30- 1

ECONOMICS
TENTH EDITION

LIPSEY &
CHRYSTAL
Chapter 30

MACROECONOMIC POLICY
IN AN OPEN ECONOMY

Slides by
Alex Stojanovic
30- 2 Learning Outcomes
• Openness of the economy matters, as international factors
directly affect real demand, world financial forces influence
domestic financial markets, and the exchange rate regime
affects the policy choices that are available.
• Monetary policy is powerless to affect domestic aggregate
demand under a fixed exchange rate regime when capital
is perfectly mobile.
• The exchange rate is an important element of the
monetary transmission under a floating rate regime.
• The effects of fiscal policy depend on the exchange rate
regime and the monetary policy rule that is used.
• The long-run impact of fiscal policy is mainly on the trade
balance.
• Financial and spending linkages between economies
cause business cycles to have similar patterns in many
major economies.
30- 3
Interest Rate The Macroeconomic Implications of Perfect Capital Mobility

i = i* BB

Real GDP
30- 4
Interest Rate The Macroeconomic Implications of Perfect Capital Mobility

i = i* BB

IS

Real GDP
30- 5 The Macroeconomic Implications of Perfect Capital Mobility

LM
Interest Rate

i = i* BB

IS

Real GDP
30- 6 The Macroeconomic Implications of Perfect Capital Mobility

 With perfect capital mobility the domestic interest rate

must be equal to foreign interest rate in equilibrium.
 The BB line shows the combinations of interest rates and
GDP for which a current account surplus (deficit) equals
the associated capital outflow (inflow).
 The BB line is drawn horizontally at the point where the
domestic interest rate is equal to the foreign rate i*.
 The shape of BB means that any size of current account
deficit can be financed by borrowing at the going interest
rate on world capital markets.
30- 7
Interest Rate Monetary Policy With Fixed Exchange Rates and Perfect Capital Mobility

i* BB

Real GDP
30- 8
Interest Rate Monetary Policy With Fixed Exchange Rates and Perfect Capital Mobility

i*
BB

IS

Real GDP
30- 9 Monetary Policy With Fixed Exchange Rates and Perfect Capital Mobility

LM0
Interest Rate

i*
BB

IS

Y*
Real GDP
30- 10 Monetary Policy With Fixed Exchange Rates and Perfect Capital Mobility

LM0

1 LM1

2
Interest Rate

i*

IS

Y*
Real GDP
30- 11 Monetary Policy With Fixed Exchange Rates and Perfect Capital Mobility

 Monetary policy is powerless to influence economic activity

under fixed exchange rates and perfect capital mobility.
 An attempted cut in domestic interest rates increases the
money supply and shifts the LM curve to the right from LM0 to
LM1.
 However, the smallest fall in domestic interest rates causes a
massive desired capital outflow. This puts downward pressure
on the exchange rate.
 The monetary authorities are forced to buy sterling
immediately in order to stop the exchange rate failing, and the
LM curve shifts back to its original position, LM0.
30- 12 Fiscal Policy With Fixed Exchange Rates and Perfect Capital Mobility
LM0
LM2
LM1

Interest Rate
i* BB

IS1
IS2

IS0

GDP Y* Y1 Y2
0 (i). IS/LM

SRAS1
LRAS
SRAS0

P1
Price Level

P0

AD1
AD0

0 GDP Y* Y1 Y2 (ii). AS/AD

30- 13 Fiscal Policy With Fixed Exchange Rates and Perfect Capital Mobility
 Starting from full equilibrium, an increase in government spending creates
a significant stimulus to real activity in the short run, but in the long run it
leads to a higher price level and a current account deficit.
 The increase in government spending shifts the IS curve from IS 0 to IS1 in
part (i). With a given money supply this puts upward pressure on
domestic interest rates. The slightest rise in domestic interest rates
causes a massive capital inflow, which puts upward pressure on the
exchange rate.
 To stop the exchange rate rising, the monetary authorities sell sterling in
the foreign exchange market. This increases the money supply and shifts
the LM curve to the right, from LM 0 to LM1. The combined effect of the IS
and LM curves shifting is that AD shifts right, from AD 0 to AD1, as shown
in part (i).
30- 14Fiscal Policy With Fixed Exchange Rates and Perfect Capital Mobility
 The increase in aggregate demand causes GDP to increase from Y* to Y 1
in the short run, and there is a small initial increase in the price level. (This
price level rise shifts the IS and LM curves slightly leftward to IS 2 and LM2
so that they intersect at Y1 rather than Y2.) Net exports become negative.
 In the long run inflationary pressure causes the price level to rise to P 1 as
the SRAS curve shifts up to SRAS 1 and GDP returns to Y*.
 However, the sustained rise in the price level (for given foreign prices)
causes a permanent trade deficit, which is equal to the budget deficit.
 At price level P1 the real money supply has fallen, so the LM curve shifts
back to LM0. The higher price of domestic goods causes net exports to shift
downwards, so IS also shifts back to its original position, IS 0.
30- 15 Monetary Policy with Floating Exchange Rates and Perfect Capital Mobility
LM0 LM1

Interest Rate
i* BB

IS1
(i). IS/LM

IS0

0
Y* GDP

LRAS
SRAS1

SRAS0

P1
Price Level

P0
(ii). AS/AD

AD1

AD0
0 GDP Y* Y1
30- 16 Monetary Policy with Floating Exchange Rates and Perfect Capital Mobility

 Starting at full equilibrium, a monetary loosening causes an output

boom in the short run but in the long run causes only higher prices
and currency depreciation.
 The LM curve shifts to the right. Any fall in domestic interest rates
causes the exchange rate to depreciate to a point from which it is
expected to appreciate.
 This involves overshooting and a fall in the real exchange rate.
 This fall in the real exchange rate shifts the net export function
upwards, so, as part (i) shows, there is a shift in the IS curve from
LM0 to LM1.
 The combined effect of these two shifts on aggregate demand is
shown in part (ii) as the shift from AD0 to AD1.
30- 17 Monetary Policy with Floating Exchange Rates and Perfect Capital Mobility

 The increase in aggregate demand creates and inflationary gap. GDP

increases from Y* to Y1 in the short run, and the price level starts to rise to
the level indicated by the intersection of AD1 and SRAS0.
 Eventually inflationary pressure works through to input prices, and the
short-run aggregate supply curve shifts upwards to SRAS1.
 The price level rises to P1 and GDP falls back to Y*.
 The LM curve shifts back to LM0 as the rise in price level reduces the real
money supply.
 The IS curve shifts back to IS0 as higher domestic prices raise the relative
price of domestic goods and the net export function shifts downwards.
 The long run outcome is an increase in the prices but the same real GDP.
30- 18
Interest Rate Fiscal Policy With Floating Exchange Rates and Perfect Capital Mobility

i* BB

Y*
GDP
30- 19 Fiscal Policy With Floating Exchange Rates and Perfect Capital Mobility

LM
Interest Rate

i* BB

Y*
GDP
30- 20 Fiscal Policy With Floating Exchange Rates and Perfect Capital Mobility

LM
Interest Rate

i* BB

IS0

Y*
GDP
30- 21 Fiscal Policy With Floating Exchange Rates and Perfect Capital Mobility

LM

1
Interest Rate

i* BB

2
IS1

IS0

Y*
GDP
30- 22 Fiscal Policy With Floating Exchange Rates and Perfect Capital Mobility

 Starting at full equilibrium, a fiscal expansion leads to a

currency appreciation which crowds out an equivalent
volume of net exports, causing a current account deficit
but little or no stimulus to GDP.
 The initial increase in government spending shifts the IS
curve to the right from IS0 to IS1.
 But the resulting appreciation of the exchange rate (real
and nominal) shifts the net export function downwards,
which shifts the IS curve back to the left.
30- 23 MACROECONOMIC POLICY IN AN OPEN ECONOMY

Why Does Openness Matter?

• Openness of the economy matters because
trade and capital flows influence real activity,
international financial markets influence
domestic money markets, and the exchange rate
regime determines which monetary instruments
are available to the authorities.
30- 24 MACROECONOMIC POLICY IN AN OPEN ECONOMY
Macro Policy in a World with Perfect Capital Mobility

• Perfect capital mobility can be represented by a horizontal BB line in

the IS/LM diagram.
• Under fixed exchange rates and perfect capital mobility an
expansionary monetary policy is rapidly reversed through losses of
foreign exchange reserves. It has no real impact.
• Starting from equilibrium GDP, an increase in government spending,
with floating exchange rates and perfect capital mobility, creates little
or no stimulus to real GDP if the money stock is held constant; but it
does create a temporary stimulus if the interest rate is held constant.
• In the long run in both cases it leads to a real exchange rate
appreciation and a trade deficit.
30- 25 MACROECONOMIC POLICY IN AN OPEN ECONOMY

• The budget deficit and the trade deficit are

of equal size.
• Starting with recessionary gap, both
monetary fiscal policies can speed up the
return to potential GDP if they are timed
correctly.
• Fiscal policy can be used to increase final
demand, while monetary policy can lower
interest rates and/or the exchange rate.
30- 26 MACROECONOMIC POLICY IN AN OPEN ECONOMY

Some Implications
• The transmission mechanism of monetary
policy and the efficacy of fiscal policy are
both affected by openness and mobility.
• Financial and expenditure linkages
between economies mean that business
cycles are a global phenomenon, and
cycles in one country are often closely
related to cycles in other important
economies.