OPEN ECONOMY MACROECONOMICS: ADJUSTMENT POLICIES

1. OPEN ECONOMY MACROECONOMICS: ADJUSTMENT POLICIES • INTERNAL BALANCE & EXTERNAL BALANCE • IS-LM-BP • THE ROLE OF CAPITAL MOBILITY • Objectives • Policy instruments • Good market • Money market • Balance of payment • Low CM and high CM • Capital control Normaz wana@2003

2. INTERNAL BALANCE • One aim f CB & govt. could be to achieve Internal Balance (IB) refer to the attainment of purely domestic policy objectives. • IB objectives: include maintaining low and stable inflation, in addition to attaining high growth in per capita real income and minimizing cyclical unemployment rates. Normaz wana@2003

3. Real income goals: »to achieve the highest possible growth in its citizens’ living standard »To measure the growth » the growth rate of per capita growth domestic product or GDP per capita • Employment goals »labor is a key factor of production » Govt. usually feel pressure to follow policies intended to reduce the size and volatility of worker unemployment rates • Inflation goals »try to maintain low inflation and to limit inflation volatility Normaz wana@2003

4. EXTERNAL BALANCE • The attainment of objectives for international flows of g&s, income, and assets or for the relative value of their national currencies. • Equilibrium in the balance of payments or desired temporary disequilibrium such as surplus Normaz wana@2003

5. In general, nation place priority on internal over external balance, BUT they are sometimes forced to switch their priority when faced with large external imbalance. • To achieve these objectives, the follow policy instruments: a)expenditure-changing policies b)Expenditure-switching policies c)Direct control Normaz wana@2003

6. A) FISCAL POLICY Refers to changes govt. expenditure, T or both Expansionary (g,T) lead to expansion of dom. Production & income through multiplier process  Induce a rise in M (depend n MPM) Contractionary (T, g) reduce dom. Production & income  Induce a fall in M Expenditure-changing policies I + X + G = S + M + T (injection) (leakage) (G – T) = (S – I) + (M – X) G>T : govt. budget deficit )must financed by an excess of S over I or excess M over X) Normaz wana@2003

7. B) Monetary policy Involves a change in the nation’s money supply that affects domestic interest rates EASY (Ms , i) »induces an in the level of I and Y »induces iM to  »at the same time, the reduction of I, induces a short-term capital outflow (or reduce inflow) TIGHT (Ms, I) »discourage I, y, iM » Leads to a short term capital inflow (or outflow) Normaz wana@2003

8. Switch expenditure from domestic to foreign product Used to correct surplus in BOP  Reduces dom. Production  Induces a decline in M  Neutralizes part of the effect of revaluation Switches expenditure from foreign to domestic commodities and can be used to connect deficit in BOP   dom. production  Induces a rise in M  Neutralizes a part of original improvement in Trade balance. Expenditure-switching policiesRefers to changes in the exchange rate (devaluation/revaluation) Normaz wana@2003

9. Tariff, quotas, other restriction on the flow of international trade and capital Also expenditure switching (but they can be aimed at specified BOP) In the form of price & wage control (can be used to stem domestic inflation when other policies fail DIRECT CONTROL Normaz wana@2003

10. Examine how a nation can simultaneously attain IB & EB with those policies. Assume: 1. International capital flow = 0 (BOP = BOT) 2. Price constant (until AD > full employment) IB & EB with expenditure-changing & expenditure-switching policies Normaz wana@2003

11. Swan diagram EE : combination R & D that result in EB) +vely sloped R improves TB (if MLC satisfied) Must be match by an dom.exp (D) to induce M to  sufficiently to keep TB in equilibrium and maintain EB Fr. F : R (R2 R3) accompanied by D to maintain EB (J’) R EE R3 J’ F R2 R1 C D2 DOM. EXP. Normaz wana@2003

12. Swan diagram YY : combination R & D that result in IB) -vely sloped R (due to revaluation) worsen TB and must be matched with large dom exp. To remain in IB Fr. F :  R (R2  R1) accompanied by D to maintain IB (J) R EE R3 C” J’ F R2 J YY R1 C D2 D3 DOM. EXP. Normaz wana@2003

13. Swan diagram Fr C: Excess deficit , unemployment R EE Surplus inflation R3 C” J’ F surplus unemployment deficit inflation R2 • If R reach EB at C’ or if larger R reach at C” • If D reach TB at J (EB deficit) J YY C’ R1 Deficit Unemployment C D2 D3 DOM. EXP. Normaz wana@2003

14. Swan diagram If already at IB (J) a devaluation reach at (J’) but face inflation  Thus 2 policies are usually requirement to achieve 2 goals simultaneously R EE Surplus inflation R3 C” J’ F surplus unemployment deficit inflation R2 J YY R1 Deficit Unemployment C • According to Mundell: • By using Fiscal policy can achieve IB • By using monetary policy can achieve EB D2 D3 DOM. EXP. Normaz wana@2003

15. How a nation can use fiscal & monetary policy to achieve IB & EB without any changes in the exchange rate Mundell Fleming Model Normaz wana@2003

16. IS combination R & Y  -vely sloped IS Good Market • AD = AS • Injection = leakages • I inverse relation with R • S,m direct relation with Y • G, T, X : exogenous (independent of Y) R Ye Yf Y Y > Yf : inflation Y < Yf : unemployment Normaz wana@2003

17. LM curve +vely inclined R ,demand for transaction,demand for speculative Md = Ms Money Market 1. Transaction dd for $ : +vely related to Y 2. Speculativedd for $ : fr the desire to hold $ balances isntead of interest-bearing securities To avoid the risk of falling securities P (because of interest foregone) R LM Y Ye Yf Normaz wana@2003

18. BP line: +vely sloped R  greater capital inflows or smaller capital outflows and must be balanced with higher of national income and import for BOP to remain in equilibrium Balance of Payment (BP) Combination of R & Y at which the nation’s BOP is in equilibrium at a given exchange rate BP LM IS Normaz wana@2003

19. At R=8%, national income have to be at Yf = 1500 for the nation’s BOP remain in eqm. On the left BP line: BOP surplus On the right BP line: BOP deficit Balance of Payment (BP) Combination of R & Y at which the nation’s BOP is in equilibrium at a given exchange rate R BP LM 8 IS Y Yf=1500 Normaz wana@2003

20. The more responsive international short-term capital flows are to changes in interest rates, the flatter BP line The BP line is drawn on the assumption of a constant exchange rates Trade deficit = net capital inflow Trade surplus = net capital outflow Trade balance = 0 capital flow • A devaluation or depreciation of the nation’s currency shift BP down (improve TB, lower R and smaller capital inflows)are required to keep the BOP in eqm. • A revaluation / appreciation of the nation’s currency shift BP upward (worsen TB, higher R and greater capital inflows)are required to keep the BOP in eqm. • HOWEVER, we are assuming that the exchange rate is fixed, thus the BP line does not shift Normaz wana@2003

21. Simultaneously in equilibrium in good market, money market, and BOP IS – LM – BP The combination of fiscal & monetary policies can reach the full employment level of national income (and remain in External Balance) while keeping the exchange rate fixed!! Balance of Payment (BP) BP LM E IS Normaz wana@2003

22. THE ROLE OF CAPITAL MOBILITY • The manner in which monetary and fiscal policy actions may influence a nation’s economic performance relative to either IB or EB objective depends n the extent of capital mobility. • Refers to the degree to which funds and financial assets are free to flow across a nation’s borders. Normaz wana@2003

23. A nation with ‘ high CM’ open to experience cross-border flow of funds and financial assets. After accounting for differing risk across alternative assets, the owners of financial asset around the world seek the highest available returns. many are willing and able to shift their funds from one nation to another Flow of funds across national boundaries are significant if the returns to reallocations are high enough. Normaz wana@2003

24. Capital control However, a number of nations have imposed legal impediments • Restrict the ability of their residents to hold and exchange assets denominated in the currencies of other nations • It inhibit flow of funds and asset across the borders of a country and can lead to LOW CAPITAL MOBILITY for a nation that adopt such control. Normaz wana@2003

25. Did Capital Control save Malaysia?? Event of financial crisis: • Sept 97 : govt announced the restriction of short-selling stock but instead of that stock price to a 14% • Govt. gave up, the removed the restriction • Late Nov 97: Malaysia stock prices were 60% lower than they had been just nine months earlier, and the dollar value of Malaysia’s currency was plugging • Sept. 98: RM had lost nearly half its value relative to the dollar Normaz wana@2003

26. The Controls. How? • Began by ordering the KLCE to ban trading Malaysia shares outside the country (particularly in Singapore) – prior restriction many foreign holders remove share to S’pore. • Within a couple days, PM declared an immediate end to trading the Malaysia Ringgit abroad immediately, financial mkt fell into turmoil billions of dollars in untradable financial contracts were denominated in M’sian Ringgit. • All ringgit hold outside Malaysia were to be repatriated within a month or declared worthless Normaz wana@2003

27. Foreign residents who sold M’sian stock were barred from exporting the proceeds for a yr • The govt. placed limits on how much money M’sian could carry abroad, and required all M’sian X & M to be settled in foreign currency. • Why govt. imposed CC? • To insulate the nation’s currency fr speculative pressure • To cut interest rates • To stimulus fiscal Normaz wana@2003

28. Did the control works? • Feb 99: the M’sian govt. had replaced its complete ban on cross-border currency movements with less rules • Sept 99: the director of the IMF formally commended Malaysian authorities for making good use of the breathing space that capital control had provided “to push ahead with a well-designed and effectively implemented strategy for financial-sector restructuring” that had contributed to renewed economic growth. Normaz wana@2003

29. The degree of Capital mobility (CM) and the resulting slope of the BP line determine how monetary and fiscal policy actions influence a nation’s economic performance. LOW CM BP steeper BOP at pt A »Y , M » CA deficit at C » large in R is needed to induce foreign residents to overcome barriers to capital inflows sufficient to achieve a new BOP at B CAPITAL MOBILITY & BP LINE R BP B A C Y Y1 Y2 Normaz wana@2003

30. R BP B HIGH CM BP flatter if Y, M • Ca deficit at C • Smaller in R is required to induce sufficient capital inflows when there are fewer barriers to capital mobility A C Y • WITH PERFECT CM • R=R* (as uncovered int. parity condition) • BP horizontal • Dom & foreign do not anticipate any depreciation of dom. Currency • If R (R’) at C: R < R* : capital flows out of the dom. Currency. BOP deficit R=R* A BP R1 C Normaz wana@2003

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