Chapter 29 Open economy macroeconomics

1. Chapter 29Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

2. Open economy macroeconomics • … is the study of economies in which international transactions play a significant role • international considerations are especially important for open economies like the UK, Germany or the Netherlands • Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world • especially via the exchange rate.

3. Macroeconomic policy under fixed exchange rates • Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply. • When the government intervene to maintain the exchange rate, there is a direct effect on money supply. • Sterilisation • an open market operation between domestic money and domestic bonds to neutralise the tendency of balance of payments surpluses and deficits to change domestic money supply.

4. Monetary policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices • An increase in nominal money supply • tends to reduce interest rates • leads to a capital outflow • reducing money supply as the government seeks to maintain the exchange rate • so monetary policy is powerless • the government cannot fix independent targets for both money supply and the exchange rate • domestic and foreign interest rates cannot diverge

5. Beginning at A, a monetary expansion lowers r to r’, leading to capital outflows. LM’ r’ Fixed exchange rates and the loss of monetary sovereignty LM To the consequent capital outflow caused by the r falling below r*, will continue until r* is restored. A r* Interest rates The need to match r* leads to a loss of monetary sovereignty IS Y* Output

6. Fiscal policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices • An increase in government expenditure, • in the short run, • stimulates output • but also increases interest rates • which leads to a capital inflow • money supply expands to maintain the exchange rate • there is no crowding-out • as interest rates cannot rise • in the long run, • wages and prices adjust, affecting competitiveness • the economy returns to potential output.

8. Beginning at A, a fiscal expansion shifts the IS curve to IS’. LM’ Ordinarily, interest rates would rise to dampen some of the increase in Y. Since rates cannot rise above r*, extra money supply (LM to LM’) has to accommodate the extra demand for money. B IS’ Y’ Fixed exchange rates and fiscal expansion LM A r* Interest rates IS A fiscal expansion leads to a big short-run effect on output i.e. from Y* to Y’. Y* Output

9. Suppose the economy begins in equilibrium with the nominal exchange rate at e1. At time t, nominal money supply is halved... B e3 e2 will be the new equilibrium exchange rate once the economy has adjusted C e2 e1 A t These higher rates push the exchange rate to e3. Adjustment towards e2 takes place along BC as wages and prices become more flexible. Monetary policy under floating exchange rates e But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise. Time

11. Monetary policy under floating exchange rates (2) • This analysis suggests that with floating exchange rates • monetary policy is highly effective in the short run • but the effect is only transitional.

13. Fiscal policyunder floating exchange rates • Following an increase in government expenditure ... • the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate • which dampens export demand • so fiscal policy is less effective under floating exchange rates.

14. Further Reading • Ercan KUMCU: “Kafamızın Karışık Olduğu Konular” August 14, 2007 http://www.hurriyet.com.tr/yazarlar/7080158.asp