L27 - Economic Policy in an Open Economy

Question 1

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

Answer 1

• To see the full implications of the trade balance
• Because the financial markets have become more integrated (Globalisation). Money markets in own country become influenced by world financial market
• Exchange rate matters for the conduct of monetary policy because affects arbitrage of domestic and overseas financial markets (link between 2 countries interest rate)

Question 2

What is Arbitrage?

Answer 2

Buying goods where price is low. Selling them at a higher price.

Question 3

Why does the Openness of the economy matter?

Answer 3

Since international matters directly influence:

• Real demand,
• World financial forces influence domestic financial markets,
• The exchange rate regime affects the policy choices that are available.

Question 4

What do the effects of fiscal policy depend on?

Answer 4

Depend on the exchange rate regime and the monetary policy used

Question 5

Why is the exchange rate important?

Answer 5

It determines which variable free to adjust

Question 6

What can occur under a fixed exchange rate?

Answer 6

• 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 rate with mobile capital also tie value of domestic and foreign money together because there is no exchange rate uncertainty
• Monetary authorities of nations with independent currencies can fix any one (but only one), of (interest rate, exchange rate and the money supply)–> also applies to groups of a single currency e.g. eurozone

Once chosen, the other factors become endogenous

Question 7

How does currency systems (Floating) adjust from a shock?

Answer 7

-Floating:

Adjustment via exchange rate changes and resulting effect on relative prices of domestic and foreign goods and services

Question 8

How does the fixed exchange rate adjust from a shock?

Answer 8

• Fixed:

Adjustment worked out via AD,Money Stock and output changes at given relative prices

Question 9

In the Long Run what does fiscal policy affect?

Answer 9

The LR impact of the Fiscal Policy is mainly on 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 economies

Question 11

What are the implication of the Open Market IS-LM Model? (With Perfect Capital Mobility)

Answer 11

-The BB line shows the combinations of interest rates and GDP for which a current account surplus (deficit) equals the associated capital
outflow (inflow).

-With perfect capital mobility the domestic interest rate must be equal to foreign interest rate in equilibrium.

• 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 be financed by borrowing at the going interest rate on world capital markets.

(SEE DIAGRAM IN NOTES)

Question 12

What is Perfect Capital Mobility?

Answer 12

Means that a practically unlimited amount of international capital flows in response to the slightest change in one country’s interest rates.

Question 13

What does Perfect Capital Mobility imply about the exchange rate?

Answer 13

• Perfect capital mobility implies with fixed exchange rate the domestic interest rate must always equal the foreign exchange rate
• With floating exchange rates any interest differential (difference in interest between domestic and foreign bonds) must be dictated by the expected exchange-rate change (Will be 0 in full equilibrium)

Question 14

What are the impacts of Monetary Policy with fixed exchange rates and perfect capital mobility?

Answer 14

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 LM0 to LM1.

However, the smallest fall in domestic interest rates causes a massive desired capital outflow.

This puts downward pressure on the exchange rate.
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, LM0.

(SEE DIAGRAM IN NOTES)

Question 15

What are the Impacts of Fiscal Policy with fixed exchange rates and perfect capital mobility upon the IS/LM model?

Answer 15

• 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 16

What are the impacts of Fiscal Policy with fixed exchange rate and perfect capital mobility upon the AD/AS Model?

Answer 16

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 17

What is the summary of Fiscal and Monetary Policy to fixed exchange rates and perfect capital mobility?

Answer 17

Fiscal:
G rises - AD Shifts to the 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 falls - Capital flows out until M falls back or r rises to r* - r=r* and Y and P remain at initial positions

Question 18

What is the impacts of Monetary Policy with floating exchange rate and perfect capital mobility upon IS/LM Model?

Answer 18

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 LM0 to LM1.

Combined effect of these two shifts on AD shown in AD/AS MODEL

(SEE DIAGRAM IN NOTES)

Question 19

What is the impacts of Monetary Policy with floating exchange rate and perfect capital mobility upon AD/AS Model?

Answer 19

The combined effect of these two shifts on aggregate demand is shown in part (ii) as the shift from AD0 to AD1

• The increase in aggregate demand creates and ináationary gap.
• GDP increases from Y* to Y1 in the short run, and the price level starts to rise to the level indicated by the intersection of AD1 and SRAS0.
• Eventually inflationary pressure works through to input prices, and the short-run aggregate supply curve shifts upwards to SRAS1.
• The price level rises to P1 and GDP falls back to Y*.
• The increase in aggregate demand creates
• The LM curve shifts back to LM0 as the rise in price level reduces the real money supply.
• The IS curve shifts back to IS0 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.

(SEE DIAGRAM IN NOTES)

Question 20

What is the impact of Fiscal Policy with floating exchange rates and Perfect Capital Mobility?

Answer 20

• 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 IS0 to IS1.
• 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 21

When can Monetary Policy be used to correct a disequilibrium?

Answer 21

Can be used in the short term to offset the recessionary effects of a negative demand shock whether this is done with enough accuracy to improve on automatic adjustment mechanisms is controversial and depends on specific characteristics of each recession.

Question 22

When can Fiscal Policy be used to correct a disequilibrium?

Answer 22

Can be used to help return GDP back to potential when recessionary gap has been created by negative demand shock but precise impact depend on nature of original shock.