L27 - Economic Policy in an Open Economy

Question 1

Why do we need to look at the interactions between our macro models and the rest of the world?

Answer 1

• Firstly, while we have always had net exports in our models, we have not paid attention to all the possible implications of trade balance
• Secondly, the financial markets have become more integrated around the word –> the globalisation of the financial markets –>due to high international mobility of financial capital - the money markets in own country are influenced by what happens in the world’s financial market
• thirdly the exchange-rate regime matters fro the conduct of monetary policy because it affects the possibilities for arbitrage between domestic and overseas financial markets –> therefore a link between the two countries interest rates

Question 2

What is Arbitrage?

Answer 2

• involes buying where a price is low and selling where it is high in order to make profit
• the process of arbitrage tends to drive prices of the same commodity or asset towards equality in different locations

Question 3

What does capital flow mean in the context of the balance of payments?

Answer 3

• its not the imports and exports of capital goods, but rather about the trade in assets and liabilities such as money balances shares and bonds, or lending by banks in one country to customers in another

Question 4

What are the two reasons why is capital flow important?

Answer 4

• changes affecting capital flows have implications for net exports (possibly via exchange rate changes)
• capital flow also influence the domestic interest rate

Question 5

Why does the openness of a economy matter?

Answer 5

Openness of the economy matters, as international factors directly affect:

• real demand,
• world financial forces influence domestic financial markets,
• and the exchange rate regime affects the policy choices that are available.

Question 6

Why is the exchange rate regime important?

Answer 6

• it determines which variables are free to adjust

Question 7

What can occur under a fixed exchange rate?

Answer 7

• it ties together the value of domestic and foreign money which implies the domestic price level cannot deviate from the foreign price level in the long run
• Fixed exchange rates with mobile capital also tie domestic and foreign interest rates together because there is no exchange rate uncertainty –> in these circumstances the domestic monetary authorities have no discretion in setting the domestic interest rate
• the money supply is endogenously determined by demand at whatever the interest rate is dictated by world money markets
• in general monetary authorities of nations with independent currencies can fix any one (but only one), of the interest rate, exchange rate and the money supply, –> also applies to groups of a single currency e.g. eurozone
• Once choosing one the others become endogenous
• Fixing interest rates in one monetary policy but having done this authorities cannot also control either the interest rate or the money supply –> most major countries set short-term interest rates and let the money supply and the exchange rate adjust

Question 8

Where does most of the adjustment to shocks come from under the two exchange rate policies?

Answer 8

• under floating exchange rates much of the adjustment to shocks comes through exchange -rate changes and the resulting effect on the relative price of domestic and foreign goods (and assets)
• under fixed exchange rates much more of the adjustment to shocks is worked out via aggregate demand, money stock, and output changes at give relative prices

Question 9

In the long run what does fiscal policy affect?

Answer 9

• the long-run impact of fiscal policy is mainly on the trade balance

Question 10

What can financial and spending linkages between economies cause?

Answer 10

• Financial and spending linkages between economies cause business cycles to have similar patterns in many major economies.

Question 11

What does the IS-LM model look when incorporating Perfect Capital Mobility?

Answer 11

• With interest rates (r) on the y-axis and Real GDP (Y) on the x-axis
• inclined line of LM
• declined line of IS
• a horizontal line of BB –> represents combinations of the interest rate and GDP which there is equality between the current account balance of payments and capital flow
• there is an equilibrium point of i=i* when these lines cross

Question 12

What are the implications of Perfect Capital Mobility?

Answer 12

• With perfect capital mobility the domestic interest rate must be equal to 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 BB line is drawn horizontally at the point where the domestic interest rate is equal to the foreign rate i*.
• The shape of BB means that any size of current account deficit can b financed by borrowing at the going interest rate on
  world capital markets.

Question 13

What is Perfect Capital Mobility?

Answer 13

• for this model we make the assumption that that foreign demand for domestic bonds is perfectly elastic with respect to the interest differential –> they are perfect substitutes
• this assumption is close to the realities of the modern world of globalised finance and highly mobile international capital than the assumption of perfect immobility

Question 14

What are two relationships we need to keep in mind when incorporating capital flow into the IS-LM model?

Answer 14

• since net capital flows must be of equal size and opposite sign to the current account balance of payment surplus or deficit, an actual capital inflow implies a current account deficit of equal size
• the foreign demand for domestic bonds depends in part upon the differential in interest rates between domestic and foreign bonds

Question 15

What does Perfect capital Mobility imply about the exchange rates?

Answer 15

• Perfect capital mobility implies that with fixed exchange rates the domestic interest rate must always equal the foreign interest rate
• with floating exchanges rates any interest differential must be dictated by the expect exchange-rate change
• this will be zero in full equilibrium

Question 16

How does monetary policy affect the IS-LM model under a Fixed Exchange Rate Regime?

Answer 16

• Monetary policy is powerless to influence economic activity under fixed exchange rates and perfect capital mobility.
• An attempted cut in domestic interest rates increases the money supply and shifts the LM curve to the right from LM{0} to LM{1}.
• However, the smallest fall in domestic interest rates causes a massive
  desired capital outflow. –> as bonds are perfectly elastic –> above the BB line everyone buys domestic bonds for higher return but everyone sells then below the BB line
• This puts downward pressure on the exchange rate. –> as everyone is selling sterling to buy dollar
  The monetary authorities are forced to buy sterling immediately in order to stop the exchange rate failing, and the LM curve shifts back to its original position, LM{0}

Question 17

How does fiscal policy affect the IS-LM model under a Fixed Exchange Rate Regime?

Answer 17

-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 I{1} . 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 rising, the monetary authorities sell sterling
in the foreign exchange market.
- This increases the money supply and shifts the LM curve to the right,
from LM{0} to LM{1}.

Question 18

How does fiscal policy affect the AD-AS model under a Fixed Exchange Rate Regime?

Answer 18

• The combined effect of the IS and LM curves shifting is that AD shifts right, from AD{0} to AD[1}
• The increase in aggregate demand causes GDP to increase from Y* to Y{1} in the short run, and there is a small initial increase in the price level.
• This price level rise shifts the IS and LM curves slightly leftward to IS{2} and LM{2} so that they intersect at Y{1} rather than Y{2}.
  Net exports become negative. In the long run inflationary pressure causes the price level to rise to P{1} as the SRAS curve shifts up to SRAS{1} and GDP returns to Y*.
• However, the sustained rise in the price level (for given foreign prices) causes a permanent trade deficit, which is equal to the budget deficit.
• At price level P[1} the real money supply has fallen, so the LM curve shifts back to LM{0}.
• The higher price of domestic goods causes net exports to shift downwards, so IS also shifts back to its original position, IS{0}
• thus instead of crowding out investment ( as would happen in the absence of capital flows ) the increase in government spending has led to a trade deficit of equal value

Question 19

How can you summarise reactions to monetary and fiscal policy changes under fixed rates?

Answer 19

• Fiscal –> G rises –> AD shifts right –> Y goes above Y* and NX goes negative –> p rises and Y falls back to Y* –> Rise in G matched by -NX
• Monetary –>r falls or M rises –> Capital flows out until M falls back or r rises to r* –> r = r* and Y and P remain at initial position

Question 20

How does monetary policy effect the IS-LM model under a Floating Exchange Rate Regime?

Answer 20

• 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 domestic interest rates causes the exchange rate to depreciate to a point from which it is expected to appreciate.
• This involves overshooting and a fall in the real exchange rate.
• This fall in the real exchange rate shifts the net export function upwards, so, as part (i) shows, there is a shift in the IS curve from IS{0} to IS{1}.

Question 21

How does monetary policy effect the AD-AS model under a Floating Exchange Rate Regime?

Answer 21

• The combined effect of these two shifts on aggregate demand as the shift from AD{0} to AD{1}.
• The increase in aggregate demand creates and inflationary gap. GDP
  increases from Y* to Y{1} in the short run, and the price level starts to rise to the level indicated by the intersection of AD{1} and SRAS{0}.
• Eventually inflationary pressure works through to input prices, and the
  short-run aggregate supply curve shifts upwards to SRAS{1}.
• The price level rises to P{1} and GDP falls back to Y*.
• The increase in aggregate demand creates and
• The LM curve shifts back to LM{0} as the rise in price level reduces the real money supply.
• The IS curve shifts back to IS{0} as higher domestic prices raise the relative price of domestic goods and the net export function shifts downwards.
• The long-run outcome is an increase in the prices but the same real GDP.

Question 22

How does fiscal policy effect the IS-LM model under a Floating Exchange Rate Regime?

Answer 22

• Starting at full equilibrium, a fiscal expansion leads to a currency appreciation which crowds out an equivalent volume of net exports, causing a current account deficit but little or no stimulus to GDP.
• The initial increase in government spending shifts the IS curve to the right from IS{0} to IS{1}.
• But the resulting appreciation of the exchange rate (real and nominal) shifts the net export function downwards, which shifts the IS curve back to the left

Question 23

What is the reaction of an increase in Fiscal Policy when there is a fixed Money Supply under a floating Exchange Rate?

Answer 23

An expansionary fiscal policy under floating exchange rates has little impact on real GDP in the short run when the money stock is fixed rather it causes an exchange rate appreciation and trade deficit
- In the long- run given that we started for Y* there is a permanent appreciation of the real exchange rate, and the government budget deficit is equal to the trade deficit

Question 24

What is the Reaction of an increase in Fiscal Policy when there is a Fixed interest rate under a floating regime?

Answer 24

• A fiscal policy expansion does have a short run-expansionary effect in the economy if the monetary authorities increase he money supply to accommodate the increase in GDP at a constant interest rate
• • But given we started at Y* net exports are crowed out in the long run bu higher domestic price level that raises the real exchange rate

Question 25

How can the effects of Fiscal and Monetary Policy under a Floating Exchange Rate be summarised?

Answer 25

• Fiscal Policy with fixed M –> r rises and exchange rate rises –> NX falls and offsets rise in G
• Fiscal Policy with fixed r –> M rises to offset upwards pressure on r –> Y goes above Y* and P starts to rise –> Rise in P reduces NX and Y reverts to Y* but with negative NX
• Monetary Policy –> AD shifts right and Y goes above Y* –> P rises as SRAS shifts up–> Y reverts to Y* and long-run effects is higher P and currency depreciation

Question 26

When can Monetary Policy be used to correct a disequilibrium?

Answer 26

monetary policy can be used int he short term to offset the recessionary effects of a negative demand shock whether this can be done with enough accuracy to improve on the automatic adjustment mechanisms is controversial and depends on specific characteristic of each recession

Question 27

When can Fiscal Policy be used to correct a disequilibrium?

Answer 27

Fiscal policy can be used to help return GDP to potential when a recessionary gap has been created by a negative demand shock but its precise impact will depend on the nature of the original shock