Monetary and Fiscal Policy in a Global Setting Chapter 34

Laugher Curve Did you hear about the economist who dove into his pool and broke his neck? He forgot to seasonally adjust his pool.

Ambiguous International Goals of Macroeconomic Policy Macroeconomics international goals are less straightforward than its domestic goals. There is great debate about how the U.S. should maintain its position in the world economy.

Ambiguous International Goals of Macroeconomic Policy Do we want a high or a low exchange rate? Do we want a balance of trade surplus or a trade deficit? Should we even pay attention to the balance of trade.

The Exchange Rate Goal A high exchange rate has advantages and disadvantages. Depending on the state of the economy, there are arguments both for high and low exchange rates.

The Value of the Dollar 140 130 120 110 100 90 80 70 1973 1978 1983 1988 1993 1998 2003 2008

Advantages of a High Exchange Rate Makes foreign currencies cheaper. Lowers the price of imports.

Advantages of a High Exchange Rate Lower import prices puts competitive pressure on U.S. firms and helps to keep down inflation. U.S. residents’ living standards are enhanced. A low exchange rate has the opposite effect.

Disadvantages of a High Exchange Rate A high exchange rate encourages imports and discourages exports. It can cause a trade deficit that can have a contractionary effect on the economy. A low exchange rate has the opposite effect.

The Trade Balance Goal A deficit in the trade balance means that, as a country, we are consuming more than we are producing. Trade balance – the difference between imports and exports.

The Trade Balance Goal There is a debate about whether we should worry about a trade deficit or not. A trade deficit is not without costs. We pay for a trade deficit by selling off U.S. assets to foreigners.

The Trade Balance Goal All the future interest and profits on those assets will flow to foreigners, not U.S. citizens.

The Trade Balance Goal Eventually, we will have to produce more than we consume so that we can pay them their profit and interest on their assets.

The Trade Balance Goal In the short-run a trade deficit allows more current consumption, in the long run it presents problems.

The Trade Balance Goal –100 50 –50 –150 –200 –250 –300 –350 –400 –450 –50 –100 –150 –200 –250 –300 –350 –400 –450 1970 1975 1980 1985 1990 1995 2000 2005

International versus Domestic Goals Domestic goals generally dominate international goals. International goals are ambiguous. International goals affect a nation’s population indirectly. In politics, indirect effects take a back seat.

International versus Domestic Goals International goals can become its primary goals when a nation is forced to face certain economic facts. As countries become more economically integrated, these pressures from other countries become more important.

Monetary and Fiscal Policy with Fixed Exchange Rates An economy with fixed exchange rates is much more restricted in its monetary and fiscal policies than one with flexible exchange rates.

Monetary and Fiscal Policy with Fixed Exchange Rates Since a nation's foreign reserves are limited, the amount of currency stabilization that can be achieved with direct intervention is quite small.

Monetary and Fiscal Policy with Fixed Exchange Rates If a nation's foreign reserves are limited, it must adjust its economy to maintain the exchange rate.

Using Monetary and Fiscal Policy Increase the Value of the Euro There are three options for raising the value of the euro: Increase the private demand for euros via contractionary monetary policy. Decrease the private supply of euros via contractionary monetary and fiscal policy. Use some combination of both.

Increase the Private Demand for Euros The primary way to increase the demand for euros in the short run is through contractionary monetary policy. The interest rate will increase which increases the demand for interest-bearing assets.

Increase the Private Demand for Euros The problem? A country can achieve an interest rate target or an exchange rate target, but not both at the same time.

Decrease the Private Supply of Euros The private supply of euros can be decreased via contractionary monetary and fiscal policy.

Decrease the Private Supply of Francs Contractionary monetary and fiscal policy will create a recession. The demand for imports will decreases, thereby decreasing the private supply of euros.

Decrease the Private Supply of Euros The problem? Governments that purposefully induce recessions do not stay in office long.

Adjusting the Economy to the Exchange Rate Price of euros (in dollars) $1.00 $0.80 Quantity of euros S0 D1 D0 Q2 Q1 QE McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Monetary and Fiscal Policy with Flexible or Partially Flexible Exchange Rates Many nations choose flexible or partially flexible exchange rate regimes to avoid the constraints fixed exchange rates place on domestic monetary and fiscal policy.

Monetary Policy’s Effect on Exchange Rates Monetary policy's effect on exchange rates is felt in three ways: Through its effect on the interest rate. Through its effect on income. Through its effect on price levels and inflation.

The Effect on Exchange Rates via Interest Rates An expansionary monetary policy pushes down the U.S. interest rate. A lower interest rates decreases foreign capital inflow into the U.S.

The Effect on Exchange Rates via Interest Rates Less foreign capital inflow decreases the demand for dollars. Lower demand for U.S. dollars decreases the exchange rate. A contractionary monetary policy does the opposite.

The Effect on Exchange Rates via Income As money supply rises, income expands. When money supply falls, income contracts.

The Effect on Exchange Rates via Income Rising U.S. income increases the demand for imported goods. To buy imported goods, U.S. citizens need foreign currency that they must buy with dollars.

The Effect on Exchange Rates via Income The supply of dollars in the foreign exchange market increases. The increase in the supply of dollars causes its exchange rate to drop.

The Effect on Exchange Rates via Price Levels Expansionary monetary policy pushes up the U.S. price level. As the prices rise relative to foreign prices, U.S. exports become more expensive and goods the U.S. imports become cheaper.

The Effect on Exchange Rates via Price Levels The demand for foreign currencies increases and the demand for dollars decreases. This pushes down the value of the dollar.

The Effect on Exchange Rates via Price Levels Contractionary monetary policy puts downward pressure on the U.S. price level and slows down any existing inflation.

The Effect on Exchange Rates via Price Levels As a result, contractionary monetary policy pushes the value of the dollar up via the price path.

The Net Effect of Monetary Policy on Exchange Rates Expansionary monetary policy lowers exchange rates. It decreases the relative value of a currency.

The Net Effect of Monetary Policy on Exchange Rates Contractionary monetary policy increases exchange rates. It increases the relative value of a country's currency.

Net Effect of Monetary Policy on Exchange Rates L-R effect Exchange rate P Y Imports Competi-tiveness Expansionary monetary policy McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Net Effect of Monetary Policy on Exchange Rates Contractionary monetary policy i Exchange rate Exchange rate M P Imports Exchange rate Competi-tiveness Exchange rate L-R effect Y McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Monetary Policy’s Effect on the Trade Balance Expansionary monetary policy increases income. When incomes rise, imports rise; exports are unaffected.

Monetary Policy’s Effect on the Trade Balance As imports rise, the trade balance shifts in the direction of deficit. As a result, the trade balance shifts toward a deficit.

Monetary Policy’s Effect on the Trade Balance Contractionary monetary policy works in the opposite direction. As a result, the trade balance shifts toward a surplus.

The Net Effect of Monetary Policy on the Trade Balance Expansionary monetary policy makes a trade deficit larger. Contractionary monetary policy makes a trade deficit smaller.

Net Effect of Monetary Policy on the Trade Deficit Expansionary monetary policy M Y Imports Trade deficit Contractionary monetary policy M Y Imports Trade deficit McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Fiscal Policy’s Effect on Exchange Rates Fiscal policy affects exchange rates in three ways. Through income. Through price levels. Through interest rates.

The Effect on Exchange Rates via Income Expansionary fiscal policy increases income. When incomes rise, imports rise; exports are unaffected. As imports rise, the trade deficit increases and the exchange rate drops.

The Effect on Exchange Rates via Income Contractionary fiscal policy works in the opposite direction. Imports decrease and the exchange rate increases.

The Effect on Exchange Rates via Price Levels Expansionary fiscal policy increases aggregate demand. The prices of a country’s exports increases. The competitiveness of a country’s exports decreases and the exchange rate drops.

The Effect on Exchange Rates via Price Levels Contractionary fiscal policy works in the opposite direction. The price path is a long-run effect.

The Effect on Exchange Rates via Interest Rates Expansionary fiscal policy increases interest rates because the government sells bonds to finance the deficit. Higher U.S. interest rates causes foreign capital to flow into the U.S. The exchange rate goes up.

The Effect on Exchange Rates via Interest Rates Contractionary fiscal policy works in the opposite direction. Capital flows out of the U.S. exchange rate decreases.

The Net Effect of Fiscal Policy on Exchange Rates The interest rate effect and the income effect are both short-term effects. The two work in opposite directions, so the net effect of fiscal policy is unknown.

The Net Effect of Fiscal Policy on Exchange Rates It is unclear what the effect of expansionary or contractionary fiscal policy will be on exchange rates.

Net Effect of Fiscal Policy on Exchange Rates M i Exchange rate ? Y Imports Exchange rate P Competi-tiveness Exchange rate L-R effect Expansionary fiscal policy McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Net Effect of Fiscal Policy on Exchange Rates Contractionary fiscal policy i Exchange rate M ? P Imports Exchange rate Competi-tiveness Exchange rate L-R effect Y McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Fiscal Policy’s Effect on the Trade Deficit Fiscal policy works on the trade deficit through its effects on income. Contractionary fiscal policy decreases a trade deficit.

Fiscal Policy’s Effect on the Trade Deficit Expansionary fiscal policy Y Imports Trade deficit Contractionary fiscal policy Y Imports Trade deficit McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Monetary and Fiscal Policy’s Effect on International Goals

International Phenomena and Domestic Goals Monetary and fiscal policy can work the other way around. The monetary and fiscal policies of other nations can have significant effects on the U.S. domestic economy.

International Monetary and Fiscal Coordination Governments try to coordinate their monetary and fiscal policies because their economies are interdependent.

International Monetary and Fiscal Coordination Because of this interdependence, many economists argue that all countries must work together to coordinate their monetary and fiscal policies.

Coordination Is a Two-Way Street If other nations are to take the needs of the U.S. economy into account, the U.S. must take the needs of other nations into account in determining its goals.

Coordination Is a Two-Way Street Each nation will likely do what is best for the world economy as long as it is also best for itself.

Crowding Out and International Considerations There is another way to avoid crowding out that results from financing the debt. Foreigners could buy the debt at the existing interest rate. This is called internationalizing the debt.

Crowding Out and International Considerations Internationalizing a country’s debt may help in the short run.

Crowding Out and International Considerations In the long run it presents potential problems. Foreign ownership of a country’s debts means the country must pay interest to those foreign countries and that debt may come due.

Conclusion: Selecting Policies to Achieve Goals

Conclusion: Selecting Policies to Achieve Goals

Conclusion: Selecting Policies to Achieve Goals

Monetary and Fiscal Policy in a Global Setting End of Chapter 34