1. © 2003 McGraw-Hill Ryerson Limited. International Dimensions of Monetary and Fiscal Policy Chapter 17

2. 17 - 2 © 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u Macroeconomics’ international goals are less straightforward than its domestic goals.

3. 17 - 3 © 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u There is great debate about how Canada should maintain its position in the world economy.

4. 17 - 4 © 2003 McGraw-Hill Ryerson Limited. Ambiguous International Goals of Macroeconomic Policy u Do we want a high or a low value for our currency? u Do we want a balance of trade surplus or a trade deficit? u Should we even pay attention to the balance of trade?

5. 17 - 5 © 2003 McGraw-Hill Ryerson Limited. The Exchange Rate Goal u A high value for a currency has advantages and disadvantages. u Depending on the state of the economy, there are arguments both for high and low exchange rates.

6. 17 - 6 © 2003 McGraw-Hill Ryerson Limited. Advantages of a High Value for the Dollar u It makes foreign currencies cheaper. u It lowers the price of imports.

7. 17 - 7 © 2003 McGraw-Hill Ryerson Limited. Advantages of a High Value for the Dollar u Lower import prices puts competitive pressure on domestic firms and helps to keep down inflation. u Canadian residents’ living standards are enhanced.

8. 17 - 8 © 2003 McGraw-Hill Ryerson Limited. Advantages of a High Exchange Rate u A low value for the dollar has the opposite effect.

9. 17 - 9 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of a High Value for the Dollar u A high value for a currency encourages imports and discourages exports. u It can cause a trade deficit that can have a contractionary effect of the economy by decreasing aggregate demand for domestic output.

10. 17 - 10 © 2003 McGraw-Hill Ryerson Limited. Disadvantages of a High Value for the Dollar u A low exchange rate has the opposite effect.

11. 17 - 11 © 2003 McGraw-Hill Ryerson Limited. The Exchange Rate Goal u Because of the divergent views, some economists argue that government should simply accept whatever exchange rate exists and not consider it in its conduct of monetary and fiscal policies.

12. 17 - 12 © 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u A deficit in the trade balance means that, as a country, we are consuming more than we are producing. l Trade balance – the difference between imports and exports.

13. 17 - 13 © 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u There is a debate about whether we should worry about a trade deficit or not. u A trade deficit is not without costs. u We pay for a trade deficit by selling off Canadian assets to foreigners.

14. 17 - 14 © 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u All the future interest and profits on those assets will flow to foreigners, not Canadian citizens.

15. 17 - 15 © 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u Eventually, we will have to produce more than we consume so that we can pay them their profit and interest on their assets.

16. 17 - 16 © 2003 McGraw-Hill Ryerson Limited. The Trade Balance Goal u In the short-run a trade deficit allows more current consumption, in the long run it presents problems.

17. 17 - 17 © 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u Domestic goals generally dominate international goals. u International goals are ambiguous.

18. 17 - 18 © 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u International goals affect a country’s population indirectly. u In politics, indirect effects take a back seat.

19. 17 - 19 © 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u When a nation is forced to face certain economic facts (threats by other countries that they must limit their imports), international goals can become its primary goals.

20. 17 - 20 © 2003 McGraw-Hill Ryerson Limited. International versus Domestic Goals u As countries become more economically integrated, these pressures from other countries become more important.

21. 17 - 21 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u An economy with fixed exchange rates is much more restricted in its monetary and fiscal policies than one with flexible exchange rates.

22. 17 - 22 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u The reason is that the amount of currency stabilization that can be achieved with direct intervention is quite small, since a country's foreign reserves are limited.

23. 17 - 23 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Fixed Exchange Rates u If foreign reserves are limited, a country must adjust its economy to maintain the value of its currency.

24. 17 - 24 © 2003 McGraw-Hill Ryerson Limited. Raising the Value of the Euro Using Monetary and Fiscal Policy u There are three options for raising the value of the euro: l Increase the private demand for euros via contractionary monetary policy. l Decrease the private supply of euros via contractionary monetary and fiscal policy. l Use some combination of both.

25. 17 - 25 © 2003 McGraw-Hill Ryerson Limited. Increase the Private Demand for Euros u The primary way to increase the demand for euros in the short run is through contractionary monetary policy. u The interest rate will increase which increases the demand for the countries’ interest-bearing assets.

26. 17 - 26 © 2003 McGraw-Hill Ryerson Limited. Increase the Private Demand for Euros u The problem? u The area can achieve an interest rate target or an exchange rate target, but not both at the same time.

27. 17 - 27 © 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u The private supply of euros can be decreased via contractionary monetary and fiscal policy.

28. 17 - 28 © 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u Contractionary monetary and fiscal policy will create a recession. u The demand for imports will decrease, thereby decreasing the private supply of euros.

29. 17 - 29 © 2003 McGraw-Hill Ryerson Limited. Decrease the Private Supply of Euros u The problem? u A purposely induced recession for political reasons is not a very popular decision.

30. 17 - 30 © 2003 McGraw-Hill Ryerson Limited. S0S0 D0D0 Price of euros (in dollars) $0.30 0.20 Quantity of euros D1D1 S1S1 Targeting an Exchange Rate with Monetary and Fiscal Policy, Fig. 17-1, p 419

31. 17 - 31 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy with Flexible or Partially Flexible Exchange Rates u Many countries choose flexible or partially flexible exchange rate regimes to avoid the constraints that a fixed exchange rate regime places on domestic monetary and fiscal policy.

32. 17 - 32 © 2003 McGraw-Hill Ryerson Limited. Monetary Policy’s Effect on Exchange Rates u Monetary policy's effect on exchange rates is felt in three ways: l Through its effect on the interest rate. l Through its effect on income. l Through its effect on price levels and inflation.

33. 17 - 33 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u An expansionary monetary policy pushes down the Canadian interest rate. u Lower interest rates decrease foreign capital inflow into Canada.

34. 17 - 34 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Less foreign capital inflow decreases the demand for dollars. u Lower demand for Canadian dollars decreases the exchange.

35. 17 - 35 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u A contractionary monetary policy does the opposite. u It raises Canadian interest rate, bringing in the capital from abroad, increasing the demand for dollars and increasing the value of the dollar.

36. 17 - 36 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Monetary policy affects income in a country. l As money supply rises, income expands. l When money supply falls, income contracts.

37. 17 - 37 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Rising Canada’s income increases the demand for imported goods. u To buy imported goods, Canadian citizens need foreign currency that they must buy with dollars.

38. 17 - 38 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u The supply of dollars in the foreign exchange market increases as Canadian citizens sell dollars to buy foreign currencies to pay for the imports. u The increase in the supply of dollars causes its value to decrease.

39. 17 - 39 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Expansionary monetary policy pushes up the Canadian price level. u As the prices rise relative to foreign prices, Canadian exports become more expensive and goods Canadian imports become cheaper.

40. 17 - 40 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u The demand for foreign currencies increases and the demand for dollars decreases, pushing the value of the dollar down.

41. 17 - 41 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Contractionary monetary policy puts downward pressure on Canadian price level and slows down any existing inflation.

42. 17 - 42 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u As a result, contractionary monetary policy pushes the value of the dollar up via the price path.

43. 17 - 43 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on Exchange Rates u Expansionary monetary policy lowers exchange rates. u It decreases the relative value of a currency.

44. 17 - 44 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on Exchange Rates u Contractionary monetary policy increases exchange rates. u It increases the relative value of a country's currency.

45. 17 - 45 © 2003 McGraw-Hill Ryerson Limited. M Competi- tiveness Expansionary monetary policy i P Y Net Effect of Monetary Policy on Exchange Rates Value of domestic currency Value of domestic currency L-R effect Value of domestic currency Imports

46. 17 - 46 © 2003 McGraw-Hill Ryerson Limited. M Competi- tiveness Imports Contractionary monetary policy i P Y Net Effect of Monetary Policy on Exchange Rates Value of domestic currency Value of domestic currency L-R effect Value of domestic currency

47. 17 - 47 © 2003 McGraw-Hill Ryerson Limited. Monetary Policy’s Effect on the Trade Balance u Monetary policy affects the trade balance in three ways. l Through income. l Through price levels. l Through the exchange rate.

48. 17 - 48 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u Expansionary monetary policy increases income. u When incomes rise, imports rise; exports are unaffected.

49. 17 - 49 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u As imports rise, the trade balance shifts in the direction of deficit. u As a result, the trade balance shifts toward a deficit.

50. 17 - 50 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Income u Contractionary monetary policy works in the opposite direction. u As a result, the trade balance shifts toward a surplus.

51. 17 - 51 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Expansionary monetary policy pushes a country’s price level up. u This decreases it competitiveness. u Trade deficits go up as residents substitute imported for domestic goods.

52. 17 - 52 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Contractionary monetary policy works in the opposite direction. u As a result, contractionary monetary policy decreases a trade deficit.

53. 17 - 53 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Price Levels u Monetary policy’s effect on the price level is a long-run effect.

54. 17 - 54 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Expansionary monetary policy decreases the interest rate. u This tends to push the dollar exchange rate down. u This increases Canadian competitiveness which decreases a trade deficit.

55. 17 - 55 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Contractionary monetary policy works in the opposite direction. u As a result, contractionary monetary policy increases a trade deficit.

56. 17 - 56 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Balance via Exchange Rates u Like the price level effect, the effect of the exchange rate on the trade deficit is a long-term effect.

57. 17 - 57 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Monetary Policy on the Trade Balance u Expansionary monetary policy makes a trade deficit larger. u Contractionary monetary policy makes a trade deficit smaller.

58. 17 - 58 © 2003 McGraw-Hill Ryerson Limited. M Value of domestic currency Expansionary monetary policy Net Effect of Monetary Policy on the Trade Deficit Imports Trade deficit YP i Competi- tiveness

59. 17 - 59 © 2003 McGraw-Hill Ryerson Limited. M Contractionary monetary policy Net Effect of Monetary Policy on the Trade Deficit Imports Competi- tiveness Trade deficit Y i Competi- tiveness P Value of domestic currency

60. 17 - 60 © 2003 McGraw-Hill Ryerson Limited. Fiscal Policy’s Effect on Exchange Rates u Fiscal policy affects exchange rates in three ways. l Through income. l Through price. l Through interest rates.

61. 17 - 61 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Expansionary fiscal policy increases income. u When incomes rise, imports rise; exports are unaffected. u As imports rise, the trade deficit increases and the currency value drops.

62. 17 - 62 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Income u Contractionary fiscal policy works in the opposite direction. u Imports decrease and the currency value increases.

63. 17 - 63 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Expansionary fiscal policy increases aggregate demand. u The prices of a country’s exports increases. u The competitiveness of a country’s exports decreases and the currency value drops.

64. 17 - 64 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Price Levels u Contractionary fiscal policy works in the opposite direction. u The price path is a long-run effect.

65. 17 - 65 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Expansionary fiscal policy increases interest rates because the government sells bonds to finance the deficit. u Higher Canadian interest rates cause foreign capital to flow into Canada. u The dollar value goes up.

66. 17 - 66 © 2003 McGraw-Hill Ryerson Limited. The Effect on Exchange Rates via Interest Rates u Contractionary fiscal policy works in the opposite direction. u Interest rates decrease, capital flows out of Canada and the value of the dollar decreases.

67. 17 - 67 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on Exchange Rates u The interest rate effect and the income effect are both short-term effects. u The two work in opposite directions, so the net effect of fiscal policy is ambiguous.

68. 17 - 68 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on Exchange Rates u It is unclear what the effect of expansionary or contractionary fiscal policy will be on exchange rates.

69. 17 - 69 © 2003 McGraw-Hill Ryerson Limited. Net Effect of Fiscal Policy on Exchange Rates Competi- tiveness Expansionary fiscal policy i P Y Value of domestic currency Value of domestic currency L-R effect Imports ?

70. 17 - 70 © 2003 McGraw-Hill Ryerson Limited. Net Effect of Fiscal Policy on Exchange Rates Competi- tiveness Imports Contractionary fiscal policy iP Y Value of domestic currency L-R effect ?

71. 17 - 71 © 2003 McGraw-Hill Ryerson Limited. Fiscal Policy’s Effect on the Trade Deficit u Fiscal policy works on the trade deficit through its effects on income and prices.

72. 17 - 72 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Income u Expansionary fiscal policy increases income. u Imports go up, as does the trade deficit.

73. 17 - 73 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Income u Contractionary fiscal policy works in the opposite direction. u It decreases the size of the trade deficit. u These are the same effects as those of monetary policy.

74. 17 - 74 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Prices u Expansionary fiscal policy increases the price level. u This increases the price of a country’s exports and decreases it competitiveness. u This increases the trade deficit.

75. 17 - 75 © 2003 McGraw-Hill Ryerson Limited. The Effect on the Trade Deficit via Prices u Contractionary fiscal policy works in the opposite direction. u It decreases the size of the trade deficit. u These are the same effects as those of monetary policy.

76. 17 - 76 © 2003 McGraw-Hill Ryerson Limited. The Net Effect of Fiscal Policy on the Trade Deficit u Expansionary fiscal policy increases a trade deficit. u Contractionary fiscal policy decreases a trade deficit.

77. 17 - 77 © 2003 McGraw-Hill Ryerson Limited. Expansionary fiscal policy The Net Effect of Fiscal Policy on the Trade Deficit Imports Trade deficit Y P Competi- tiveness

78. 17 - 78 © 2003 McGraw-Hill Ryerson Limited. Contractionary fiscal policy The Net Effect of Fiscal Policy on the Trade Deficit Imports Competi- tiveness Trade deficit Y P

79. 17 - 79 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy’s Effect on International Goals

80. 17 - 80 © 2003 McGraw-Hill Ryerson Limited. International Phenomena and Domestic Goals u Monetary and fiscal policy can work the other way around. u The monetary and fiscal policies of other countries can have significant effects on Canadian domestic economy.

81. 17 - 81 © 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Governments try to coordinate their monetary and fiscal policies because their economies are interdependent.

82. 17 - 82 © 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Because of this interdependence, many economists argue that all countries must work together to coordinate their monetary and fiscal policies.

83. 17 - 83 © 2003 McGraw-Hill Ryerson Limited. International Monetary and Fiscal Coordination u Because of the fear of retaliatory measures, nations take their trading partners’ desires into account when making their monetary and fiscal policies.

84. 17 - 84 © 2003 McGraw-Hill Ryerson Limited. Coordination Is a Two-Way Street u If other nations are to take the needs of Canadian economy into account, Canada must take the needs of other countries into account in determining its goals.

85. 17 - 85 © 2003 McGraw-Hill Ryerson Limited. Coordination Is a Two-Way Street u Each country will likely do what is best for the world economy as long as it is also best for itself.

86. 17 - 86 © 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u There is another way to avoid crowding out that results from financing the debt. u Foreigners could buy the debt at the existing interest rate. u This is called internationalizing the debt.

87. 17 - 87 © 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u Internationalizing a country’s debt may help in the short run.

88. 17 - 88 © 2003 McGraw-Hill Ryerson Limited. Crowding Out and International Considerations u In the long run it presents potential problems since foreign ownership of a country’s debts means the country must pay interest to those foreign countries and that debt may come due.

89. 17 - 89 © 2003 McGraw-Hill Ryerson Limited. Selecting Policies to Achieve Goals, Table17-1, p 429

90. 17 - 90 © 2003 McGraw-Hill Ryerson Limited. Selecting Policies to Achieve Goals, Table17-1, p 429

91. © 2003 McGraw-Hill Ryerson Limited. International Dimensions of Monetary and Fiscal Policy End of Chapter 17