International Economics

By Robert J. Carbaugh
8th Edition

Chapter 17:
Macroeconomic Policy in an
Open Economy

Copyright 2002, South-Western College Publishing

Open economy macro policy

Policy in an open economy

Countries which are open to the world economy
cannot make domestic economic policy choices
without considering the impact on trade and
payments and their international relationships
Nor can open economies entirely insulate
themselves from other countries policy choices
As a result, nations make efforts to coordinate their
international economic policies
Economic policies are also subject to domestic
and foreign institutional constraints
Carbaugh, Chap. 17

Open economy macro policy

Economic objectives
Internal balance
Fully employed economy
Little or no inflation

External balance
Current account is close enough to balance
that foreign debts can be repaid (deficit) or that
other nations can repay their debts (surplus)

Carbaugh, Chap. 17

Open economy macro policy

Policy instruments
Expenditure-changing policies: alter aggregate
demand for goods
fiscal policy
Monetary policy

Expenditure-switching policies: shift demand

to/from imports or domestic goods
Devaluation or revaluation (fixed rates)
Exchange market intervention (managed float)

Direct controls
Tariffs, quotas, subsidies, capital controls
Carbaugh, Chap. 17

Open economy macro policy

Economic objectives and macro policy

Carbaugh, Chap. 17

Open economy macro policy

Exchange rate policies & overall balance

If a nation was experiencing recession and
a BOP deficit, a currency devaluation would
encourage exports and help boost
domestic production
If it were experiencing inflation and a BOP
surplus, a revaluation would cut back on
exports and cool domestic spending

Carbaugh, Chap. 17

Open economy macro policy

Exchange rate & overall balance (contd)

Such policy moves are not made in a
vacuum; one countrys devaluation
effectively means a revaluation for its main
trading partners
If done without international consultation,
these policy shifts might invite retaliation
(as occurred during the Great Depression)

Carbaugh, Chap. 17

Open economy macro policy

Fiscal & monetary policy: internal effects

Fiscal and monetary policy are generally used to
achieve internal balance, but their effectiveness
depends on the external sector
Under a fixed exchange rate system, fiscal policy
is more successful in promoting internal balance
than is monetary policy
Under a floating rate system, monetary policy is
more effective than fiscal policy at achieving
internal balance
Carbaugh, Chap. 17

Open economy macro policy

Fiscal policy: short run internal effects

Under fixed exchange rates
Aggregate
demand
rises
Increase in
government
spending

Monetary
demand and
interest
rates
increase

Output and
employment rise

Net
capital
inflows

Central bank
sells
currency and
money
supply rises

Output and
employment rise
further

Assumes high degree of capital mobility

For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17

Open economy macro policy

Fiscal policy: short run internal effects

Under floating exchange rates
Aggregate
demand
rises
Increase in
government
spending

Monetary
demand and
interest
rates
increase

Imports rise
and trade
account
worsens

Output and
employment
rise

Net
capital
inflows

Decrease in
aggregate
demand, output,
employment

Currency
appreciation

Assumes high degree of capital mobility

For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17

10

Open economy macro policy

Monetary policy: short run internal effects

Under floating exchange rates
Money
supply
increases

Aggregate
demand
rises

Output and
employment rise

Interest
rate
falls
Net
capital
outflows

Currency
depreciates

Exports
rise and
trade
account
improves

Output and
employment rise
further

Assumes high degree of capital mobility

For contractionary monetary policy, reverse all changes
Carbaugh, Chap. 17

11

Open economy macro policy

Monetary policy: short run internal effects

Under fixed exchange rates
Money
supply
increases

Aggregate
demand
rises

Interest
rate
falls
Net
capital
outflows

Output and
employment rise

Central
bank
purchases
currency

Money
supply
decreases

Output and
employment fall

Assumes high degree of capital mobility

For contractionary monetary policy, reverse all changes
Carbaugh, Chap. 17

12

Open economy macro policy

Fiscal & monetary policy: external effects

Since floating rates foster BOP equilibrium, focus
is on fixed rates
In short run, monetary policy has a clear effect on
BOP
Expansion worsens BOP balance
Contraction improves BOP balance

Short run effects of fiscal policy are not certain they depend on capital mobility

Carbaugh, Chap. 17

13

Open economy macro policy

Monetary policy: short run external effects

Aggregate
demand
rises
Money
supply
increases

Trade
account
worsens

Interest
rates
fall

Overall BOP
worsens
Net capital
outflows

Capital
account
worsens

Assumes high degree of capital mobility

For contractionary fiscal policy, reverse all changes
Carbaugh, Chap. 17

14

Open economy macro policy

Fiscal policy: short run external effects

Aggregate
demand
rises

Trade
account
worsens

Increase in
government
spending

Overall BOP
may improve
Money
demand
rises

Interest
rates
rise

Net
capital
inflows

For contractionary fiscal policy, reverse all changes

Carbaugh, Chap. 17

15

Open economy macro policy

Policy agreement and policy conflict

Monetary policy
If a nation has unemployment with a BOP surplus, or
inflation with a BOP deficit, an increase/decrease in the
money supply will restore both internal and external
balances
But if a nation has unemployment with a BOP deficit, or
inflation with a BOP surplus, a policy aimed at solving
one problem will worsen the other

Fiscal policy - effects are unclear under those

circumstances
Carbaugh, Chap. 17

16

Open economy macro policy

Policy agreement and conflict (contd)

In such cases where policy aims do conflict, some
combination of fiscal and monetary policy
measures will be necessary
Some imbalances are even more intractable,
such as the case where a nation experiences
both inflation and unemployment along with a
BOP imbalance, and require a wider range of
policy instruments

Carbaugh, Chap. 17

17

Open economy macro policy

International policy coordination

Domestic economic policy moves can spill
over to affect other countries
Major industrial nations have worked to
coordinate economic policy so that external
balances are maintained without sacrificing
domestic objectives

Carbaugh, Chap. 17

18

Open economy macro policy

International policy coordination

Annual Group of Seven (G-7) economic
summits
Regular meetings of central bank heads at
the Bank for International Settlements
Major international policy agreements, such
as the Smithsonian Agreement (1971);
Bonn Summit (1978); Plaza Accord (1985);
Louvre Accord (1987)
Carbaugh, Chap. 17

19