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Macroeconomic Policy in An Open Econolny: - Chapter

international economics ii

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46 views2 pages

Macroeconomic Policy in An Open Econolny: - Chapter

international economics ii

Uploaded by

Gebyaw Demeke Aniley
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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• Chapter 4.

Macroeconomic Policy in an
Open Econolny
4.1 Introduction 75 4.9 Internal and External
4.2 The Problem of Internal Balance 88
and External Balance 76 4.10 Internal and External
4.3 The Mundell- Fleming Balance Under Fixed
Model 79 Exchange Rates 91
4.4 The Derivation of the IS 4.11 Internal and External
Schedule for an Open Balance Under Floating
Economy 79 Exchange Rates 92
4.5 The Derivation of the LM 4.12 A Small Open Economy
Schedule for an Open with Perfect Capital
Economy 81 Mobility 95
4.6 The Derivation of the BP 4.13 The Principle of Effective
Schedule for an Open Market Classification 98
Economy 83 4.14 Limitations of rhe
4.7 Equilibrium of the Model 86 Mundell- Fleming Model 101
4.8 Factors Shifting the 4.15 Conclusions 103
IS- LM- BP Schedules 86

• 4.1 Introduction
In Chapter 3 we looked at some of the fundamental identities for an open
economy and considered the possible effect of devaluation on the current
account. It was noted that the ultimate impact of a devaluation will in
large part be dependent upon the economic policies that accompany the
devaluation. In this chapter we shall be examining how both exchange-rate
changes and macroeconomic policies impact upon an open economy. A
fundamental difference between an open economy and a closed economy is
that over time a country has to ensure that there is an approximate balance
in its current account. This is because no country can continuously build
up a stock of net liabilities to the rest of the world by running a continuous
current account deficit. Conversely, it does not make sense for a surplus
country to continuously build up a stock of net claims on the rest of the
world; eventually it will wish to spend those claims.
The need for economic policy-makers to pay attention to the implica-
tions of changes in monetary and fiscal policy on the balance of payments
is an important additional dimension for consideration in the formulation

75
K. Pilbeam, International Finance
© Keith Pilbeam 1998
76 Balance-of-Payments Theory and Policy

of economic policy in an open economy. Ensuring a sustainable balance-


of-payments position over time is an important economic objective to go
along with high economic growth, low unemployment and low inflation.
One of the additional policy choices that has to be made by the
authorities of an open economy is to decide whether to fix the exchange
rate, allow it to float, or perhaps to choose some arrangement between
these two extremes. The choice between these two regimes is the focus of
analysis of Chapter 10; in this chapter we concentrate upon how fiscal and
monetary policies operate under both regimes.

1 4.2 The Problem of Internal and External


Balance
To appreciate the development of the postwar literature on open econo-
mies readers need to bear in mind that between 1948 and 1973 the
international monetary system was one of fixed exchange rates, with the
major currencies being pegged to the US dollar. Only in cases of 'funda-
mental disequilibrium' were authorities allowed to devalue or revalue their
currency. This meant that there was considerable interest in the relative
effectiveness of fiscal and monetary policies as a means of influencing the
economy. Although economic policy-makers generally have many macro-
economic aims, the discussion in the 1950s and 1960s was primarily
concerned with two objectives. The principal goal was one of achieving
full employment for the labour force along with a stable level of prices
which may be termed internal balance. Although governments were
generally committed to achieving full employment, it is widely recognized
that expanding output in an open economy will have implications for the
balance of payments. For instance, expanding output and employment will
result in greater expenditure on imports and consequently will lead to a
deterioration of the current account. As authorities had agreed to maintain
fixed exchange rates, they were interested in running an equilibrium in the
balance of payments; that is, balance in the supply and demand for their
currency. This latter objective can be termed external balance.
Changes in fiscal and monetary policies which aim to influence the level
of aggregate demand in the economy are termed expenditure changing
policies. Whereas policies such as devaluation/revaluation of the exchange
rate which attempt to influence the composition of spending between
domestic and foreign goods are known as expenditure switching policies.
Much of the 1950s and 1960s literature was concerned with how the
authorities might simultaneously achieve both internal and external
balance. The policy problem of achieving both was conceptualised by
Trevor Swan (1955) in what is known as the Swan diagram, which is
depicted in Figure 4.1. On the vertical axis is the real exchange rate,

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