Macroeconomic Policy in an

Open Economy
Macroeconomic Policy in an Open Economy

Introduction
It was noted that the ultimate impact of a devaluation will in large part be
dependent upon the economic policies that accompany the devaluation
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 close
economy is that over time a country has to ensure that there is an
approximate balance in its current account
No country can continuously keep deficit, It is no sense to continuously
keep surplus
Policy-makers need to pay attention to the effects of the changes in fiscal
and monetary policies on the balance of payments to fulfill internal and
external balance

The Problem of Internal and External

Balance
Ensuring a sustainable BOP position over time is an important economic
objective to go along with high economic growth, low unemployment
and low inflation
We study how fiscal and monetary policies operate under fixed and
floating exchange rate regimes
Although economic policy-makers generally have many macroeconomic
aims, the discussion in the 1950s and 1960s was primarily concerned
with two objectives:

Internal balance: full employment along with a stable level of prices;

External balance: running an equilibrium in the balance of
payments.

The Problem of Internal and External

Balance
Policy instruments:
Expenditure changing policy: policies such as fiscal and
monetary policies which aim to influence the level of
the aggregate demand in the economy;
Expenditure switching policy: policies such as
devaluation/revaluation of the exchange rate which
attempt to influence the composition of spending
between domestic and foreign goods

The Problem of Internal and External

Balance
The policy problem of achieving
both was conceptualized by
Trevor Swan (1955) in what is
known as the Swan diagram
The vertical axis: the real
exchange rate.
Erforeign currency real
appreciate domestic currency
real depreciate international
competitiveness;
The horizontal axis: the amount

The Problem of Internal and External

Balance
: Swan
Diagram
The
IB schedule: represents
combinations
of the real exchange rate and domestic
absorption for which the economy is in
internal balance

It is downward-sloping from left to right

(ErX&Mmaintain full employment
A)
To the right of IB: inflation.
To the
left of IB: unemployment.
The
EB schedule:
represents combinations
of the real exchange rate and domestic
absorption for which the economy is in
external balance
It is upward-sloping from left to right
(ErX&M maintain current account
balance A)

Four different possible states for an economy:

Zone 1 a deficit and inflationary pressures.
Zone 2 a deficit and deflationary pressures.
Zone 3 a surplus and deflationary pressures.
Zone 4 a surplus and inflationary pressures.
At point A, the economy is in both internal and external
equilibrium.

The Problem of Internal and External

Balance : Swan Diagram
Suppose economy at point
B(inflation, deficit):

If the authorities maintain a fixed exchange rate

and try to reduce the current account deficit by
cutting back real domestic expenditure they
move the economy towards point C. Achieving
external balance by using expenditure-reducing
policies alone would require such a cut back in
absorption that the economy is pushed into
recession, with resulting unemployment.
Alternatively, the authorities might try to tackle
the deficit by devaluing the exchange rate; this
has the effect of moving the economy towards
point D on the EB schedule. While the
devaluation has the effect of reducing the
current account deficit it does so at the expense
of adding further inflationary pressures to the

The Problem of Internal and External

Balance : Swan Diagram
To move from point B to point A:
Deflate control inflation

two targets

Devalue improve current account

can met

Tinbergens instrument-targets rule: a country generally

requires as many instruments as it has targets to fulfill
both internal and external equilibrium.

The Problem of Internal and External

Balance : Swan Diagram
Tinbergen's rule is a useful conceptual framework for
economic policy discussion, but rather simplistic:
The underlying economic relationships are not explicitly
defined;
No role for international capital movements;
No distinction made between monetary and fiscal
policies;
Mundell-Fleming model to integrate such features into a
formal open economy macroeconomic models.

The Mundell-Fleming model

Their major contribution: incorporate international
capital movement into formal macroeconomic models
based on the Keynesian IS-LM framework and led to
some dramatic implications concerning the
effectiveness of fiscal and monetary policy for the
attainment of internal and external balance.

The Mundell-Fleming model

IS Schedule

The Mundell-Fleming model

LM Schedule

The Mundell-Fleming model

The BP schedule: shows different
combinations of r and Y that are
compatible with equilibrium in the
balance of payments.
Current account balance(CA)=X-M
X: independent of Y and r;

Capital
account balance(K) is
M=Ma+mY
positive function of the domestic
interest rate.
K=K(r-r*)
In equilibrium:
CA+K=-dR=0=(X-M)+K=0

The Mundell-Fleming model

Equilibrium of the model

The Mundell-Fleming model

Surplus (a) and deficit (b) in the balance of payments

The Mundell-Fleming model

1. Factors shifting the IS schedule
.The IS schedule will shift to the right if there is an increase
in either investment, government expenditure or exports.
.An autonomous fall in savings or imports will also require a
rightward shift of the IS schedule
.Another important factor that causes a rightward shift of
the IS schedule is a depreciation or devaluation of the
exchange rate, providing that the Marshall-Lerner
condition holds

The Mundell-Fleming model

2. Factors shifting the LM schedule
The LM schedule will shift to the right if there is an
increase in the domestic money supply
A depreciation of the exchange rate will lead to a rise in
the aggregate price index This means that real money
balances will be reduced and there will be a resulting
increase in the demand for money that can only be
eliminated by reducing the transactions demand for
money

The Mundell-Fleming model

3. Factors shifting the BP schedule
An autonomous increase in exports or an autonomous
decrease in imports will lead to an improvement in the current
account requiring a rightward shift of the BP schedule
Another factor that can cause a rightward shift of the BP
schedule is a depreciation/devaluation of the exchange rate,
providing the Marshall-Lerner condition holds; the value of
export sales will rise and the value of import expenditure
decline. Hence, the only way to ensure overall balance-ofpayments equilibrium is a rise in the level of domestic income

The Mundell-Fleming model

Monetary policy
Expansionary monetary policy(purchase bonds)the price of bonds and r
IYCA BOP deficit
K
Fiscal policy
Expansionary fiscal policy(G financed by selling bonds) the price of
bonds and r
G YCA
r IYCA
K

BOPor

The Mundell-Fleming model

Sterilized and non-sterilized intervention
Sterilized intervention: the authorities offset the moneybase implications of their exchange market
interventions to ensure that the reserve changes due to
intervention do not affect the domestic money base;
Non-sterilized intervention: the authorities allow the
reserve changes resulting from their interventions to
affect the money base.

Internal and External Balance Under

Fixed Exchange Rates
Money expansion under fixed exchange
rates.
Money expansion LM1LM2
r(r1r2), Y(Y1Y2) BOP deficit
excess supply of home currency to
maintain fixed exchange rates
purchase home currency with reserves
MsLM2LM1(non-sterilized)
Msoffset by sterilized intervention) LM
remains at LM2 suffer continuous BOP
deficit and R such a policy is only
feasible in the short run.

Internal and External Balance Under

Fixed Exchange Rates
fiscal expansion

Assume economy is initially at point A, in external bal

but Y1<Yf: Bond-financed fiscal expansionGIS1

Y(Y1Y2)

r(r1r2) BOP deficitpurchase home currency

MsLM1LM2
Y(Y2Yf)
r(r2r3)
BOP balance

achieve both internal and external objectives (point

Internal and External Balance Under

Floating Exchange Rates
1. Monetary expansion under floating
exchange rates
Expansionary monetary policyMs
LM1LM2 YCA BOP
rK
X& M

IS1IS2

ER X& M BP1BP2
PMd LM2LM3

deficit(B)

Internal and External Balance Under

Floating Exchange Rates
2. Fiscal expansion under floating exchange rates
Case 1: BP steeper than LM.
capital flows insensitive to r, Md elastic to r.
Expansionary fiscal policyG IS1IS2
Y CA BOP
r

deficit(B)

IS2IS3
ER BP1BP2
LM1LM2

Internal and External Balance Under

Floating
Exchange
Rates
Case 2: BP flatter
than LM.
Expansionary fiscal policyG IS1IS2
Y CA BOP
r

surplus(B)

IS2IS3
ER BP1BP2
LM1LM2

A Small Open Economy with Perfect

Capital Mobility
To examine the implication of high capital mobility for a
small country that had no ability to influence world
interest rates.
Mundell and Fleming (1962) showed that the choice of
exchange-rate regime would have a radical implications
concerning the effectiveness of monetary and fiscal
policy.
Assume a small country facing perfect capital mobility
the BP schedule becomes a horizontal line at a domestic
interest rate that is the same as the world interest rate.

A Small Open Economy with Perfect

Capital Mobility
1. Fixed exchange rates and perfect capital mobility.
Monetary expansion:
Monetary expansion(Ms) LM1LM2 downward pressure on r
massive capital outflow pressure for S intervene buy home
currency Ms till LM2LM1 r=r*,Y monetary policy ineffective
at influencing Y.
Fiscal expansion:
Fiscal expansion(G) IS1IS2 upward pressure for r massive
capital inflow pressure for S intervene sell home currency
Ms LM1LM2 till intersect IS2 at the initial rr=r*, Y active
fiscal policy alone has the ability to achieve both IB and EB.

A Small Open Economy with Perfect

Capital Mobility
Fixed exchange rates and perfect capital mobility.

A Small Open Economy with Perfect

Capital Mobility
2. Floating exchange rates and perfect capital mobility
Monetary expansion:
expansion(Ms) LM1LM2 downward pressure
Monetary
Fiscal expansion:
on r massive capital outflow S X& M
Fiscal expansion(G) IS1IS2 upward pressure for r
IS1IS2 r=r*,Y
massive capital inflow S X& M IS2IS1 r=r*,
LM2LM3
Y
fiscal policy ineffective at influencing Y
monetary policy effective at influencing Y.

A Small Open Economy with Perfect

Capital Mobility
Floating exchange rates and perfect capital mobility.

The impossible three

The macroeconomic trilemma

The macroeconomic trilemma

is that the authorities have
to make a choice out of two
of the following three goals.
Some have termed the
trilemma the impossible
trinity, reflecting the fact
that is not possible to
achieve all three goals
simultaneously.

The impossible three are:

2.Fixed exchange rates

1.Monetary
Independence

3.Free movement of
international capital

The Principle of Effective Market

Classification
Tinbergens rule does
not tell us which
instrument should be
assigned to which
target the principle of
effective market
classification stated
that policies should
be paired with the
objectives on which
they have the most

The problem for economic

policy-makers to
determine which
instruments to assign to
which targets, is termed
the assignment problem.
Mundell suggested that
under fixed exchange
rates, monetary policy
should be assigned to
external balance and fiscal
policy to internal balance.

The Principle of Effective Market

Classification
Vertical axis: monetary policy;
Horizontal axis: fiscal policy.
The IB schedule: negative slop.

To the right of the IB schedule: inflation

To the left of the IB schedule:
unemployment.
The EB schedule: positive or negative slop.
If expansionary fiscal policyBOP deficit to
maintain EBcontractionary monetary policy
negative slop;
If expansionary fiscal policyBOP surplus to
maintain EBexpansionary monetary policy
positive slop;
Assume the EB schedule has negative slop.
To the right of the EB schedule: deficit
To the left of the EB schedule: surplus

The Principle of Effective Market

Classification

Point A contractionary
The IB schedule is drawn steeper than themonetary policy point B
EB schedule.
expansionary fiscal policy
point C converge the
Expansionary fiscal policy(G)
economy to the intersection of
YMCA BOP deficit
the IB and EB schedules the
rK
but small;
assignment is stable;
Expansionary monetary policy(Ms) r Point A contractionary fiscal
policy point D expansionary
K
BOP deficit
monetary policy point E
IYMCA
but great;
move the economy away from
the simultaneous achievement
deficitM>deficitF & surplusM>surplusF;
of the IB and EB the
EBM>EBF or IBF>IBM.
assignment is unstable.

The Principle of Effective Market

Classification
Unfortunately, there is no unambiguous answer to the
assignment problem.
Depending upon the structural parameters:
1)the degree of capital mobility;
2)marginal propensity to save and import;
3)income and interest elasticity of demand for money;
4)the price elasticity of demand for imports and exports;
5)responsiveness of investment to interest rate
variations.

Limitations of the Mundell-Fleming

Model
A number of the criticisms relate to the short-run nature
of the model:
1.The Marshall-Lerner condition.
2.Interaction of stocks and flows.
3. Neglect of long-run budget constraints.
4. Wealth effect.
5. Neglect of supply-side factors.