TÀI CHÍNH QUỐC TẾ 8 monetary and fiscal policy

Nguyễn Phúc Hiền - ðại học Ngoại thương 7 The LM Curve • The LM curve represents all combinations of i and Y at which the money market is in equilibrium supply M equals money demand L •

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VIII Monetary, Fiscal Policy and Exchange Rate in an Open Economy

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TS Nguyễn Phúc Hiền - ðại học

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1 Open Economies

Starting Point

different compared to closed economies

Internal and External Goals of Economic Policy Making

rate stability

have to be considered In addition they are intertwined

• This applies for countries with fixed and flexible

exchange rates

• Monetary and fiscal policies are the most important

macroeconomic tools to achieve economic policy goals in open economies

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2 Equilibrium Condition in an Open Economy (Mundell-Fleming)

• The IS Curve represents all equilibrium combinations of

the interest rate i and the income Y at which the goods market is ceteris paribus in equilibrium

• The goods market equilibrium is given if supply (S)

equals the demand (D)

S = D (1)

government spending (G) and exports (EX)

D = I + G + EX (2)

represent income that is not used for domestic goods and services

S = Sv + T + IM (3)

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Derivation of the IS Curve

intercept)

• I is assumed to be a function of the interest rate i, but

independent from income Y

income is assumed to be constant

The demand curve is parallel to the x-axis

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Graphical Derivation of the IS Curve

IS B

A C

B A C

Ib + G + EX

Ic + G + EX

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The LM Curve

• The LM curve represents all combinations of i and Y at

which the money market is in equilibrium

supply (M) equals money demand (L)

• The money supply function of the central bank is

exogenous, as the central bank can determine the

money supply (M) independently

because, at the higher level of income, people want to hold more money for the increased transactions

• The money demand (L) function shifts to the right, as

money supply is constant the interest rate increases

rate (opportunity costs of holding money)

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LM

Ya Yb

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Balance of Payments Equilibrium

combinations of Y and i at which current account and financial account (capital account) are in equilibrium

be constant

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This implies a negative slope of the current account (CS)

• The financial account depend positively on the interest

rate (rising interest rates imply capital inflows), but not

on the income (horizontal line)

The FC is parallel to x-axis

• In equilibrium, the current account is equal to the

financial account

• Here, we assume as starting point, a current account

surplus (CS) which correspond to a financial account

deficit (FD)

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Ye

i

E

Y For small open economies

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3 Monetary Policy and Exchange

Rate in an Open Economy

Monetary policy under fixed exchange rates

Monetary policy under flexible exchange rates

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• It is assumed that perfect capital mobility holds and

domestic and foreign bonds are perfect substitutes

• This implies that the interest rates are equal in both

countries (id=if) and the BP curve is horizontal (small

economy)

• With fixed exchange rates monetary policy in the small

country cannot be independent from the monetary policy

in the foreign country

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Monetary policy under fixed exchange rates

Implication of an Expansionary Monetary Policy

• Due to a declining interest rate, capital flows out

currency and to sell foreign currency

• The foreign exchange interventions shift the LM curve

back

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Monetary Policy under Flexible Exchange Rate

to the right

• With constant domestic and foreign prices, domestic

goods become cheaper through the depreciation

• The IS curve shifts to the right

• Under flexible exchange rates the monetary policy is

very effective

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IS‘

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Economic Policy Implications

• Within a stability oriented environment (low inflation in

the anchor country) is not possible to boost economic

growth through an expansionary monetary policy

• An independent monetary policy is „self defeating“

• Monetary policy has to follow the monetary policy of the

the anchor country)

currency → redirection of trade flows, (higher exports, lower imports) → employment increases → income

increases as well

• Expansionary monetary policies is an effective tool, but

at the cost of the neighbouring countries

„beggar-thy-neigbour“

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4 Fiscal Policy in an Open Economy

Fiscal policy under fixed exchange rate

Fiscal policy under flexible exchange rate

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Fiscal Policy under Fixed Exchange Rate

• Perfect capital mobility and constant prices are assumed

goverment bond sales) shifts the IS-curve to the right

• The income, but also interest rates increases

• The higher interest rate attracts international capital→

positive financial account → the domestic currency

appreciates

• To keep the exchang rate fixed, the central bank has to

buy foreign currency and sell domestic currency

• The LM-curve shifts to the right and the interest rate

declines

policy

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Ya Yb

Fiscal policy is very effective

Y i

IS‘

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• The balance of payments is not equilibrated through

foreign exchange intervention

exogenously

• It holds id=if due to perfect capital mobility

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Fiscal Policy under Flexible Exchange Rate

• The expansionary fiscal policy shifts the IS curve to the

right

• The interest rate rises, → higher capital inflow → the

exchange rate appreciates

imports and decreasing exports)

• The IS curve shifts to the left again

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A

Ya Yb

Fiscal policy is not effective

Y i

IS‘

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Economic Policy Implication

appreciation, which dampen the expansionary effect

• Due to the fact that central bank has to increase the

money supply because of fixed exchange rate regime, is counteracted

• An expansionary fiscal policy under fixed exchange rates

is very effective

• The expansionary effect of fiscal policy leads ceteris

paribus to rising interest rates and appreciation

• This countervails the expansionary effect

• With flexible exchange rates this would suggest a

coordination of monetary and fiscal policy, which is

achieved under fixed exchange rates

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Conclusion

of monetary and fiscal policies in an open economy

2 It is a short-term approach as prices are assumed to be

fixed (Keynes)

policy is not effective (self defeating), while an

expansionary fiscal policy is very effective

policy is very effective in the short term, but at the cost

of the neighours

5 With flexible exchange rates an expansionary fiscal

policy is comparatively ineffective

6 This may suggest a coordination of fiscal and monetary

policies under flexible exchange rates (US)

7 The long term effects of expansionary fiscal and

monetary policies on inflation have to kept in mind

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