policy makers have any power over their own economy, or is it the world economy that matters? •

How do macro policy choices change with the exchange rate regime adopted?

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Should stabilization policy be conducted at the world level? •

Why does openness matter?  There are three main reasons why we have to take a much closer look at the interactions between the macro model and the rest of the t he world. 1. Net export exports s 2. Mobile capital capital between between countries-shares, countries-shares, bonds bonds 3. The exchange exchange rate regime-fixed exchange rate rate (domestic interest is fixed therefore the monetary authority has no role to play). 4. Under floating exchange rate every every thing can be adjusted. 5. How the presence presence of capital flows alters the impact of monetary and fiscal policies.

Net Exports  The Net Exports (NX) fall as GDP rises—because rises—becaus e induced imports rise while autonomous exports are constant. The net export function will shift if there is a change in export demand, and if  there is a change in the domestic price level relative to foreign prices (appreciation or depreciation).  The impact of monetary and fiscal policies are influenced by the degree of mobility of financial capital and by the exchange rate regime.

Mobile Capital When we discuss about the capital flows in the context of the BOP, we do not mean about imports and exports of capital goods, such as machine tools and heavy equipment. Rather, we would be discussing about trade in assets and liabilities, such as shares and bonds, or about lending by banks in one country to customers in another.

Capital flows mater for two reasons. First, net capital flows must be equal in magnitude(but with the opposite sign) to the current account balance. Second, why capital flows matter for the macro model is that they influence the domestic interest rate. If everyone is free f ree to borrow and lend both domestically and internationally, they will borrow where the interest rate is lowest and lend where it is highest. Mobile capital tends to drive the domestic interest rate towards the level of interest rates in world markets. With a pegged a pegged exchange rate the monetary authority have no choice in the interest rate they set. Under floating exchange rates they have more discretion, but world market forces also matter.

 The exchange rate regime Fixed exchange rates tie together the value of domestic and foreign money, which implies that the domestic price level cannot deviate from the foreign price level in the the long run. Like the EU member countries countries where the interest rate is fixed.

Under floating exchange rates, rates, much of the adjustment to shocks comes through exchange rate changes and the resulting effect on the relative prices of domestic and foreign goods. In contrast under fixed exchange rates, rates, much more adjustment to shocks is worked out via aggregate demand, money stock, and output changes at given relative prices.

 The macro model with capital flows

s e r e t nI

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with perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate in equilibrium. The BB line shows the combinations of interest rates and GDP for which a current account surplus (deficit) equals the associated capital outflow (inflow). The e line BB is drawn horizontally at the point where the local interest rate is t equal to the foreign rate i*. The shape of BB means that any size of current account a R deficit can be financed by borrowing at the going interest rate on world capital LM markets.

t

i=

BB

i

IS Real GDP

Policy changes with fixed exchange rates Now we can trace through the effects of monetary and fiscal policy changes in a model that allows for perfect capital mobility. Monetary Policy  with fixed exchange rates and perfect  In capital mobility  LM R t e a Monetary Policy is Policy is powerless to influence economic r t e e activity under fixed exchange rates and perfectst

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LM 1

capital mobility. An attempted cut in domestic interest B rates increases the money supply and shifts the LM i* B curve to the right from LM0 to LM1. However, the smallest fall in domestic interest rates causes a massive IS desired capital outflow. This puts downward pressure on the exchange rate. The monetary monetary authorities authorities are  Y* forced to buy local currency immediately immediately in order to Real GDP stop the exchange rate falling, falling, and LM curve shifts back

Fiscal Policy with fixed exchange rates and perfect  capital mobility  Starting from full equilibrium, an increase in government spending creates a significant stimulus to real activity in the short run, but in the long run it leads to a higher price level and a current account deficit. The increase in government spending shifts the IS curve from IS 0 to IS1 in part (i). With a given money supply, this puts upward pressure on domestic interest rates. The slightest rise in domestic interest rates causes a massive capital inflow, which puts upward   pressure on the exchange rate. To stop the exchange rate from rising the government starts sells dollar in the market , this increases money supply and the LM curve shifts to the right ( LM 0 to LM1). This causes the AD curve shift to the right from AD 0 to AD1. in part (ii). This increase in AD will raise the SRAS  price level and net will decrease in the long LRA run. LM exports LM S 1 0 2 LM SRAS 1 0 B P1 i* B AD1 P0 AD0 IS IS  Y*

 Y1

IS 0  Y2

2

1

 Y*

Policy changes with floating exchange rates Monetary policy with floating exchange rates and perfect capital mobility Starting at full equilibrium, a monetary loosening causes an output boom in the short run but in the long run causes only higher prices and currency depreciation. The LM curve shifts to the right. Any fall in the domestic interest rate causes the exchange rate to depreciate to a point from which it is expected to appreciate. This shifts exports, part (i) shows the shift of IS curve from IS0 to IS1. the combined shift of IS and LM causes the shift of AD from AD0 to AD1 in part (ii) and aLRAS rise in GDP. The increase in ADLM0 causes the inflation to rise and rise in input prices SRAS1 shifts the SRAS curve and GDP falls back to the original position. i*

LM1

P1

B B

P0

SRAS0

AD1 IS 0

 Y *

IS 1

AD0

 Y*

 Y1

Fiscal Policy with floating exchange rates and perfect capital mobility Starting at full equilibrium, a fiscal expansion leads to a currency appreciation which crowds out an equilivant volume of net exports, causing a current account deficit but little or no stimulus stimulus to GDP. The initial initial increase in government spending shifts the IS curve to the right from IS0 to IS1. but the resulting appreciation of the exchange rate shifts the net export function downwards, which shifts the IS curve back to the left. LM BB

I*

IS1 IS0  Y*

Macro Policies to correct a Disequilibrium Monetary and Fiscal policy can help the economy ec onomy recover from a negative demand shock, so long as they are appropriately timed. The negative demand shock is assumed to be an autonomous fall in investment. The economy is initially in full equilibrium at Y*. The fall in investment shifts the IS curve from IS0 to IS1 in part (i), and it shifts the AD curve from AD0 to AD1 in part (ii). The resulting fall in the price level from P0 to P1 increases the real money supply which shifts the LM curve to LM1. The economy thus goes to GDP level Y1 where there is a recessionary gap. There would be a fall in the domestic interest rate and thus cause LRALM and AD to the depreciation to happenLM and this will shift SRA S 0LM the IS and AD curves right. Fiscal policy can shift S back to their original positions. 1 B B

I*

y 2

IS IS 0 1 y y* 1

P 0 P 1

AD0 AD1 y 1

y*

Implications Implications of an open EconomyIndian Case •

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Fixed Exchange Rate Managed floating exchange rate ( Dirty Floating) Freely floating exchange rate. Current Account and Capital Account