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Topic 7

Topic 7. Monetary and Fiscal Policy in the Open Economy. Introduction. How do the effects of policy action differ in the open economy relative to the closed economy? How do they differ depending on whether exchange rates are fixed of flexible?

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Topic 7

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  1. Topic 7 Monetary and Fiscal Policy in the Open Economy

  2. Introduction • How do the effects of policy action differ in the open economy relative to the closed economy? • How do they differ depending on whether exchange rates are fixed of flexible? • Conflicts between internal and external balance in a system of fixed exchange rates. • The absence of such conflicts when exchange rates are flexible • Effects of changes in policy and other variables under assumption of imperfect and perfect capital mobility between countries.

  3. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks) • Itis an open economy version of the IS-LM model • A closed economy IS-LM model consist of • M= L(Y.r) (16.1) • Refers to money mkt eqm (LM schedule) • S(Y) + T = I( r) + G (16.2) • Refers to goods mkt eqm (IS schedule) • The model simultaneously determine the nominal interest rate, r and the level of real income, Y with the agg price level held constant

  4. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks) • Adjustment to the model with an open economy scenario: • LM schedule will not be changed • Real MS as controlled by domestic policymaker must be equal to real MD • Policymaker controls nominal MS (as well as real MS due to assumption of fixed price) • Equation for the IS schedule will be adjusted • For a closed economy, goods mkt eqm is • C+S+T=Y=C+I+G reduces to • S+T=I+G ( cancel out C on both sides)

  5. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks) • For an open economy, we add imports (Z) and exports (X) to the model: • C+S+T=Y=C+I+G+X-Z • The new IS equation becomes S+T=I+G+(X-Z) • where (x-Z) is net exports-foreign sector’s contribution to aggregate demand • The equation can be rewritten and indicate the variables upon which each element in the equation depends; S(Y) + T+Z(Y, ) = I ( r) +G+X (Yf, )

  6. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks) • S and I are the same as in the closed economy model • Imports, Z • depend positively on income, YZ • Depend negatively on exchange rate,  •    foreign goods more expensive thus Z • Exports, X • Depend positively on foreign income, YfX • Depend positively on exchange rate,  •    (domestic currency depreciates/foreign currency appreciates)  lower cost of domestic goods to foreigners X

  7. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks • IS schedule is d/ward sloping- high values of interest rate leads to low levels of investment • At high r, Y must be low so that Z and S will be low • At low r, with high I, goods mkt eqm requires S and Z high so that Y must be high • Four variables are held constant to construct IS schedule- T, G, and Yf • These are variables that shift IS schedule • Expansionary shocks- T G ,  and Yf will shift IS to the right

  8. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks • Balance of Payments equilibrium schedule • It shows interest rate-income combinations that results in BOP eqm at a given exchange rate. • BOP eqm means official reserve transaction balance is zero • BP schedule equation is X (Yf, ,  ) –Z(Y,  ) + F(r-rf)=0 • Trade balance is indicated by X (Yf, ,  ) –Z(Y,  ) • Net capital flow is shown as F(rf-r). It depends positively on the domestic interest rate, r minus foreign interest rate rf • A r relative to rf leads to  dd for domestic financial assets at the expense of foreign assets

  9. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks • BP schedule is positively sloped- • As Y Z whereas X demand remains • To maintain BOP eqm K inflow must rise which happens if r is higher • Factors shifting BP schedule horizontally to the right • Exchange rate   (for a given r which fixes K flow, at a higher  a higher Y level is required for BOP to be in eqm. Higher  encourages X and discourages Z, thus higher Y will stimulate M demand needed for BOP eqm) • Exogenous X (due to Yf ) • a fall in demand for Z • A fall in foreign interest rf(at a given domestic r)

  10. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks • BP schedule under imperfect K mobility • BP schedule will be upward sloping • Domestic and foreign assets (eg bonds) are less than perfect substitutes. • Imperfect K mobility implies rfrwhich is either rf>r or rf<r • Factors causing foreign assets less than perfect substitutes for domestic assets: • Differential risks on assets of different countries • Risks due to exchange rate changes • Transaction costs • Lack of info on properties of foreign assets.

  11. MUNDELL-FLEMING MODEL(an open economy macroeconomic frameworks • BP schedule under perfect K mobility • Perfect K mobility implies rf=r • BP schedule will be horizontal • Domestic and foreign assets (eg bonds) are perfect substitutes. • Investors would move to equalize int rates among countries • If one type of asset has a slightly higher interest rate temporarily, investors would switch to that asset until the rate is driven down to restore equality.

  12. Figure 1-Open Economy IS-LM Model r LM LM schedule shows combinations of Y and r that are points of equilibrium for the money market IS schedule shows combinations of Y and r that clear the goods market BP schedule shows combinations of Y and r that will equate supply and demand in the foreign exchange market at given exchange rate. BP Interest rate IS income

  13. IMPERFECT CAPITAL MOBILITYMonetary Policy under Fixed Exchange Rate Effects of expansionary monetary policy: • An increase in MS shift LM curve rightward. • The eqm point moved to a lower point E1 at lower r & higher Y. E1 is located below BP schedule • The effects on BOP: • Lower r,higher Y or both creates BOP deficit • MS  and r  will cause capital outflow since rf>r resulting in net capital flow F decline (negative) • Y  stimulates imports worsening the trade balance Note: • All points below BP schedule represent BOPD • All points above BP schedule represent BOPS

  14. Figure 1a-Open Economy IS-LM Model r • Higher r causes capital inflow + lesser capital outflow-improve K acct • Lower Y means lesser import expenditures-improve trade balance Points above BP Balance of Payment Surplus BP Interest rate • lower r causes capital outflow + lesser capital inflow- worsen K acct • higher Y means more import expenditures-worsen trade balance Points below BP Balance of Payment Deficit income

  15. IMPERFECT CAPITAL MOBILITYMonetary Policy under Fixed Exchange Rate • Outcome: • Exp Monetary Policy results in BOPD • It raises potential conflicts between domestic goals and external balance: • At E0, Y0 < Y full employment thus eqm moves to point E1 and Y1-this is preferable on domestic grounds BUT • At E1 there is deficit in BOP. With limited foreign exchange this cannot be maintained indefinitely.

  16. Figure 2IMPERFECT CAPITAL MOBILITYMonetary Policy under Fixed Exchange Rate r LM(M0) • An increase in quantity of money : • shifts LM to the right • The eqm pt shifts fr E0 to E1 • rate of interest falls • level of income rises • The new equilibrium point is below the BP schedule , indicating a deficit in the balance of payments. LM(M1) Interest rate E0 BP r0 E1 r1 IS Y0 Y1 income

  17. IMPERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate Effects of expansionary fiscal policy: • An increase in G shift IScurve rightward. • The eqm point moved to a higher point E1 at higher r & higher Y. E1 is located above BP schedule with a flatter LM • The effects on BOP: • higher r,higher Y or both creates BOP surplus . • This is true for cases where BP flatter than LM schedule • r  will attract capital inflow since rf< r resulting in net capital flow F increases (positive) • Y  stimulates Z- deterioration in trade balance

  18. Figure 3IMPERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate r LM • An increase in government spending : • shifts IS to the right • The eqm point shifts fr E0 to E1 • rate of interest rises • level of income rises • For the case in which BP schedule is flatter than the LM schedule: • The new equilibrium point is above the BP schedule , indicating a surplus in the balance of payments. Interest rate E1 r1 E0 BP r0 IS(G1) IS(G0) Y0 Y1 income

  19. IMPERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate Outcome: • Exp FP results in BOPSurplus (BP flatter than LM) • Deterioration in trade balance + improvement in K account • The steeper BP schedule • the larger unfavorable effect (effect on import and trade balance) • the smaller the favorable effect on K flows thus the more likely exp FP cause BOPD

  20. IMPERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate Note: SLOPE OF LM DETERMINES WHETHER EXPANSIONARY FISCAL POLICY WILL EITHER CAUSE BOPD OR BOPS (given BP) • If LM schedule steeper than BP schedule – exp FP causes BOPS • If LM schedule flatter than BP schedule - exp FP causes BOPD • Steeper LM means • higher r (thus favorable k inflow) plus • smaller Y (thus smaller unfavorable trade balance effect) Overall effect - BOPS

  21. Figure 3a-Open Economy IS-LM Modeldifferent outcome of exp FP based on slope of LM schedule r r New eqm points above BP BOPS Steeper LM BP E2 BP E2 Flatter LM Interest rate Interest rate New eqm points Below BP BOPS E1 E1 income income

  22. IMPERFECT CAPITAL MOBILITYMonetary Policy under Flexible Exchange Rate Effects of expansionary monetary policy: • An increase in MS shift LM rightward. • The eqm point E1 where r  &  Y. E1 is located below BP schedule • Exchange rate rises 0 to 1 to clear the forex market • BP shift rightward • IS shifts rightward as X  and Z  due to XR  At new eqm pt E2, r2 and Y2: Exch rate adjustment to equilibrate BOP after easy MP And eliminate potential conflict between internal and external balance

  23. IMPERFECT CAPITAL MOBILITYMonetary Policy under Flexible Exchange Rate Outcome: •  Y under flexible rate regime >  Y under fixed rate regime. There are 2 increases in income- • Y0 to Y1 due to MP • Y1 to Y2 due to XR appreciation (which X and  Z) • Therefore MP is more effective stabilization tool in a flexible exchange rate regime

  24. Figure 4IMPERFECT CAPITAL MOBILITYMonetary Policy under Flexible Exchange Rate r LM(M0) • An increase MS : • shifts LM rightward • move E0 to E1 • E1 below BP thus there is incipient BOPD • For flex regime • Exc rate rises • BP shift right • IS shift right • Final eqm: • Pt E2 • Income level Y2>Y1 eqm under fixed regime. LM(M1) BP (Π0) Interest rate E0 BP (Π1) E2 r0 r2 E1 r1 IS(Π1) IS(Π0) income Y0 Y1 Y2

  25. IMPERFECT CAPITAL MOBILITYFiscal Policy under Flexible Exchange Rate • Exp FP G shifting IS curve rightward causing both r and Y to increase. • Flatter BP than LM schedule means there will be BOPS • Exch rate must fall to clear market. Thus BP shift leftward: • BP shift from BP(0) to BP(1) • IS shift leftward for IS (G1, 0) to IS (G1, 1) (there is a fall in XR ie X  and M ) This changes partially offset exp FP action • At new eqm pt E2, Y1>Y2>Y)

  26. IMPERFECT CAPITAL MOBILITYFiscal Policy under Flexible Exchange Rate • Outcome: • There is no definite relationship between potency of Exp FP an the type of exch rate regime • If BP is steeper than LM; • exp FP (given exch rate) create BOPD. Exch rate must rise to restore eqm. • BP and IS curve shift rightward; reinforce initial exp effect of G  • Thus exp FP has larger effect on Y than in fixed exch rate system Most economies – exp FP leads to a fall in exc rate

  27. Figure 5IMPERFECT CAPITAL MOBILITYFiscal Policy under Flexible Exchange Rate r • An increase G: • shifts ISto the right • The eqm pt shifts fr E0 to E1 • Int rate rises to r1 • income rises to Y1 • BP flatter than LM thus create BOPS causing XR fall • BP shift leftward and IS backwards • The new equilibrium point is E2 at income Y2 below Y1 LM BP (1) E1 r1 BP (0) r2 E2 Interest rate r0 E0 IS(G1, 0) IS(G1, 1) IS(G0, 0) Y0 Y1 income Y2

  28. PERFECT CAPITAL MOBILITY • Capital moves freely between countries, differential risks across countries is not important, transaction costs are negligible • The flows of capital will bring both domestic and foreign int rate into equality. • Eg if f is 4.1% whereas rf is 4.0%, then the domestic country would experience a massive capital inflow until domestic rate was driven down to equal the foreign rate • In Mundell Fleming model- BP equation is replaced with condition r=rf • BP schedule is HORIZONTAL • BOP eqm only occur when r=rf

  29. PERFECT CAPITAL MOBILITY • Assumption: • Foreign int rate is exogenously determined • Domestic country is small that its action cannot affect world financial market condition • Thus domestic int rate must move into line with world rates

  30. PERFECT CAPITAL MOBILITYMonetary Policy under Fixed Exchange Rate

  31. Figure 6PERFECT CAPITAL MOBILITYMonetary Policy under Fixed Exchange Rate r LM(M0) • An increase in quantity of money : • shifts LM to the right • Domestic r < foreign interest rate • There is massive K outlflow • CB intervene to maintain fixed XR • MS fall back to initial level • Domestic r restored and income returns to initial level LM(M1) Interest rate E0 BP rf=r0 r1 IS Y0 income

  32. PERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate

  33. Figure 7PERFECT CAPITAL MOBILITYFiscal Policy under Fixed Exchange Rate r LM(M0) • An increase in govt spending : • shifts IS to the right • Domestic r > foreign interest rate • There is massive K inflow • CB intervene to maintain fixed XR • MS rise-LM shifts right • Domestic r restored equal to foreign r • Increase in MS reinforces the expansionary FP LM(M1) Interest rate r1 E1 E0 BP rf=r0 IS(G1) IS(G0) income Y0 Y’0 Y1

  34. PERFECT CAPITAL MOBILITYMonetary Policy under Flexible Exchange Rate

  35. Figure 8PERFECT CAPITAL MOBILITYMonetary Policy under Flexible Exchange Rate r LM(M0) LM(M1) • An increase in quantity of money : • shifts LM to the right • Domestic r , foreign interest rate • There is massive K outlflow • XR rises shifting IS rightward • Domestic r restored and income rises to Y1 Interest rate BP E0 E1 rf=r0 r1 IS( 1) IS(, 0) income Y0 Y1

  36. Figure 9PERFECT CAPITAL MOBILITYFiscal Policy under Flexible Exchange Rate

  37. Figure 9PERFECT CAPITAL MOBILITYFiscal Policy under Flexible Exchange Rate r LM(M0) • An increase in govt spending : • shifts IS to the right • Domestic r > foreign r • There is massive K inflow • XR falls shifting IS back to IS(G1, 1) • Domestic r reequated with foreign rate and income returns to initial level r1 E0 BP rf=r0 IS(G1, 0) IS(G0, 0)= IS(G1, 1) Y0 income

  38. conclusion • Perfect capital mobility • MP is completely ineffective if XR is fixed • FP is completely ineffective if XR is flexible • Imperfect capital mobility

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