Principles & Policies I: Macroeconomics

1. Principles & Policies I: Macroeconomics Chapter 19: Monetary and Fiscal Policy in a Global Setting Maclachlan, Macroeconomics Fall 2004

2. Chapter 19 Learning Objectives. You should be able to: • Discuss debate about U.S. international goals • Explain how a country influences its exchange rate using monetary or fiscal policy • Describe the paths through which monetary policy affects exchange rates and the trade balance • Summarize the reasons why governments try to coordinate their monetary and fiscal policies • State potential problem of internationalizing a country’s debt Maclachlan, Macroeconomics Fall 2004

3. The Twin Deficits Budget deficit: US Treasury spends more (on G and transfer payments) than it receives in the form of taxes. Current account deficit: US consumers buy more goods from foreigners than US producers sell to foreigners. Is there a connection? Maclachlan, Macroeconomics Fall 2004

4. Goals at international level are not clear cut Do we want a strong or a weak exchange rate? A weak exchange rate is good for exports. A strong exchange rate is keeps prices of imports low for consumers. Do we want a trade surplus or a trade deficit? A trade deficit means we get to consume more than we produce … But it also means that foreigners are getting claims on our assets. Profits and interest will flow abroad. If foreigner suddenly sell off the dollar could collapse. Maclachlan, Macroeconomics Fall 2004

5. Contractionary Interest rate ↑ Real GDP ↓ Price level ↓ Domestic currency rises and trade deficit widens. Expansionary Real interest rate ↓ Real GDP ↑ Price level ↑ Domestic currency falls and trade deficit narrows. How does monetary policy affect the exchange rate and trade deficit? Maclachlan, Macroeconomics Fall 2004

6. Effect of fiscal policy is ambiguous FP affects real GDP and the price level like MP. The difference is in the effect on real interest rates Expansionary FP causes real interest rates to rise and contractionary FP causes real interest rates to fall. The effect on the exchange rate could go either way. Maclachlan, Macroeconomics Fall 2004

7. 19-2 Schematics for the effect of expansionary MP on trade deficit Expansionary MP → Y ↑ → Imports ↑ Therefore, trade deficit widens. Maclachlan, Macroeconomics Fall 2004

8. 19-5 a. You want to lower interest rate, decrease inflationary pressures, and lower trade deficit. Contractionary FP (contractionary MP would increase interest rate) Maclachlan, Macroeconomics Fall 2004

9. 19-5 b. You want to lower interest rates, decrease inflationary expectations and lower the trade surplus. Contractionary FP. If dollar rises in value the surplus will be lowered—but it’s not certain that the dollar will rise in value. Maclachlan, Macroeconomics Fall 2004

10. 19-5 c. You want to lower the interest rate, decrease unemployment and lower the trade deficit. Expansionary MP will do the first two but not the third. Maclachlan, Macroeconomics Fall 2004

11. 19-5 d. You want to raise the interest rate, decrease unemployment, and lower the trade deficit. Expansionary FP will do the first two but not the third. Maclachlan, Macroeconomics Fall 2004