Tài liệu Tcqt8 monetary and fiscal policy

VIII.Monetary, Fiscal Policy and Exchange Rate in an Open Economy Outline 1. Open Economies 2. Equilibrium Condition in an Open Economy Mundell-Fleming Model 3. Monetary Policy and Exchange Rat in an Open Economy 4. Fiscal Policy and Exchange Rate in an Open Economy 5. Conclusion TS. Nguyễn Phúc Hiền - ðại học Ngoại thương 2 1. 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 3 2. 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 4 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 5 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 6 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 7 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 8 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 9 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 Graphical illustration of BP-Curve i BP B A FD A B Ya Yb TS. Nguyễn Phúc Hiền - ðại học Ngoại thương CS Y 11 Macroeconomic Equilibrium BP i LM E For small open economies IS Ye TS. Nguyễn Phúc Hiền - ðại học Ngoại thương Y 12 3. 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 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