LECTURE

FIFTEEN

15

International Economics

15. Open-Economy Macroeconomics: Adjustment Policies

Mathew Joseph FORE School of Management
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
1

In this lecture:
Introduction
Internal and External Balance with

Expenditure-Changing and ExpenditureSwitching Policies Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments Fiscal and Monetary Policies for Internal and External Balance with Fixed Exchange Rates
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
2

In this lecture:
The IS-LM-BP Model with Flexible Exchange

Rates Policy Mix and Price Changes Direct Controls

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Introduction
The need for adjustment policies arises

because the automatic adjustment mechanisms have serious unwanted side effects.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Introduction
National objectives

Internal balance Non-accelerating inflationary rate of unemployment (NAIRU) External balance Sustainable balance of payments A reasonable rate of growth An equitable distribution of income Adequate environmental protection
5

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Internal and External Balance with Expenditure-Changing and ExpenditureSwitching Policies

Expenditure changing policies

Fiscal and monetary policy tools to alter the level of aggregate expenditures in the economy. Devaluation or revaluation of the exchange rate to alter the balance of spending on domestic and foreign goods and services.

Expenditure switching policies

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Internal and External Balance with Expenditure-Changing and ExpenditureSwitching Policies

Internal imbalances

Inflation imbalance

Assumed to be caused by excess aggregate demand. Caused by insufficient aggregate demand

Recession imbalance

External imbalances

A deficit in the balance of payments A surplus in the balance of payments

7

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Internal and External Balance with Expenditure-Changing and ExpenditureSwitching Policies

Possible situations

External surplus and internal unemployment External surplus and internal inflation External deficit and internal inflation External deficit and internal unemployment

It is possible that the policies available for

correcting the imbalances may improve one situation only at the expense of worsening another.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
8

FIGURE 15-1 Swan-Salter Diagram

Vertical axis measures exchange rate (an increase in R is devaluation and decrease revaluation) and horizontal axis measures real domestic expenditure or absorption. Points on EE curve refer to external balance, with points to the left indicating external surplus and points to the right external deficit. Points on the YY curve refer to internal balance, with points to the left indicating unemployment and points to the right indicating inflation. The intersection of EE and YY curves defines four zones of external and internal imbalance. This helps to determine the appropriate policy mix to reach external and internal balance simultaneously at point F.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Equilibrium in the Goods Market, in the Money Market and in the Balance of Payments
Goods market equilibrium

When quantities of goods and services demanded and supplied are equal. When quantity of money demanded for transactions and speculation is equal to given supply of money. When trade deficit is matched by an equal net capital inflow or trade surplus is matched by equal net capital outflow.
10

Money market equilibrium

Balance of payments equilibrium

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Equilibrium in the Goods Market, in the Money Market and in the Balance of Payments
The Mundell-Fleming model shows how

nation can use monetary and fiscal policy to achieve internal and external balance without a change in exchange rates.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

11

Equilibrium in the Goods Market, in the Money Market and in the Balance of Payments The IS, LM and BP curves show various combinations of interest rates and national income at which the goods market, the money market and the balance of payments, respectively, are in equilibrium.
IS LM BP Goods market equilibrium Money market equilibrium Balance of payments equilibrium Negatively sloped Positively sloped Positively sloped

IS-LM-BP model workhorse of economic policy formulation for open economies during past 4 decades
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
12

FIGURE 15-2 Equilibrium in the Goods and Money Markets and in the Balance of Payments
IS, LM and BP curves show various combinations of interest rates and national income at which goods market, money market and nations balance of payments, respectively, are in equilibrium. IS curve negatively inclined and LM curve positively inclined . BP curve is positively inclined because higher incomes (and imports) require higher interest rates (and capital flows) for the nation to remain in balance-of-payments equilibrium. All markets are in equilibrium at point E, where the IS, LM and BP curves crosses at i=5%, and YE=1000. However, YE<YF, the fullemployment level of national income.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

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

From unemployment / external balance:

Expansionary fiscal policy Tight monetary policy No change in exchange rate

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

14

FIGURE 15-3 Fiscal and Monetary Policies from Domestic Unemployment and External Balance
Starting from point E with domestic unemployment and external balance, the country can reach full employment income of YF=1500 with external balance by pursuing expansionary fiscal policy that shifts IS curve to the right to IS and tight monetary policy that shifts LM curve to the left to LM, while holding the exchange rate fixed. All three markets are then in equilibrium at point F, where curves IS and LM cross on the unchanged BP curve at i=8% and YF=1500.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

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

From unemployment / external deficit:

Inelastic capital mobility Expansionary fiscal policy Tight monetary policy Elastic (high) capital mobility Expansionary fiscal policy Easy monetary policy Perfect capital mobility Expansionary fiscal policy Monetary policy is ineffective
16

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 15-4 Fiscal and Monetary Policies from Domestic Unemployment and External Deficit
Starting from point E with domestic unemployment and external deficit, the country can reach full employment income of YF=1500 with external balance by pursuing expansionary fiscal policy that shifts IS curve to the right to IS and tight monetary policy that shifts LM curve to the left to LM, while keeping exchange rate fixed. All three markets are in equilibrium at point F, where curves IS and LM cross on the unchanged BP curve at i=9% and YF=1500. Because of the original external deficit, the country now requires a higher interest rate than in Fig . 15.3 to reach external and internal balance.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 15-5 Fiscal and Monetary Policies with Elastic Capital Flows
Starting with point E with domestic unemployment and external deficit, the nation can reach full employment level of income of YF=1500 with external balance by pursuing expansionary fiscal policy that shifts IS curve to the right to IS and easy monetary policy that shifts LM curve to the right to LM, while keeping exchange rate fixed. All three markets are then in equilibrium at point F, where curves IS and LM cross on the unchanged BP curve at i=6% and YF=1500. Since international capital flows are much more elastic than in the previous case (Fig. 15.4), interest rate needs to rise from i=5% to i=6%, instead of to i=9% in the earlier case.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 15-6 U.S. Current Account and Budget Deficits as a Percentage of GDP, 1980-2005
From 1980 to 1989 and 2002 to 2003, the US current account deficit and US budget deficit, as a percentage of GDP, moved together as twins, but they moved in opposite direction in other years. From the equation: (G-T)=(S-I)+(M-X), the two deficits move together only if (S-I) stays the same.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 15-7 Fiscal and Monetary Policies with Perfect Capital Mobility and Fixed Exchange Rates
Starting from point E with domestic unemployment and external balance, and perfect capital mobility and a fixed exchange rate, the nation can reach the full-employment level of national income of YF=1500 with expansionary fiscal policy that shifts the IS curve to the right to IS and with the LM curve shifting to the right to LM because of capital inflows that the nation is unable to neutralize.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The IS-LM-BP Model with Flexible Exchange Rates

Achieving Internal and External Balance

From unemployment / external balance:

Imperfect capital mobility Expansionary fiscal policy Easy monetary policy Perfect capital mobility Expansionary monetary policy Fiscal policy is ineffective

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

21

FIGURE 15-8 The IS-LM-BP Model with Flexible Exchange Rates

Starting from point E, where all three markets are in equilibrium with external balance and domestic unemployment, the nation could use easy monetary policy to shift LM curve to right to LM so as to cross IS curve at point U and reach full employment income of YF=1500. However, since U is to the right of BP curve, nation is in external deficit. With flexible exchange rates, currency depreciates and BP and IS curves shift to the right and LM curve to left (as a result of rising domestic prices) until BP, IS and LM cross at E, with YE=1400. The process repeats with additional doses of easy monetary policy and further depreciation until all three markets are in equilibrium at YF=1500.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 15-9 Adjustment Policies with Perfect Capital Flows and Flexible Exchange Rates
Starting from point E with domestic unemployment and external balance, and perfectly elastic capital flows and flexible exchange rates, the nation can reach full-employment national income level of YF=1500 with easy monetary policy that shifts LM curve to right to LM. This causes IS curve to shift to right to IS (as currency tends to depreciate and that improves trade balance) and LM curve back part of the way to LM (as real money supply declines with rise in domestic prices). Final equilibrium at point F where IS and LM curves cross BP curve at YF=1500. Thus, with perfect capital mobility, monetary policy is effective and fiscal policy ineffective with flexible exchange rates, while fiscal policy is effective and monetary policy ineffective with fixed exchange rates.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Policy Mix and Price Changes

Inflation and surplus Contractionary fiscal policy Easy monetary policy Recession and surplus Expansionary fiscal policy Inflation and deficit Contractionary fiscal policy

Recession and deficit Expansionary fiscal policy and contractionary monetary policy
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
24

Policy Mix and Price Changes

With fixed exchange rates, fiscal policy tends to

be more effective than monetary policy.

With flexible exchange rates, monetary policy

tends to be more effective than fiscal policy.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

25

FIGURE 15-10 Effective Market Classification and the Policy Mix

Moving right on the horizontal axis refers to expansionary fiscal policy, while moving upward along vertical axis refers to tight monetary policy and higher interest rates. Various combination of fiscal and monetary policies that result in internal balance are given by IB line, and those that result in external balance are given by EB line. EB line is flatter than IB line because monetary policy also induces short-term international capital flows. Starting from point C in zone IV, nation should use expansionary fiscal policy to reach point C 1 on IB line and then tight monetary policy to reach point C2 on EB line, on its way to point F, where the nation is simultaneously in internal and external balance. If done opposite, it moves to point C 1 on EB line and then to C2 on IB line, moving farther away from point F.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Direct Controls
Trade Controls

Tariffs, quotas and other quantitative restrictions on the flow of international trade.

An import tariff and export subsidy of a given percentage applied across the board on all goods are equivalent to a devaluation of the currency by the same percentage.
Import tariffs and export subsidies are expenditure-switching policies, stimulate domestic production.
27

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Direct Controls
Exchange Controls

Restrictions on international capital flows, multiple exchange rates.

Nations sometimes restrict capital exports when in balance of payments deficit and capital imports when in surplus.
Higher exchange rates on luxuries and nonessentials discourages their importation, while lower exchange rates on essential imports encourage their import.
28

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Direct Controls
For direct controls to be effective, a great deal

of international cooperation is required.

Imposition of import quotas may result in retaliation if affected nations are not consulted.

Further, the use of many direct controls (for

instance, tariffs and non-tariff barriers) is constrained by international treaties such as GATT.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.
29