Economic Policies in Open Economies - Lecture 7

Economic Environment Analysis - Lecture 7

• Last week's topics included the financial side of globalization, the balance of payments, and money and exchange rates.

This Week: Economic Policies in Open Economies

• This week focuses on the role of economic policies in open economies, particularly with regard to flexible exchange rates.
• Key questions to consider include how monetary or fiscal policy functions in open economies, and how globalization affects the efficiency of macroeconomic policies.

This Week's Topics

• Real exchange rate and competitiveness
• Exchange rate and output
• Monetary and fiscal policy effects
• Policies during economic crises

Exchange Rates & Competitiveness

• The Law of One Price (LOP) states that in competitive markets, in the absence of transport costs and tariffs, identical goods must sell for the same price in the same currency.
• This is a long-term arbitrage mechanism.
• If the price of a good in one country (e.g., the US) is higher than in another (e.g., Europe), arbitrageurs can buy the good in the cheaper market and sell it in the more expensive market, leading to price convergence in trade.
• Purchasing power parity (PPP) applies LOP across countries for all goods and services, implying the exchange rate is determined by the average price levels of each country's basket of goods and services.

Purchasing Power Parity (PPP)

• PPP exchange rate: E=(p$/p€).
• Absolute PPP: exchange rates equal the level of relative average prices across countries.
• Relative PPP: changes in exchange rates match changes in prices (inflation) between periods.

Empirical Validity of PPP

• PPP fails in the short run, but works better in the long run.
• Factors that make LOP/PPP less accurate in the short run include transportation costs, trade barriers, and imperfect competition.
• Many traded goods also have nontraded components that affect the final consumer price.
• The variability of floating nominal exchange rates is often significantly greater than the variability of relative price indices.
• Studies generally reject the PPP concept as a short-run phenomenon.

The Yen/$ Exchange Rate and Relative Price Ratio

• Graphical illustration of the Yen/$ exchange rate and relative price level ratio over time.
• Data shows fluctuation in the exchange rate, but a general tendency over the long term towards a relationship with relative price levels.

The Real Exchange Rate

• Real exchange rate (RER = q) is the relative price index of goods and services between two countries, calculating as E x (p$/p€).
• A real depreciation of one currency against another (q ↑) can arise from nominal depreciation, an increase in the price of the other currency's goods, or a decrease in the price of the home country's goods.

Current Account and Real Exchange Rate

• Current Account (CA) is the balance of trade, investments, and other financial transactions between two countries. Positive CA indicates a country's export exceeds imports.
• Changes in real exchange rates affect current accounts. A real depreciation of a currency makes domestic goods more expensive, leading to higher net exports.

Exchange Rate and Output

• In the long run, think in terms of Purchasing Power Parity, where nominal exchange rates are neutral.
• However, PPP deviations are large in the medium term, connected to price rigidities.
• Impact of exchange rates on output needs more theory for short/medium-term.

Asset and Forex Market Equilibrium

• Focus on flexible exchange rates.
• Need to align exchange rates with output and equilibrium in domestic and foreign markets.
• Uncovered interest parity relationship: r€ = r$ + [(Ee − E)/E] .
• Graphical illustrations of relationships between exchange rate (E) and domestic output (Y€ ) in money markets .

A Booming Economy

• Illustrates how a booming economy (higher GDP) influences the exchange rate E and money supply, with implications for currency appreciation and asset returns.

Asset and Forex Market Equilibrium

• Equilibrium is characterized by alignment between domestic and foreign money market equilibrium.

Goods Market Equilibrium- Overview

• Aggregate demand (AD) determines output and income levels in a fixed price environment.
• AD consists of consumption (C), investment (I), government spending (G), exports (EX), and imports (IM).
• In theory, investment (I) is inversely proportional to real interest rates.

Goods Market Equilibrium - Keynesian Consumption Function

• Consumption (C) depends on disposable income (Y) which consists of Total income less taxes. (Y−T).
• Consumption function: C€ = C(Y€− T€) = Co + (1 − s)(Y€ − T€). Co represents autonomous consumption, and marginal propensity to consume (1-s).

Goods Market Equilibrium - Equilibrium

• Equilibrium: Aggregate Demand = Output
• Output and income are driven by demand conditions in the short run with fixed prices.

Goods Market Equilibrium- Euro Depreciation and Output

• A euro depreciation reduces the price of domestic goods in foreign markets, impacting net exports positively. This increase in net exports drives an increase in aggregate demand and ultimately output.

Goods Market Equilibrium- DD Curve

• A graphical illustration of the relationship between Exchange rate (E) and output (Y) in equilibrium, represented by the DD (Demand and Domestic) curve.
• A fiscal expansion (increased government spending) shifts the DD curve.

Monetary and Fiscal Policies in an Open Economy

• Monetary policy involves modifying the money supply (MS), frequently used for stabilisation and economic stimulus.
• Fiscal policy involves government spending (G), also a stabilisation tool, but with often broader impact.

Monetary Policy in an Open Economy- Impact

• Monetary policy, by lowering interest rates, has a strong impact on demand (consumption and investment) in a closed economy.
• In open economies (due to flexibility in exchange rate), monetary policy also influences exchange rates and net exports.

Fiscal Policy in an Open Economy- Impact

• Fiscal policy, by influencing domestic spending (Government Spending), is less efficient to stimulate demand in open economies as the impact on exchange rates is less predictable.

How Globalization Changed Macro-Policy

• Trade openness negatively affects domestic fiscal policy effectiveness.
• Fiscal expansion results in increased imports, reducing the total impact of domestic stimulus.
• Financial openness similarly dilutes domestic fiscal policy's effectiveness.
• This impact is greater in countries with more open economies.

Fiscal Response to the 2008 Financial Crisis

• Illustrates fiscal packages implemented across various countries as a response to the global financial crisis and the relative size of these packages in %GDP.

Fiscal policy coordination

• International coordination is essential in order to deal with the negative externalities imposed by economic crises, including the 2008 and 2020 crises.

Policies in times of crisis

• Conventional monetary policy, in times of crisis, typically involves efforts to bring interest rates to close to zero.
• But, sometimes additional unconventional tools, for example quantitative easing, may be required.

How has Globalization Changed Policy During Crisis

• Governments are increasingly using macroeconomic policies, such as fiscal and monetary, during economic crises.

Unconventional Monetary Policy

• Central Banks in crisis often employ unconventional monetary policies to combat the financial crisis.
• These may include quantitative easing (QE), through which Central Banks purchase assets to inject liquidity into financial markets or through direct lending to firms/banks.

Unconventional Monetary Policy and Inflation

• Unconventional monetary policies do not necessarily lead to significant inflation, particularly in environments with limited expansion in the credit markets.
• Inflationary pressure may appear later in the economic recovery when credit markets expand, reflecting increase in liquidity throughout the economy.

Unwinding Quantitative Easing

• Central Banks need to be mindful in unwinding unconventional monetary policies to avoid abrupt changes to interest rates that could negatively impact markets or the stability of the economy.
• A careful approach that avoids too-rapid tightening of monetary policy is crucial in a recovery.

Summary of Economic Effects

• In the long run, PPP equalizes prices across countries.
• Nominal exchange rates reflect inflation differentials.
• A real currency depreciation boosts competitiveness, exports and thus aggregate demand.
• Globalization reduces the effectiveness of fiscal policy while strengthening monetary policy's role as a stabilization tool.
• Effective policies require international coordination during crises.

Explore key concepts in economic policies within open economies, focusing on flexible exchange rates and their relationship to monetary and fiscal policy. This quiz will cover the effects of globalization on macroeconomic policy efficiency and examine the real exchange rate's impact on competitiveness and output.