Sawye
Sprinkle Chapter 18
Macroeconomic Policy and Floating
Exchange Rates
C h a p t e r XXXXXXXXXX
To accompany
International Economics, 3e by Sawye
Sprinkle
PowerPoint slides created by Jeff Heyl
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Publishing as Prentice Hall
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CHAPTER ORGANIZATION
Introduction
Fiscal and Monetary Policy
Changes in Fiscal Policy
Changes in Monetary Policy
Monetary and Fiscal Policy in an Open Economy
Trade Flow Adjustment and Cu
ent Account Dynamics
Summary
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2
INTRODUCTION
Fiscal and monetary policies are two macroeconomic policies that governments employ to affect domestic output, maintain full employment and price stability
These are the 2 macroeconomic policies used to achieve the 3 goals of any economic policy
These polices have an effect on the exchange rate, the cu
ent account, interest rates, and short-run capital flows within an environment of floating exchange rates
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FISCAL AND MONETARY POLICY
Fiscal policy entails using changes in government taxation and/or spending to affect the level of economic activity GDP
Monetary policy uses changes in the money supply and/or interest rates to affect a county’s GDP
Changes in these policies have predictable effects on the exchange rate, the cu
ent account balance, and short-run capital flows
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FISCAL AND MONETARY POLICY
In this chapter (Ch18) we’ll assume these policies are conducted in a floating exchange rate regime ERR (effects in a fixed ERR are in Ch19)
The assumption is that the government does not employ fiscal and/or monetary policy in an attempt to generate a balanced cu
ent account, but to affect the output and price level
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FISCAL AND MONETARY POLICY
It used to be common practice for governments to focus fiscal and/or monetary policy on obtaining what is known as an external balance
Governments now tend to use monetary and fiscal policy to focus on a country’s internal balance
Internal balance refers to the levels of unemployment and inflation that fit the preferences of the citizens of various economies
The focus on internal balance comes at the expense of external balance considerations
Policies designed to achieve a desired internal balance may have large consequences for a country’s external balance
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CHANGES IN FISCAL POLICY
In most countries, government spending is such a large part of the GDP that any changes can have a critical impact on an economy
Substantial amounts spent on transfer payments mean tax revenues add to this amount
A portion of total government spending is usually financed through bo
owing, thereby having a significant impact on country’s domestic financial markets and interest rates
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CHANGES IN FISCAL POLICY
The demand for loanable funds is the total demand for loans in the economy
It includes private sector demand from the public’s consumption activities that must be financed and business demand for funds for investment
The public sector demand is generated by the government’s need for funds which is the difference between total government spending and total taxes collected
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CHANGES IN FISCAL POLICY
The supply of loanable funds represents the total amount of money available to be bo
owed by the private and public sectors of the economy
This is represented as perfectly inelastic; the amount of loanable funds is not related to the interest rate
In the short-run, the amount of money held in savings by the public determines the supply of loanable fund
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CHANGES IN FISCAL POLICY
Figure 18.1 Supply and Demand for Loanable Funds and Expansionary Fiscal Policy
Interest Rate (i)
ie
Loanable Funds (L)
S
D
E
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CHANGES IN FISCAL POLICY
Expansionary Fiscal Policy
The government adopts an expansionary fiscal policy by choosing to lower tax revenues and/or have higher government spending
This leads to a government budget deficit (or larger deficit)
Assume government bo
ows to finance and does not print money
This will have a predicable effect on interest rates as in Fig 18.1
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CHANGES IN FISCAL POLICY
An expansionary fiscal policy causes an increase in the demand for loanable funds (from D to D’)
In a closed economy, this would cause interest rates to rise (from ie to i’)
In an open economy with freely flowing international capital, the rise in interest rates causes an inflow of capital and an increase in the supply of loanable funds (from S to S’)
This inflow of capital lowers domestic interest rates (from i’ back to ie)
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CHANGES IN FISCAL POLICY
Figure 18.1 Supply and Demand for Loanable Funds and Expansionary Fiscal Policy
Interest Rate (i)
ie
i’
Loanable Funds (L)
F
G
S
D
D’
E
S’
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CHANGES IN FISCAL POLICY
The net result of an expansionary fiscal policy in an open economy is that less upward pressure is put on interest rates than would be the case in a closed economy
A larger federal government budget deficit tends to increase domestic interest rates which causes an inflow of foreign capital into the country
The capital flows have an effect on the equili
ium exchange rate (as described in Ch15)
This effect is shown in Fig. 18.2
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CHANGES IN FISCAL POLICY
Figure 18.2 Effects of Expansionary Fiscal Policy on the Exchange Rate
Exchange Rate (XR)
XRe
XR’
Foreign Exchange (FX)
X
M
S
D
E
S’
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CHANGES IN FISCAL POLICY
In an economy with a balanced cu
ent account, if the government adopts an expansionary fiscal policy and domestic interest rates rise, the inflow of foreign capital requires foreign investors to sell foreign cu
ency to buy dollars
The supply of foreign exchange increases (from S to S’) and the nominal exchange rate appreciates (from XRe to XR’)
The capital inflows encouraged by the higher interest rates will result in a capital account surplus and a cu
ent account deficit (M-X at XR’)
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CHANGES IN FISCAL POLICY
Therefore, an expansionary fiscal policy puts upward pressure on domestic interest rates which leads to an increase in the flow of capital from a
oad into the domestic financial markets leading to an appreciating cu
ency and a cu
ent account deficit
However, we need to consider the effect of an expansionary fiscal policy on the domestic economy (using tools of AD and AS from Ch17)?
In a closed economy, this would lead to an increase in domestic output and price level
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CHANGES IN FISCAL POLICY
Figure 18.3 Effects of Fiscal Policy on Equili
ium Output and Price Level
Price Level (P)
Pe
P’
Real GDP (Y)
Ye
F
AS
AD
E
AD’
Y’
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CHANGES IN FISCAL POLICY
In an open economy, the effects are less clear as an expansionary fiscal policy has two conflicting effects
The policy increases AD as the government reduces taxes and/or increases spending –the direct effect
On the other hand, the policy reduces AD as the exchange rate appreciates and the cu
ent account balance deteriorates – the indirect effect
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CHANGES IN FISCAL POLICY
Figure 18.3 Effects of Fiscal Policy on Equili
ium Output and Price Level
Price Level (P)
Pe
P’
Real GDP (Y)
Ye
AS
AD
AD’
Y’
AD’’
AD’’’
Direct Effect: AD’
Indirect Effect: AD’’/AD’’’
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Direct Effect: Closed Economy Effect
Indirect Effect: Open Economy Effect
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CHANGES IN FISCAL POLICY
The net effect depends on the magnitude of the two effects
Conclusion: Expansionary fiscal policy in an open economy is less effective at changing equili
ium output and price levels than in a closed economy
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CHANGES IN FISCAL POLICY
Contractionary Fiscal Policy
A contractionary fiscal policy would entail some combination of higher taxes and/or lower government spending
This reduces a government budget deficit or increases size of a surplus
Adopting a contractionary fiscal policy causes the overall demand for loanable funds to shrink (from D to D’) and lowers the interest rate (from ie to i’)
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CHANGES IN FISCAL POLICY
Figure 18.4 Supply and Demand for Loanable Funds and Contractionary Fiscal Policy
Interest Rate (i)
ie
i’
Loanable Funds (L)
F
S
D
E
D’
S’
G
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CHANGES IN FISCAL POLICY
The lower domestic interest rate affects capital flow into the country as domestic and foreign investors would tend to invest less domestically and domestic investors would tend to invest more capital a
oad
The net result would be an outflow of capital from domestic economy and the supply of loanable funds would decrease (from S to S’) raising interest rates (from i’ back to ie)
A contractionary fiscal policy puts less downward pressure on domestic interest rates in an open economy than in a closed economy
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CHANGES IN FISCAL POLICY
Figure 18.5 Effects of Contractionary Fiscal Policy on the Exchange Rate
Exchange Rate (XR)
XRe
XR’
Foreign Exchange (FX)
X
S
D
E
D’
M
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CHANGES IN FISCAL POLICY
A contractionary fiscal policy lowers the federal government budget deficit which decreases domestic interest rates and causes an outflow of capital
This increases the demand for foreign exchange (from D to D’) and the exchange rate rises or the domestic cu
ency depreciates (from XRe to XR’)
This causes the capital account to become negative which causes the cu
ent account to become positive (X-M at XR’)
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CHANGES IN FISCAL POLICY
Therefore, a contractionary fiscal policy puts downward pressure on domestic interest rates which leads to an decrease in the flow of capital from a
oad into the domestic financial markets leading to an depreciating cu
ency and a cu
ent account surplus
What about the effects in a closed vs. open economy?
In a closed economy, this would lead to an decrease in domestic output and price level
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CHANGES IN FISCAL POLICY
Figure 18.6 Effects of Fiscal Policy on Equili
ium Output and Price Level