Ch 17 – Macroeconomic Policy in an Open Economy: Ch 17 – Macroeconomic Policy in an Open Economy “It’s simple economics, son . . .I don’t understand it at all.” Kenny’s Dad, Southpark


Slide2: Ch 17 – Macro Policy Internal Balance Fully employed economy Little or no inflation External Balance Neither balance of payments (BOP) deficits or surpluses BOP deficit = Current account deficit > financial acct surplus BOP surplus = Current account surplus > financial acct deficit In BOP equilibrium, current account is neither so deeply in debt that home nation can’t repay debts, or so strong in surplus that foreign nations can’t repay debt to home nation.


Slide3: Ch 17 – Macro Policy Internal Balance Fully employed economy Little or no inflation External Balance Neither balance of payments (BOP) deficits or surpluses Macroeconomic policymakers seek both internal and external equilibria. Policy agreement – economic policy eliminates internal and external disequilibria. Policy conflict – economic policy helps one, hurts the other.


Slide4: Ch 17 – Macro Policy Policy Instruments Expenditure Changing policies Alter level of aggregate demand for goods and service, both foreign and domestic Fiscal policy Monetary policy Expenditure Switching policies Modify direction of demand, shifting between domestic output and imports Expenditure direction is a function of exchange rate Depreciation/appreciation of currencies Direct controls Government restrictions on market economy, ie tariffs, wage and price controls, ceilings and floors.


Slide5: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D


Slide6: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D Expenditure Switching (Exchange Rate) Policy Assume economy is in recession with BOP deficit. Depreciating currency will increase competitiveness of domestic goods, increasing exports relative to imports, reducing BOP deficit (moving up toward external balance). Increased exports will inject income and spending into economy, encouraging production and reducing unemployment (moving right toward internal balance).


Slide7: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D Mundell’s Assignment Rule: Assign to fiscal policy the task of stabilizing the domestic economy only, and assign to monetary policy the task of stabilizing the BOP only. Expansionary Contractionary


Slide8: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D Mundell’s Assignment Rule: Assign to fiscal policy the task of stabilizing the domestic economy only, and assign to monetary policy the task of stabilizing the BOP only. Expansionary Contractionary Easier monetary policy, Easier fiscal policy Tighter monetary policy, Easier fiscal policy Easier monetary policy, tighter fiscal policy Tighter monetary policy, tighter fiscal policy


Slide9: Ch 17 – Macro Policy Effectiveness of Monetary/Fiscal Policies: Promoting Internal Balance Promoting External Balance


Slide10: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D Policy Agreement – Policies lead to internal and external balance. Policy Conflict – policies do not work together for internal and external balance. Example: Unemployment with BOP surplus, and Inflation with BOP deficit are policy agreement zones for monetary policy. A and C are zones of policy conflict. Expansionary Contractionary


Slide11: Ch 17 – Macro Policy Unemployment (Recession) Inflation Rate BOP Surplus (in billions) BOP Deficit (in billions) 0 3% 6% 3% 6% 50 50 100 100 A C B D What if economy suffers from “stagflation”? Unemployment AND inflation – may need direct controls. In 1970’s, Nixon administration used wage and price controls, currency devaluation, to achieve internal and external balance. Expansionary Contractionary