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### Economics of International FinanceEcon. 315

Chapter 6

Open Economy Macroeconomics: Adjustment Policies

Introduction

- Adjustment policies used to achieve full employment with price stability and equilibrium in BOP are examined in this chapter.
- Adjustment policies are needed because automatic adjustments (the topic of the last two chapters) have some serious side effects (James Mead).

Objectives of the nation are:

- Internal balance
- External balance
- Reasonable rate of growth
- Equitable distribution of income, and
- Adequate protection of the environment
- To achieve these objectives we have the following instruments:
- Expenditure-changing policies
- Expenditure-switching policies, and
- Direct controls

Expenditure changing policies: include fiscal and monetary policies.

- Fiscal policy refers to changes in G, T or both which can be expansionary or contractionary. Therefore, we need to introduce the government sector, which means that the equilibrium condition would be:

I + X + G = S + M + T

- This equation can be rearranged as

(G – T) = (S – I) + (M – X)

- Monetary policy involves changes in MS that affect domestic interest rates. It can be easy or tight, which would affect interest rates, investment and income.
- Expenditure switching policies: refers to changes in exchange rates (devaluation or revaluation), which affects exports, imports and income.
- Direct Controls: consists of tariffs, quotas and other restrictions (wage and price controls) on the flow of international trade and capital.

Equilibrium in Goods Market, in the Money Market and the BOP

- We now introduce Mundell-Fleming model to show how a nation can use fiscal and monetary policies to achieve internal and external balance without the need to change R (fixed exchange rates). For this reason we use the IS (combinations of i and y at which goods market is in equilibrium (AD=AS)), LM (combinations of i and y at which money marker (MS=MD) is in equilibrium (MS=MD)), and BP (combinations of i and y at which BOP is in equilibrium X=M at a given R) curves.
- We assume that short run capital flows are responsive to international interest differentials.
- The IS is negatively slopped because the higher the interest the lower is I

The LM is positively slopped because the higher the interest, the smaller is MD for speculation and the higher is MD for transactions.

- BP is positively inclined because the higher the interest, the greater the capital inflows.
- Look at figure 2. Note that at point E there is a less than full employment output, even though all markets are in eq. Point E is our starting point for analysis (here we have unemployment but external balance)

Money Market eq.

Possible eq. rates.

All markets are in eq.

But there is unemployment

Goods market eq.

Inflation

FIGURE 2 Equilibrium in the Goods and Money Markets and in the Balance of Payments.

Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates.

a - Fiscal and Monetary Policies from External Balance and Unemployment.

- Note that an expansionary fiscal policy ↑ G (↓ T) shits the IS to the RHS, while a contractionary fiscal policy shifts the IS to the LHS.
- An easy monetary policy (↑ MS) shifts LM to the RHS, and a tight monetary policy shifts the LM to the LHS.
- We assume that R is fixed, that is why BP curve will remain unchanged.
- Look at figure 3, the nation can reach full employment (internal and external balance) by combining expansionary fiscal policy (shift in IS to the RHS) and tight monetary policy (shift in LM to the LHS). Equilibrium will be achieved at point F.

Note that full employment can be achieved by an easy monetary policy at point U, BOP will be in deficit because at i=2.5, BOP deficit will be accompanied by smaller capital inflows. On the other hand the expansionary fiscal policy that shifts the IS to the RHS to cross LM at Z will increase capital inflows (reduce capital outflows), but capital inflows are still insufficient to avoid the deficit in BOP.

- To reach full employment and have equilibrium BOP, the nation should pursue a stronger expansionary fiscal policy to shift LM to point F, and tight monetary policy to raise interest to 8% as required for BOP balance. These two conflicting policies are required for simultaneous balance.

i

Tight M. Policy

LM’

LM

Equilibrium is achieved with expansionary

fiscal policy and tight monetary policy

F

8

Z

IS’

5

E

Expansionary

Fiscal Policy

U

2.5

IS

Y

YE=1000

YF=1500

i

LM

F

We could use easy

monetary policy at

point U, but BOP will

be in deficit

8

Z

IS’

5

E

U

2.5

IS

Y

YE=1000

YF=1500

i

LM

F

Or expansionary fiscal

policy, at point Z, but

BOP still in deficit

8

Z

IS’

5

E

2.5

IS

Y

YE=1000

YF=1500

Fiscal and Monetary Policies from External Deficit and Unemployment

- Look at figure 4, at point E the domestic economy is in equilibrium (IS intersects LM), but BOP is not, there is a deficit in BOP (point E is on the RHS of BP. External balance requires Y to be 700 ant i=5%.
- At point B’ there is a deficit in BOP equals excess level of Y time MPM (note X is exogenous), = (1000-7000)× .15 = 45. (in case of foreign repercussions the deficit would be smaller). At Y=1000, interest rate should be 6.5% for capital inflows to be larger by 45 (or less capital outflows by 45), for BOP to be in equilibrium.
- Starting from E the nation can reach full employment level of output YF=1500 with external balance by using expansionary fiscal policy (to shift IS to IS’) and tight monetary policy (to shift LM to the left to LM’, so that i = 9% to achieve balance.
- Note a tight monetary policy was required because the BP curve was steeper than the LM curve.

All markets are in eq.

Equilibrium is achieved with expansionary

fiscal policy and tight monetary policy

BP

LM’

9

F

BOP deficit =(1000-700)×.15=45

LM

6.5

B’

Z

IS’

E

5

B

Unemployment

IS

Y

Y=700

YE=1000

YF=1500

Fiscal and Monetary Policies with Elastic Capital Flows

- Suppose that BP is flatter, and is located to the RHS of the LM as in figure 5.
- At eq., the nation has unemployment and BOP deficit. Internal and external balance can be reached by expansionary fiscal policy (shifts the IS to IS’ as well as easy monetary policy (shifts the LM to LM’), such that LM’ and IS’ intersects BP at F at YF = 1500, where i = 6%.
- As compared with last figure, interest rate has to rise only by 1% instead of 4%.

Equilibrium is achieved with expansionary

fiscal policy and easy monetary policy

LM

LM’

BP

F

6

B’

B

E

IS’

5

unemployment

and BOP deficit

IS

Y

Y=500

YE=1000

YF=1500

Fiscal and Monetary Policy with Perfect Capital Mobility

- With perfect capital mobility, BP will be horizontal, the nation can borrow or lend any desired amount of capital at 5%. This condition is particularly relevant for small open economy.
- In this case the small nation can reach full employment by appropriate fiscal and without monetary policies.
- Look at figure 6. Starting from point E. expansionary fiscal policy shits the IS to IS’. Intersection with LM at E’ indicates a tendency of interest rate to increase to 6.25%. Because of perfect capital mobility, there will be capital inflows from abroad, which increase MS and shifts LM to LM’. There will be an eq. at point F on the horizontal BP, with YF=1500 and i=5%.
- If the small nation attempted to reach eq. by easy monetary policy that shifts LM to LM’, interest will decline to 3.75%, which leads to capital outflows. This reduces MS and LM shifts back to its original level.
- Conclusion: with fixed exchange rates, monetary policy will be ineffective if international capital flows are highly elastic.

Use fiscal policy alone. Higher i causes capital inflows and LM to shift

LM

E’

6.25

LM’

E

F

5

BP

IS’

3.75

E”

IS

Y

YF=1500

YE=1000

Using easy monetary policy alone causes i to fall and

capital outflow shifting LM back. M. policy is ineffective

LM

E’

6.25

LM’

E

F

5

BP

IS’

3.75

E”

IS

Y

YF=1500

YE=1000

The IS-LM-BP Model with Flexible Exchange Rates and imperfect capital mobility

- Look at figure 8. At point E all markets are in equilibrium with external balance and unemployment. When the government uses easy monetary policy to reach full employment at U where YF=1500 and i=2.5%. There is a BOP deficit (Y is higher and i is lower than what is at point E).
- Under flexible exchange rate system, the nation’s currency depreciates, and BOP shits to the right (if ML conditions are satisfied), also the IS to the RHS. Domestic prices increase and LM shifts to LM’ (real money supply declines as a result of higher prices). Equilibrium will be achieved at E’ where all the markets are in eq., but output=1400 and i=4.5% (unemployment still existing).
- Further doses of easy monetary policy eventually lead to equilibrium at full employment. Note that under flexible exchange rate system the BOP shifts due to exchange rate changes.
- If expansionary fiscal policy is used to shift the IS to point Z. Since this point is on the RHS of BOP, there will be a deficit, the national currency depreciates and BOP shifts to the RHS, which induces a further shifts the IS to the RHS and LM to the LHS until IS and LM intersect the BP curve simultaneously at YF=1500.

High Prices shift LM back

Initial shift (easy monetary policy

High Y and low i cause a BOP deficit causing depreciation

FIGURE 8 The IS-LM-BP Model with Flexible Exchange Rates.

The IS-LM-BP Model with Flexible Exchange Rates and perfect capital mobility.

- Starting from point E in figure 9, with domestic unemployment and external balance, perfect capital mobility and flexible exchange rates. Expansionary fiscal policy shifts the IS to IS’ to point F at Y=1500. But this tends to increase i to 6.25% at point E’. This leads to massive capital inflows and appreciation. Exports decrease and imports increase and shifts IS back to it original position (IS). Thus with flexible exchange rates and perfect capital mobility, fiscal policy is completely ineffective at influencing the level of national income.
- An easy monetary policy shifts LM to LM’ which lowers interest to 3.5% at E”. This leads to capital outflows and depreciation, which shifts the IS to IS’ and LM shifts little back to LM” (real MS falls as P increase), such that IS’, LM” and BP cross at point F where Y=1500 (full employment). Internal and external balances are achieved using monetary policy only.
- Thus with flexible exchange rates and perfect capital mobility, monetary policy is effective and fiscal policy ineffective, while both policy are effective under fixed exchange rate system.

Expansionary fiscal policy causes rise in i and

massive capital inflows, appreciation and less

Xn. IS shifts back. Fiscal policy in ineffective

Monetary policy is effective

Capital outflows

and depreciation

FIGURE 9 Adjustment Policies with Perfect Capital Flows and Flexible Exchange Rates.

Policy Mix and External Balance

- The IB line in figure 10 shows the various combinations of fiscal and monetary policies that result in internal balance (full employment and price stability). It is positively related as an expansionary fiscal policy must be balance by a tight monetary policy of a sufficient intensity to maintain internal balance.
- The EB shows the various combinations of fiscal and monetary policies that result in external (BOP) balance. Starting from point F, an expansionary fiscal policy stimulates national income and causes a BOP deficit. This must be balanced by a tight monetary policy that increases interest rates and capital flows for the nation to remain in external balance.
- Following the principle of effective market classification, monetary policy should be assigned to achieve external balance and fiscal policy to achieve internal balance. If the nation did the opposite, it would move farther and farther away from internal and external balance.
- The more responsive international short-term capital flows are to interest rate differentials across nations, the flatter is the EB line in relation to the IB line.

Expansionary fiscal policy leads to a deficit can

be corrected by tight monetary policy (Point A”)

Excess AD and inflation to

Be corrected by tight

Monetary Policy (point A’)

FIGURE 10 Effective Market Classification and the Policy Mix.

Key Terms

- BP curve
- Direct controls
- Exchange controls
- Expenditure-changing policies
- Expenditure-switching policies
- External balance
- Internal balance
- IS curve
- Key Terms
- LM curve
- Multiple exchange rates
- Phillips curve
- Principle of effective market classification
- Speculative demand for money
- Trade controls
- Transaction demand for money

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