Macroeconomic Policies in an Open Economy

Keynesian Model of a Closed Economy

Assume:
(i) prices and wages are inflexible
(ii) unemployment exists in the labor market.

Y = C + I + G + (X - M)

C = C(Y), C' > 0

I = Io

G = Go

(ii) Y = C + S + T

Equilibrium condition:

I + G + X = S + T + M

(a) No government:

I + X = S + M

(b) No foreign sector

I = S.

Investment Multiplier: ΔY/ΔI

Y = a + bY + I

Y = (a + I)/(1 - b)

multiplier = 1/(1 - b)

b = marginal propensity to consume

Figure 1. Equilibrium in a closed economy.

Open Economy

(i) small country

Y = a + bY + I + X - mY

Y = (a + I + X)/(1 - b + m)

Foreign trade multiplier mX = 1/(1 - b + m)

= 1/(s + m) < 1/(1 - b)

For instance, if b = 0.9, the multiplier is 10 in a closed economy. If m = 0.1, then it reduces to 5. Thus, the open economy multiplier is very sensitive to the marginal propensity to import.

(ii) large country

Y = a + bY + I + m*Y* - mY

Y* = a* + b*Y* + I* + mY - m*Y*

multiplier = 1/[s + m - mm*/(s* + m*)] > 1/(s + m)

The multiplier for a large country is greater than that for a small country.

A General Model

From this point on, real variables are denoted by lowercase letters, and nominal variables by capital letters. Real variables are nominal values divided by Price level. For example, md = Md/P (Real money demand = Nominal money demand/Price level).

The Closed Economy

A simple model of the domestic economy consists of the output sector and money market.

Product market equilibrium requires

y = c(y) + i(r) + g

         Aggregate demand for domestically produced good is the sum of consumption, investment and government spending. If aggregate demand falls short of aggregate supply (y), not all goods are sold and unsold outputs will be held as unintended inventories. On the other hand, if aggregate demand exceeds the annual real output, inventories will decumulate. (The actual output sold is always less than or equal to current output plus the inventories.) When the aggregate demand is equal to the current output, the resulting inventories are exactly equal to the level of planned inventories, and hence the product market is in equilibrium. This yields IS curve, which is the locus of income and interest rate that clears the product market.

          The IS curve would be relatively steep if a large change in interest rate is required to offset the effect of a small change in income. This happens when investment is sensitive to interest changes.

Shifts of IS curve

Since this graph has only two dimensions, r, y, only their relationship can be shown. If any other factor varies, it causes a shift in the IS curve.

(i) an expansionary fiscal policy, or an increase in foreign borrowing increase income at a given interest rate.

Figure 2, IS and LM curves

Money Market

Real Money supply Ms/P = speculative + transactions + precautionary demand.
Transations demand for money is proportional to income, and hence can be expressed as k(Y+). Speculative demand and precautionary demand are inversely related to interest rate. Thus, both components can be combined and represented by: L(r¯).
 

two components: (Nominal) Money demand = L(r¯) + kPy

(Real) Money demand = ℓ(r¯) + ky, k > 0.

Money market equilibrium requires:

Ms/P = ℓ(r¯) + ky

          Classical economists assumed that economies would operate at full employment because prices and wages are flexible. If unemployment were present, wages and prices would fall until full employment was restored. The classical economists wrote in the 19th century. Empirical evidence shows that prices were indeed flexible during that period. Extreme upward and downward movements in prices took place regularly. This was due to the greater importance of agriculture in the 19th century. Agricultural prices were flexible in both directions.

Shifts of LM curve to the right

(i) M increases
(ii) P decreases

To attain FE in a closed E, shift IS or LM curve or both.

Fiscal expansion

Figure 3. Equilibrium in a closed economy

In this situation, government spending shifts the IS curve to the right, thereby reducing unemployment. However, the output rises after a time lag of uncertain duration, say 18 - 24 months. An increase in money supply can also increase income, but raises interest rate.

 


Figure 4

 


A monetary or fiscal expansion is needed to stimulate the economy.

A General Model of an Open Economy

The domestic economy consists of three markets: the product market, the money market, and the external market.
  1. Product market equilibrium requires

    y = c(y) + i(r) + g + (x - m)
    This yields the IS curve, which is the locus of income and interest rate that clears the product market.

    Inclusion of the foreign sector makes the IS curve steeper, because import increases with income.

    Figure 5. BP curve

    Shifts of IS curve

    An expansionary fiscal policy, an increase in export sales, or devaluation, increases income at a given interest rate.

  2. Money Market
    Ms/P = ℓ(r) + kY
  3. External Market
    Current account + Capital Account
    BP = x(P¯,e+,y*+) ¯ m(P+,e¯,y+) + F(r+)

    x = export

    m = import

    P = domestic price level

    y = domestic output

    y* = foreign output

    r = interest rate e = exchange rate, the price of foreign currency = $/mark or $/yen

    An increase in r, capital inflow occurs and F(r) increases. The current account must decrease to achieve BP equilibrium. That is, income must increase. Thus, there is a positive relationship between r and y.

    Shifts of BP curve

    1. an increase in x => BP curves shifts to the right
    2. an increase in foreign income.
    3. devaluation increases x.


Domestic Equilibrium with BP equilibrium

BP disequilibrium occurs under the fixed exchange rate system, or under dirty float.

The economy might be in balance of payments equilibrium as shown below:

Figure 6.

However, there is no reason for the economy to be in such an equilibrium state. For example, an economy may have a BP surplus or deficit as shown below.

Figure 7. Balance of Payments surplus

If the intersection of IS and LM is above the BP curve, there is a surplus.

If it is below the BP curve, there is a deficit in the balance of payments.

Figure 8. Balance of payments deficit


 

Automatic Adjustment in the BP surplus

In a closed economy, policymakers can use monetary or fiscal policies, or a suitable combination of both policies to correct unemployment in the labor market and reach the full employment output in the product market. In an open economy, policy makers still have the option of using monetary and fiscal policies. However, openness also means a possible disequilibrium in the foreign sector. To correct a problem in the balance of payments, policymakers can use (i) monetary policy, (ii) fiscal policy, or (iii) balance of payments policy. Or it may choose to not to intervene following the admonition of Lao Tse (variously transliterated as Lao Tsu or Lao Zi). Lao Tsu, a Chinese philosopher around 550 BC, advocated for non-intervention. He had the same idea as the classical economists of the 19th century.

 

A statue of Lao Tze. (Courtesy of yakrider.com)
A Taoist stela dedicated to Lao Tze (circa 550 BC), dated 572 AD. (Smithsonian Institution)

From the "Sayings of Lao Zi" (by Tsai Chih Chung), Courtesy of Asiapacbooks.com.

Figure 9 illustrates what happens when the policymaker does nothing. In a full employment economy, BP surplus lowers interest rate, whereas BP deficit gradually raises interest rate. This explains for instance why interest rate in Japan is lower than in the US.

Figure 9



Policy makers in surplus countries often do not feel obligated to do anything to correct surpluses in their balance of payments. They think that deficit countries should cure their deficit problems, even though some policies of surplus countries may cause deficits of their trading partners. Thus, we consider do nothing (nonintervention) policy of a surplus country.

Assume: (i) initially the internal economy attains its full employment equilibrium at point e.
(ii) There is a BP surplus.

(i) BP surplus increases money supply since commercial banks experience an increase in reserves and monetary base increases, which through money multiplier, increases money supply. LM curvs shifts to right.

(ii) Interest rate falls along the IS curve, which has an expansionary effect on the economy. However, due to full employment, price will rise.

(iii) A price increase shifts the LM curve to the left a little, and shifts the Is curve to the left, since due to inflation imports become relatively cheaper. Increased import and decreased export also shift the BP curve upward.

Adjustments in the BP through Monetary Policy

Deficit: decrease money supply

Figure 10

A decrease in money supply or a rise in the interest rate increases unemployment. (Not a good option during recession)

In recent years, since Alan Greenspan became the chairman of the Board of Governors for Federal Reserve Syste, the US has adopted interest rate fixing policy, which meant flat LM curves for all operational purposes.

Problem: The deflationary policy increases unemployment. This policy might be unpopular when the country has both unemployment and BP deficit.

It might be acceptible if the economy is overheated and the inflation rate is high.

Fiscal Policy

Deficit: decrease Government spending? Not when unemployment is a problem.

Assume: interest rates are fixed (US, Europe or Japan)

Figure 11.

BP Policy Deficit: To cure a deficit, you have the following 5 options

(a) devaluation
(b) foreign exchange control
(c) control of capital movement (For example, Renminbi is not freely convertible into dollar for capital movement)
(d) trade barriers
(e) taxes, subsidies
(devaluation) e.g., Japan permitted a rise in yen (USD fell to about 110 yen from 280 yen in 1985). This move improves BP in the US.

For instance, devaluation improves the country's balance of payments. Exchange controls are used in LDCs.