© The McGraw-Hill Companies, 2005 Chapter 29 Open economy macroeconomics David Begg, Stanley...
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Transcript of © The McGraw-Hill Companies, 2005 Chapter 29 Open economy macroeconomics David Begg, Stanley...
©The McGraw-Hill Companies, 2005
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©The McGraw-Hill Companies, 2005
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©The McGraw-Hill Companies, 2005
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©The McGraw-Hill Companies, 2005
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©The McGraw-Hill Companies, 2005
Fixed exchange rates and the loss of monetary
sovereignty
IS
A
LM
r*
Y*Output
Inte
rest
rat
es
The need to match r* leads to a loss of monetary sovereignty
To the consequent capital outflow caused by the r falling below r*, will continue until r* is restored.
LM’Beginning at A, a monetary expansion lowers r to r’, leading to capital outflows.
r’
6©The McGraw-Hill Companies, 2005
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.
7©The McGraw-Hill Companies, 2005
8©The McGraw-Hill Companies, 2005
Fixed exchange rates and fiscal expansion
IS
A
LM
r*
Y*Output
Inte
rest
rat
es
A fiscal expansion leads to a big short-run effect on output i.e. from Y* to Y’.
IS’
Beginning at A, a fiscal expansion shifts the IS curve to IS’.
B
LM’
Y’
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.
9©The McGraw-Hill Companies, 2005
C
Adjustment towards e2 takes place along BC as wages and pricesbecome more flexible.
Monetary policy under floating exchange
rates
Time
e
e1
Suppose the economy begins in equilibrium with the nominal exchange rate at e1.
t
A
At time t, nominal moneysupply is halved...
e2
e2 will be the new equilibriumexchange rate once the economy has adjusted
But prices are sluggish, soin the short run, real money supply falls and domestic interest rates rise.
e3B
These higher rates push theexchange rate to e3.
10©The McGraw-Hill Companies, 2005
11©The McGraw-Hill Companies, 2005
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.
12©The McGraw-Hill Companies, 2005
13©The McGraw-Hill Companies, 2005
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©The McGraw-Hill Companies, 2005
Further Reading
• Ercan KUMCU: “Kafamızın Karışık Olduğu Konular” August 14, 2007
http://www.hurriyet.com.tr/yazarlar/7080158.asp