Lecture 7: Open Economy Macroeconomics Monetary and fiscal policy in an open economy

Transcription

1 Lecture 7: Open Economy Macroeconomics 3 Reading: BFD ch. 29 and ch Monetary and fiscal policy in an open economy Equilibrium in the open economy (lecture 6) 1. Equilibrium under flexible exchange rates 2. Equilibrium under fixed exchange Rates Policy 1. Monetary Policy under fixed exchange rates LM Y * Output The Monetary expansion shifts the LM schedule to the right (LM LM ). This puts downward pressure on the interest rate, and international demand for domestic assets will fall. The central bank would be obliged to buy the s being sold on the forex market to maintain the exchange rate. This effectively reduces the money supply until the equilibrium interest rate is maintained at r w. The initial monetary expansion is completely offset. Under fixed exchange rates, monetary policy is unavailable as a policy instrument.

2 2. Monetary Policy under Flexible Exchange Rates LM Y 1 Y 2 Output The Monetary expansion shifts the LM schedule to the right (LM LM ). This puts downward pressure on the interest rate, and international demand for domestic assets will fall. On the forex market, demand for s fall and demand for foreign currency rises. This leads to a depreciation of the currency and subsequently imports become more expensive and exports become cheaper. This leads to a shift in the curve (goods market equilibrium to ) until the equilibrium interest rate restored at r w. The initial monetary expansion increases output from Y 1 to Y 2. Under flexible exchange rates, expansionary monetary policy increases equilibrium output.

3 3. Fiscal Policy under fixed exchange rates. LM Y 1 Y 2 Output The fiscal expansion shifts the schedule to the right ( ). This puts upward pressure on the interest rate, and international demand for domestic assets will rise. The central bank would be obliged to supply the s demanded on the forex market to maintain the exchange rate. This effectively increases the money supply until the equilibrium interest rate is maintained at r w. The fiscal expansion increases output from Y 1 to Y 2. Under fixed exchange rates there is no crowding out of private sector investment. Under fixed exchange rates, expansionary fiscal policy increases equilibrium output.

4 4. Fiscal Policy under flexible exchange rates. Y 1 Output The fiscal expansion shifts the schedule to the right ( ). This puts upward pressure on the interest rate, and international demand for domestic assets will rise. On the forex market, demand for s increases and demand for foreign currency falls. This leads to an appreciation of the currency and subsequently imports become cheaper and exports become more expensive. This shifts the curve back until equilibrium interest rate is maintained at r w. The increase in government spending is thus completely offset by an increased current account deficit. The fiscal expansion ultimately has no impact upon equilibrium output. Under flexible exchange rates, fiscal policy is unavailable as a policy instrument.

5 r w1 G2 UK2 4. The national economy in the global setting Global economy can be described as a closed economy Individual national economies are small relative to global GDP and are on the whole open. National economies in an exchange rate system. Individually lose control over money supply, but there remains a potential for collective monetary policy who decides? The Anchor Currency e.g. German Reunification France (stays in EMS) Germany UK (leaves EMS) r LM F2 LM G2 LM F1 LM G1 LM UK r w2 F G1 UK1 Y F2 Y F1 Y G1 Y G2 Y UK1 Y UK2 Under fixed exchange rates, an increase in the anchor currency s interest rate forces the national economy into recession (France) Under flexible exchange rates, an increase in the anchor currency s interest rate leads to an increase in income in the domestic economy (UK).

6 5. The European Single Currency Monetary policy in a monetary union. Conducted by the European Central Bank. It controls the overall money supply but has no control over the money supply in any individual country. A money supply increase or decrease affects all members in a similar way. r France Germany LM F0 LM G0 r 1 r 2 LM F1 LM G2 G F LM G1 Y F0 Y F1 Y G0 Y G1 Assume that Germany operates the currency union s monetary policy. A monetary expansion shifts the LM curve to the right (LM G0 LM G1 ). The interest rate must be the same in both countries. The monetary expansion puts downward pressure on the interest rate. There is an excess supply of money in Germany and an excess demand for money in France. The flow of Euros from Germany to France increases the money supply in both countries, and output will subsequently increase in both countries.

7 Fiscal policy in a monetary union. r Ireland Germany LM I0 LM G1 LM G0 LM I1 r 2 r 1 I1 G I0 Y I0 Y I1 Y G1 Y G0 A fiscal expansion in Ireland shifts the curve to the right ( I0 I1 ). The upward pressure on the interest rate means that currency flows into Ireland to maintain interest rates at the Euro-wide level of r 1. In other words the money supply in Ireland increases to maintain interest rates at the new level of aggregate demand, and the LM curve shifts right (LM I0 LM I1 ). All other things remaining equal, the money supply in other Euro zone countries (represented by Germany) will have to decrease. In a monetary union, one country can conduct expansionary fiscal policy to increase domestic income. However, it will drive incomes down in other member countries. A case for policy coordination?