1. Reducing inflation using monetary policy is easier if there is international capital mobility. Show why this true.
2. Discuss the different effects of the following policy mixes:
a. Expansionary fiscal policy and expansionary monetary policy.
b. Expansionary fiscal policy and contractionary monetary policy.
c. Contractionary fiscal policy and expansionary monetary policy.
d. Contractionary fiscal policy and contractionary monetary policy.
Sawyer/Sprinkle Chapter 18 Macroeconomic Policy and Floating Exchange Rates C h a p t e r 1 8 To accompany International Economics, 3e by Sawyer/Sprinkle PowerPoint slides created by Jeff Heyl Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHAPTER ORGANIZATION Introduction Fiscal and Monetary Policy Changes in Fiscal Policy Changes in Monetary Policy Monetary and Fiscal Policy in an Open Economy Trade Flow Adjustment and Current Account Dynamics Summary Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› 2 INTRODUCTION Fiscal and monetary policies are two macroeconomic policies that governments employ to affect domestic output, maintain full employment and price stability These are the 2 macroeconomic policies used to achieve the 3 goals of any economic policy These polices have an effect on the exchange rate, the current account, interest rates, and short-run capital flows within an environment of floating exchange rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› FISCAL AND MONETARY POLICY Fiscal policy entails using changes in government taxation and/or spending to affect the level of economic activity GDP Monetary policy uses changes in the money supply and/or interest rates to affect a county’s GDP Changes in these policies have predictable effects on the exchange rate, the current account balance, and short-run capital flows Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› FISCAL AND MONETARY POLICY In this chapter (Ch18) we’ll assume these policies are conducted in a floating exchange rate regime ERR (effects in a fixed ERR are in Ch19) The assumption is that the government does not employ fiscal and/or monetary policy in an attempt to generate a balanced current account, but to affect the output and price level Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› FISCAL AND MONETARY POLICY It used to be common practice for governments to focus fiscal and/or monetary policy on obtaining what is known as an external balance Governments now tend to use monetary and fiscal policy to focus on a country’s internal balance Internal balance refers to the levels of unemployment and inflation that fit the preferences of the citizens of various economies The focus on internal balance comes at the expense of external balance considerations Policies designed to achieve a desired internal balance may have large consequences for a country’s external balance Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY In most countries, government spending is such a large part of the GDP that any changes can have a critical impact on an economy Substantial amounts spent on transfer payments mean tax revenues add to this amount A portion of total government spending is usually financed through borrowing, thereby having a significant impact on country’s domestic financial markets and interest rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY The demand for loanable funds is the total demand for loans in the economy It includes private sector demand from the public’s consumption activities that must be financed and business demand for funds for investment The public sector demand is generated by the government’s need for funds which is the difference between total government spending and total taxes collected Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY The supply of loanable funds represents the total amount of money available to be borrowed by the private and public sectors of the economy This is represented as perfectly inelastic; the amount of loanable funds is not related to the interest rate In the short-run, the amount of money held in savings by the public determines the supply of loanable fund Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.1Supply and Demand for Loanable Funds and Expansionary Fiscal Policy Interest Rate (i) ie Loanable Funds (L) S D E Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Expansionary Fiscal Policy The government adopts an expansionary fiscal policy by choosing to lower tax revenues and/or have higher government spending This leads to a government budget deficit (or larger deficit) Assume government borrows to finance and does not print money This will have a predicable effect on interest rates as in Fig 18.1 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY An expansionary fiscal policy causes an increase in the demand for loanable funds (from D to D’) In a closed economy, this would cause interest rates to rise (from ie to i’) In an open economy with freely flowing international capital, the rise in interest rates causes an inflow of capital and an increase in the supply of loanable funds (from S to S’) This inflow of capital lowers domestic interest rates (from i’ back to ie) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.1Supply and Demand for Loanable Funds and Expansionary Fiscal Policy Interest Rate (i) ie i’ Loanable Funds (L) F G S D D’ E S’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY The net result of an expansionary fiscal policy in an open economy is that less upward pressure is put on interest rates than would be the case in a closed economy A larger federal government budget deficit tends to increase domestic interest rates which causes an inflow of foreign capital into the country The capital flows have an effect on the equilibrium exchange rate (as described in Ch15) This effect is shown in Fig. 18.2 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.2Effects of Expansionary Fiscal Policy on the Exchange Rate Exchange Rate (XR) XRe XR’ Foreign Exchange (FX) X M S D E S’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY In an economy with a balanced current account, if the government adopts an expansionary fiscal policy and domestic interest rates rise, the inflow of foreign capital requires foreign investors to sell foreign currency to buy dollars The supply of foreign exchange increases (from S to S’) and the nominal exchange rate appreciates (from XRe to XR’) The capital inflows encouraged by the higher interest rates will result in a capital account surplus and a current account deficit (M-X at XR’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Therefore, an expansionary fiscal policy puts upward pressure on domestic interest rates which leads to an increase in the flow of capital from abroad into the domestic financial markets leading to an appreciating currency and a current account deficit However, we need to consider the effect of an expansionary fiscal policy on the domestic economy (using tools of AD and AS from Ch17)? In a closed economy, this would lead to an increase in domestic output and price level Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.3Effects of Fiscal Policy on Equilibrium Output and Price Level Price Level (P) Pe P’ Real GDP (Y) Ye F AS AD E AD’ Y’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY In an open economy, the effects are less clear as an expansionary fiscal policy has two conflicting effects The policy increases AD as the government reduces taxes and/or increases spending –the direct effect On the other hand, the policy reduces AD as the exchange rate appreciates and the current account balance deteriorates – the indirect effect Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.3Effects of Fiscal Policy on Equilibrium Output and Price Level Price Level (P) Pe P’ Real GDP (Y) Ye AS AD AD’ Y’ AD’’ AD’’’ Direct Effect: AD’ Indirect Effect: AD’’/AD’’’ Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› Direct Effect: Closed Economy Effect Indirect Effect: Open Economy Effect 20 CHANGES IN FISCAL POLICY The net effect depends on the magnitude of the two effects Conclusion: Expansionary fiscal policy in an open economy is less effective at changing equilibrium output and price levels than in a closed economy Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Contractionary Fiscal Policy A contractionary fiscal policy would entail some combination of higher taxes and/or lower government spending This reduces a government budget deficit or increases size of a surplus Adopting a contractionary fiscal policy causes the overall demand for loanable funds to shrink (from D to D’) and lowers the interest rate (from ie to i’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.4Supply and Demand for Loanable Funds and Contractionary Fiscal Policy Interest Rate (i) ie i’ Loanable Funds (L) F S D E D’ S’ G Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY The lower domestic interest rate affects capital flow into the country as domestic and foreign investors would tend to invest less domestically and domestic investors would tend to invest more capital abroad The net result would be an outflow of capital from domestic economy and the supply of loanable funds would decrease (from S to S’) raising interest rates (from i’ back to ie) A contractionary fiscal policy puts less downward pressure on domestic interest rates in an open economy than in a closed economy Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.5Effects of Contractionary Fiscal Policy on the Exchange Rate Exchange Rate (XR) XRe XR’ Foreign Exchange (FX) X S D E D’ M Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY A contractionary fiscal policy lowers the federal government budget deficit which decreases domestic interest rates and causes an outflow of capital This increases the demand for foreign exchange (from D to D’) and the exchange rate rises or the domestic currency depreciates (from XRe to XR’) This causes the capital account to become negative which causes the current account to become positive (X-M at XR’) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Therefore, a contractionary fiscal policy puts downward pressure on domestic interest rates which leads to an decrease in the flow of capital from abroad into the domestic financial markets leading to an depreciating currency and a current account surplus What about the effects in a closed vs. open economy? In a closed economy, this would lead to an decrease in domestic output and price level Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 – ‹#› CHANGES IN FISCAL POLICY Figure 18.6Effects of Fiscal Policy on Equilibrium Output and Price Level