TÀI CHÍNH QUỐC TẾ 8 monetary and fiscal policy

VIII.Monetary, Fiscal Policy and Exchange Rate in an Open Economy Outline Open Economies Equilibrium Condition in an Open Economy Mundell-Fleming Model Monetary Policy and Exchange Rat in an Open Economy Fiscal Policy and Exchange Rate in an Open Economy Conclusion TS Nguyễn Phúc Hiền - ðại học Ngoại thương Open Economies Starting Point • The adjustment mechanisms in an open economy are different compared to closed economies Internal and External Goals of Economic Policy Making • Internal: growth, low unemployment, low inflation • External: balance of payments equilibrium, exchange rate stability • In an open economy both internal and external targets 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 TS Nguyễn Phúc Hiền - ðại học Ngoại thương Equilibrium Condition in an Open Economy (Mundell-Fleming) • • • • IS Curve in an Open Economy 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 Equilibrium Conditions: The goods market equilibrium is given if supply (S) equals the demand (D) S=D (1) Aggregated demand consists of: Investment (I), government spending (G) and exports (EX) D = I + G + EX (2) Supply side: Savings (Sv), Taxes (T) and imports (IM) represent income that is not used for domestic goods and services S = Sv + T + IM (3) TS Nguyễn Phúc Hiền - ðại học Ngoại thương Slope of IS Curve In the equilibrium the demand is equal to supply • Sv + T + IM = I + G + EX (4) Derivation of the IS Curve • S and IM both depend positively on income Y • T is independent from income (constant, y-axis intercept) The supply curve (S=Sv+T+IM) has a positive slope • I is assumed to be a function of the interest rate i, but independent from income Y • EX is independent from domestic income and foreign income is assumed to be constant • G independent from Y (exogenous) The demand curve is parallel to the x-axis TS Nguyễn Phúc Hiền - ðại học Ngoại thương Graphical Derivation of the IS Curve i ic ia C A B ib IS Sv+T+IM Y Ib + G + EX B A C Yc Ya Yb TS Nguyễn Phúc Hiền - ðại học Ngoại thương Ia + G + EX Ic + G + EX Y The LM Curve • • • • • • Concept The LM curve represents all combinations of i and Y at which the money market is in equilibrium An equilirium in the money market implies that money supply (M) equals money demand (L) Money supply and Demand Functions The money supply function of the central bank is exogenous, as the central bank can determine the money supply (M) independently When output grows the money demand will increase, 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 Thus money demand depends negatively on the interest rate (opportunity costs of holding money) TS Nguyễn Phúc Hiền - ðại học Ngoại thương Graphical Derivation of LM Curve i i LM B B‘ A A‘ L‘ L Mo M,L TS Nguyễn Phúc Hiền - ðại học Ngoại thương Ya Yb Y Balance of Payments Equilibrium • • Concep of BP Curve The balance of payments (BP) curve represents all combinations of Y and i at which current account and financial account (capital account) are in equilibrium Prices, exchange rate, and foreign debt are assumed to be constant TS Nguyễn Phúc Hiền - ðại học Ngoại thương Balance of Payments Equilibrium Equilibrium condition • Imports depend positively on income, while exports are exogenous 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) TS Nguyễn Phúc Hiền - ðại học Ngoại thương 10 Monetary policy under fixed exchange rates Assumption • 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 TS Nguyễn Phúc Hiền - ðại học Ngoại thương 14 Monetary policy under fixed exchange rates Implication of an Expansionary Monetary Policy • Due to a declining interest rate, capital flows out • The domestic currency depreciates • To maitain the peg the central bank has to buy domestic currency and to sell foreign currency • The foreign exchange interventions shift the LM curve back • All adjustment processes are simultaneous TS Nguyễn Phúc Hiền - ðại học Ngoại thương 15 Monetary policy under fixed exchange rates LM LM‘ id=if Autonomous monetary policy is „self defeating“ IS Ye TS Nguyễn Phúc Hiền - ðại học Ngoại thương 16 Monetary Policy under Flexible Exchange Rate • • • • Assumption The central bank does not intervence in the foreign exchange market The balance of payments is not equilibrated by foreign exchange interventions The central bank sets the money supply at any desired level Again id=if due to perfect capital mobility TS Nguyễn Phúc Hiền - ðại học Ngoại thương 17 Monetary Policy under Flexible Exchange Rate • • • • • Implication of Expansionary Monetary Policy The expansion of the money supply shifts the LM curve to the right With constant domestic and foreign prices, domestic goods become cheaper through the depreciation Export rise The IS curve shifts to the right Under flexible exchange rates the monetary policy is very effective TS Nguyễn Phúc Hiền - ðại học Ngoại thương 18 Monetary Policy under Flexible Exchange Rate i id=if Autonomous monetary policy is very effective LM LM‘ A B IS Yo Ya Yb „Beggar –thy-neigbour“ TS Nguyễn Phúc Hiền - ðại học Ngoại thương IS‘ Y 19 Economic Policy Implications • • • • • Monetary policy under fixed exchange rates 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) Monetary policy under flexible exchange rates Expansion of monetary policy→ the depreciation of home 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-thyneigbour“ TS Nguyễn Phúc Hiền - ðại học Ngoại thương 20 Fiscal Policy in an Open Economy Fiscal policy under fixed exchange rate Fiscal policy under flexible exchange rate TS Nguyễn Phúc Hiền - ðại học Ngoại thương 21 Fiscal Policy under Fixed Exchange Rate • • • • • • • • Assumption Perfect capital mobility and constant prices are assumed The current and financial accounts are balanced Working Mechanism of Fiscal Policy Increasing government spending (financed via 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 There is an additional growth impulse through monetary policy TS Nguyễn Phúc Hiền - ðại học Ngoại thương 22 Fiscal Policy under Fixed Exchange Rate i Fiscal policy is very effective LM LM‘ A B id=if IS Yo Ya Yb TS Nguyễn Phúc Hiền - ðại học Ngoại thương IS‘ Y 23 Fiscal Policy under Flexible Exchange Rate Assumption • The central bank does not intervene in the foreign exchange market • The balance of payments is not equilibrated through foreign exchange intervention • The central bank determines the money supply exogenously • It holds id=if due to perfect capital mobility TS Nguyễn Phúc Hiền - ðại học Ngoại thương 24 Fiscal Policy under Flexible Exchange Rate • • • • Working mechanism of expansionary fiscal policy The expansionary fiscal policy shifts the IS curve to the right The interest rate rises, → higher capital inflow → the exchange rate appreciates The current account becomes negative (increasing imports and decreasing exports) The IS curve shifts to the left again TS Nguyễn Phúc Hiền - ðại học Ngoại thương 25 Fiscal Policy under Flexible Exchange Rate i Fiscal policy is not effective LM A id=if IS Yo Ya Yb TS Nguyễn Phúc Hiền - ðại học Ngoại thương IS‘ Y 26 Economic Policy Implication • • • • • • Fiscal Policy under Fixed Exchange Rates Rising government spending → higher interest rates and 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 Fiscal Policy under Flexible Exchange Rates 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 TS Nguyễn Phúc Hiền - ðại học Ngoại thương 27 Conclusion The Mundell-Fleming model describes the effectiveness of monetary and fiscal policies in an open economy It is a short-term approach as prices are assumed to be fixed (Keynes) With fixed exchange rates an expansionary monetary policy is not effective (self defeating), while an expansionary fiscal policy is very effective With flexible exchange rates a expansionary monetary policy is very effective in the short term, but at the cost of the neighours With flexible exchange rates an expansionary fiscal policy is comparatively ineffective This may suggest a coordination of fiscal and monetary policies under flexible exchange rates (US) The long term effects of expansionary fiscal and monetary policies on inflation have to kept in mind TS Nguyễn Phúc Hiền - ðại học Ngoại thương 28 ... 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) Monetary policy under flexible... 12 Monetary Policy and Exchange Rate in an Open Economy Monetary policy under fixed exchange rates Monetary policy under flexible exchange rates TS Nguyễn Phúc Hiền - ðại học Ngoại thương 13 Monetary. .. Ngoại thương 20 Fiscal Policy in an Open Economy Fiscal policy under fixed exchange rate Fiscal policy under flexible exchange rate TS Nguyễn Phúc Hiền - ðại học Ngoại thương 21 Fiscal Policy under