Ch.17: Macro Policy (assuming floating exchange rates)

What this Chapter is all about Known concepts: fiscal and monetary policy. New concepts: internal and external balance. Today, internal balance is more important to policymakers than external balance. Virtually ignoring external balance is historically new. Prior to the 1970s, policymakers considered external balance more important.

Policy Objectives Internal Balance –GDP (full employment) –P (keep inflation in check) External Balance –X-M (current account balance)

Policy Instruments Fiscal Policy –expansionary: higher G / lower T –contractionary: lower G / higher T Monetary Policy –expansionary: increase MS –contractionary: decrease MS

Fiscal Policy (expansionary) (G  and/or T  )  1.direct effect: AD  and P  2.indirect effect: budget deficit  Gov. must borrow  i   attracts foreign capital (until i  back at original level)  XR  (X-M)   AD  and P  3.net effect: ambiguous! Fiscal policy now used less as a means of stabilizing the economy than 30 years ago b/c of flexible exchange rates and increased international mobility of capital.

Monetary Policy (expansionary) MS   i  1.direct effect: (C  and I  )  (AD  and P  ) 2.indirect effect:  outflow of capital  XR  (X-M)   (AD  and P  ) 3.net effect: clear! monetary policy is more effective than fiscal policy as a stabilization tool b/c of flexible exchange rates.

Summary PolicyEffectYPXRX-M fiscal: expansion Direct  Indirect  Net   fiscal: contraction Direct  Indirect  Net   monetary: expansion Direct  Indirect  Net   monetary: contraction Direct  Indirect  Net  

Policy Mixes Fiscal expansion Fiscal contraction Monetary expansion Consistent internal  external ? Inconsistent internal  ? external  Monetary contraction Inconsistent internal  ? external  Consistent internal  external ?

The J-curve Problem of time lag between change in XR and response in trade flows. Prices slow to adjust Depreciation thus implies lower revenue initially, but higher revenue later as export volume increases. This isn’t just theory. The phenomenon of the current account worsening for one or two quarters after a devaluation is practically the rule. People who don’t understand this effect are frequently fooled by the short-run reaction of the current account to changes in the exchange rate.