Macroeconomic Policy in an Open Economy PDF

15 Chapter Macroeconomic Policy in an Open Economy...

15 Chapter Macroeconomic Policy in an Open Economy Since the Great Depression of the 1930s, governments have actively pursued the goal of a fully employed economy with price stability. They have used fiscal and monetary policies to achieve this goal. A nation that has a closed economy (one that is not exposed to interna- tional trade and financial flows) could use these policies in view of its own goals. With an open economy, the nation finds that the success of these policies depends on factors such as its exports and imports of goods and services, the international mobility of financial capital, and the flexibility of its exchange rate. These factors can support or detract from the ability of monetary and fiscal policy to achieve full employment with price stability. This chapter considers macroeconomic policy in an open economy. The chapter first exam- ines the way in which monetary and fiscal policy are supposed to operate in a closed economy. The chapter then describes the effect of an open economy on monetary and fiscal policy. More can be learned about the international banking system by going to Exploring Further 15.1, “International Banking: Reserves, Debt, and Risk,” which may be accessed in MindTap. Economic Objectives of Nations What are the objectives of macroeconomic policy? Known as internal balance, this goal has two dimensions: a fully employed economy and no inflation—or more realistically, a reasonable amount of inflation. Nations traditionally have considered internal balance to be of primary importance and formulated economic policies to attain this goal. Policy makers are also aware of a nation’s current account position. A nation is said to be in external ­balance when it realizes neither deficits nor surpluses in its current account. An economy realizes overall balance when it attains internal balance and external balance. Besides pursuing internal and external balance, nations have other economic goals such as long run economic growth and a reasonably equitable distribution of national income. Although these and other commitments may influence macroeconomic policy, the discus- sion in this chapter is confined to the pursuit of internal and external balance. 495 Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 495 8/7/18 5:30 PM  496 Part 2: International M ­ onetary Relations Policy Instruments To attain external and internal balance, policy makers enact expenditure changing policies, expenditure switching policies, and direct controls. Expenditure changing policies alter the level of total spending (aggregate demand) for goods and services, including those produced domestically and those imported. They include fiscal policy, which refers to changes in government spending and taxes, and ­monetary policy, which refers to changes in the money supply and interest rates by a nation’s central bank (such as the Federal Reserve). Depending on the direction of change, expenditure changing policies are either expenditure increasing or reducing. Expenditure switching policies modify the direction of demand, shifting it between domestic output and imports. Under a system of fixed exchange rates, a nation with a trade deficit could devalue its currency to increase the international competitiveness of its firms, thus diverting spending from foreign-produced goods to domestically produced goods. To increase its competitiveness under a managed floating exchange rate system, a nation could purchase other currencies with its currency causing its currency’s exchange value to depre- ciate. The success of these policies in promoting trade balance largely depends on switching demand in the proper direction and amount, as well as on the capacity of the home economy to meet the additional demand by supplying more goods. Direct controls consist of government restrictions on the market economy. They are selective expenditure switching policies whose objective is to control particular items in the current account. Direct controls such as tariffs are levied on imports in an attempt to switch domestic spending away from foreign-produced goods to domestically pro- duced goods. Direct controls may also be used to restrain capital outflows or to stimu- late capital inflows. The formation of macroeconomic policy is subject to constraints that involve consider- ations of fairness and equity. Policy makers are aware of the needs of groups they represent such as labor and business, especially when pursuing conflicting economic objectives. To what extent should the domestic interest rate rise in order to eliminate a deficit in the capital account? The outcry of adversely affected groups within the nation that suffer from a high interest rate may be more than sufficient to convince policy makers not to pursue capital account balance. Reflecting perceptions of fairness and equity, policy formation tends to be characterized by negotiation and compromise. Aggregate Demand and Aggregate Supply: A Brief Review In your principles of macroeconomics course, you learned about a model that can be used to analyze the output and price level of an economy in the short run. This model is called the aggregate demand–aggregate supply model. Using the framework of Figure 15.1, let us review the main characteristics of this model as applied to Canada. In Figure 15.1, the aggregate demand curve (AD) shows the level of real output (real gross domestic product [GDP]) that Canadians will purchase at alternative price levels during a given year. Aggregate demand consists of spending by domestic consumers, busi- nesses, government, and foreign buyers (net exports). As the price level falls, the quantity of real output demanded increases. Figure 15.1 also shows the economy’s aggregate supply curve (AS). This curve shows the relation between the level of prices and amount of real output that will be produced by the economy during a given year. The aggregate supply curve is generally upward sloping because per-unit production costs, and therefore the prices that firms must receive, increase Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 496 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 497 Figure 15.1 Macroeconomic Equilibrium: The Aggregate Demand–Aggregate Supply Model Price Level (price index) AS Macroeconomic Equilibrium AD 0 Real GDP (trillions of dollars) The economy is in equilibrium where the aggregate demand curve intersects the aggregate supply curve. This intersection determines the equilibrium price level and output for the economy. Increases (decreases) in aggregate demand or aggregate supply result in rightward (leftward) shifts in these curves. as real output increases.1 The economy is in equilibrium when aggregate demand equals aggregate supply. This is where the two lines intersect in the figure. An increase (decrease) in aggregate demand is depicted by a rightward (leftward) shift in the aggregate demand curve. Shifts in aggregate demand are caused by changes in the deter- minants of aggregate demand: consumption, investment, government purchases, or net exports. Similarly, an increase (decrease) in aggregate supply is depicted by a rightward (leftward) shift in the aggregate supply curve. Shifts in the aggregate supply curve occur in response to changes in the price of resources, technology, business expectations, and the like. Next, we will use the aggregate demand–aggregate supply framework to analyze the effects of fiscal and monetary policy. Monetary and Fiscal Policies in a Closed Economy Monetary policy and fiscal policy are the main macroeconomic tools by which government can influence the performance of an economy. If aggregate output is too low and unemploy- ment is too high, the traditional policy solution is for government to increase aggregate demand for real output through expansionary monetary or fiscal policies. This results in an increase in the country’s real GDP. Conversely, if inflation is troublesome, its source tends to be a level of aggregate demand that exceeds the rate of output that can be supported by 1The aggregate supply curve actually has three distinct regions. First, when the economy is in deep recession or depression, the aggregate supply curve is horizontal. Because excess capacity in the economy places no upward pressure on prices, changes in aggregate demand cause changes in real output, but no change in the price level. Second, as the economy approaches full employment, scarcities in resource markets develop. Increasing aggregate demand places upward pressure on resource prices, bidding up unit production costs and causing the aggregate supply curve to slope upward: More output is produced only at a higher price level. Finally, the aggregate supply curve becomes vertical when the economy is at full employment. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 497 8/7/18 5:30 PM  498 Part 2: International M ­ onetary Relations the economy’s resources at constant prices. The solution in this situation is for the govern- ment to reduce the level of aggregate demand through contractionary monetary or fiscal policy. As the aggregate demand curve decreases, the upward pressure on prices caused by excess aggregate demand is softened and inflation moderates. Figure 15.2(a) illustrates the effects of an expansionary monetary or fiscal policy in a closed Canadian economy. For simplicity, let us assume that Canada’s aggregate supply curve is horizontal until the full employment level of real GDP is attained at $800 trillion; at this point, the aggregate supply curve becomes vertical. Also assume that the econo- my’s equilibrium real GDP equals $500 trillion, shown by the intersection of AD0 and AS0. The economy suffers from recession because its equilibrium output lies below the full employment level. To combat the recession, assume that an expansionary monetary or fiscal policy is implemented that increases aggregate demand to AD1. Equilibrium real GDP would increase from $500 trillion to $700 trillion and unemployment would decline in the economy. To expand aggregate demand, the Bank of Canada (as well as central banks of other countries) would usually increase the money supply through purchasing securities in the open market.2 Increasing the money supply reduces the interest rate within the country and this increases consumption and investment spending. The resulting increase in aggregate demand generates a multiple increase in real GDP.3 To offset inflation, the Bank of Canada would decrease the money supply by selling securities in the open market, and the interest rate would rise. The increase in the interest rate reduces consumption and investment spending, thus decreasing aggregate demand. This decrease lowers any excess demand ­pressure on prices. Instead of using monetary policy to stabilize the economy, Canada could use fiscal policy that operates either through changes in government spending or taxes. Because govern- ment spending is a component of aggregate demand, the Canadian government can directly affect aggregate demand by altering its own spending. To combat recession, the government could increase its spending to raise aggregate demand that results in a multiple increase in equilibrium real GDP. Instead, the government could combat recession by lowering income taxes that would increase the amount of disposable income in the hands of households. This increase results in a rise in consumption spending, an increase in aggregate demand, and a multiple increase in equilibrium real GDP. A contractionary fiscal policy works in the opposite direction. Monetary and Fiscal Policies in an Open Economy The previous section examined how monetary and fiscal policies can be used as ­economic stabilization tools in a closed economy. Next we consider the effects of these ­policies in an open economy. The key question is whether an expansionary monetary policy or fiscal 2Open market operations are the most important monetary tool of the Federal Reserve (Fed). They con- sist of the purchase or sale of securities by the Fed; this transaction is made with a bank or some other business or individual. Open market purchases result in an increase in bank reserves and the money supply. Open market sales cause bank reserves and the money supply to decrease. Other tools of mone- tary policy include changes in the discount rate, the interest rate that the Fed charges banks to borrow reserves, and changes in the required reserve ratio, the percentage of their deposits that banks are required to hold as reserves. 3Fiscal and monetary policies are based on the multiplier effect. According to this principle, changes in aggregate demand are multiplied into larger changes in equilibrium output and income. This process results from households receiving income and then spending it, which generates income for others, and so on. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 498 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 499 Figure 15.2 Effect of an Expansionary Monetary or Fiscal Policy on Equilibrium Real GDP (a) Expansionary Monetary Policy or Fiscal Policy in a Closed Economy Price Level (price index) AS0 A B 100 AD0 AD1 0 500 700 800 Full Employment Real GDP (trillions of dollars) (b) Expansionary Monetary Policy or Fiscal Policy in an Open Economy (1) The policy’s initial and secondary (2) The policy’s initial and secondary effects reinforce each other. effects conflict with each other. Price Level Price Level (price index) (price index) AS0 AS0 A B A D B 100 C 100 AD0 AD1 AD2 AD0 AD3 AD1 0 0 500 700 800 500 600 700 800 Real GDP Real GDP (trillions of dollars) (trillions of dollars) (a) Expansionary monetary policy or fiscal policy in a closed economy. (b) Expansionary monetary policy or fiscal policy in an open economy. (1) The policy’s initial and secondary effects reinforce each other. (2) The policy’s initial and secondary effects conflict with each other. policy in an open economy is more or less effective in increasing real GDP than it is in a closed economy.4 The answer to this question is influenced by a country’s decision to adopt a system of fixed or floating exchange rates, as discussed below. In practice, many countries maintain neither rigidly fixed exchange rates nor freely floating exchange rates. Rather, they maintain 4This chapter considers solely the effects of expansionary monetary and fiscal policy. A contractionary monetary and fiscal policy tends to have the opposite effects. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 499 8/7/18 5:30 PM  500 Part 2: International M ­ onetary Relations managed floating exchange rates in which a central bank buys or sells currencies in an attempt to prevent exchange rate movements from becoming disorderly. Heavier exchange rate intervention moves a country closer to our fixed exchange rate conclusion for m­ onetary and fiscal policies; less intervention moves a country closer to our floating exchange rate conclusion. Our conclusions depend on the expansionary or contractionary effects that monetary policy or fiscal policy has on aggregate demand. In a closed economy, an expansionary monetary or fiscal policy has a single effect on aggregate demand: It causes aggregate demand to expand by increasing domestic consumption, investment, or government spending. In an open economy, the policy has a second effect on aggregate demand: It causes aggregate demand to increase or decrease by changing net exports and other deter- minants of aggregate demand. If the initial and secondary effects of the policy result in increases in aggregate demand, the expansionary effect of the policy is strengthened. If the initial and secondary effects have conflicting impacts on aggregate demand, the expan- sionary effect of the policy is weakened. The examples below clarify this point. Let us begin by assuming that the mobility of international investment (capital) is high for Canada. This high mobility suggests that a small change in the relative interest rate across nations induces a large international flow of investment. This assumption is consistent with investment movements among many nations, such as the United States, Japan, and ­Germany, and the conclusions of many analysts that investment mobility increases as national financial markets become globalized. Effect of Fiscal and Monetary Policies under Fixed Exchange Rates Consider first the effects of an expansionary fiscal policy or monetary policy under a system of fixed exchange rates. The conclusion that emerges from our discussion is that an expansionary fiscal policy is more successful in stimulating the economy, and an expan- sionary monetary policy is less successful, than they are in a closed economy. This conclu- sion is summarized in Table 15.1. Table 15.1 The Effectiveness of Monetary and Fiscal Policy in Promoting Internal Balance for an Economy with a High Degree of Capital Mobility Exchange-Rate Regime Monetary Policy Fiscal Policy Floating exchange rates Strengthened Weakened Fixed exchange rates Weakened Strengthened Fiscal Policy Is Strengthened under Fixed Exchange Rates Referring to Figure 15.2 (b-1), assume that Canada operates under a fixed exchange rate system and its government ini- tially has a balanced budget in which government spending equals government taxes. To combat a recession, suppose the government adopts an expansionary fiscal policy, say, an increase in its spending on goods and services. The initial effect of a rise in government spending is to increase aggregate demand from AD0 to AD1, the same amount that occurs in our example of expansionary fiscal policy in a closed economy. This increase causes equilibrium real GDP to expand from $500 trillion to $700 trillion. The second effect of the expansionary fiscal policy is that increased spending causes the Canadian government’s budget to go into deficit. As the government demands more money to finance its excess spending, the domestic interest rate rises. A higher interest rate attracts Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 500 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 501 an inflow of investment from foreigners that results in an increased demand for Canadian dollars in the foreign exchange market. The dollar’s exchange rate is under pressure to appreciate. Appreciation cannot occur because Canada has a fixed exchange rate system. To prevent its dollar from appreciating, the Canadian government must intervene in the for- eign exchange market and purchase foreign currency with dollars. This purchase results in an increase in the domestic money supply. The effect of the rise in the money supply is to increase the amount of loanable funds available in the economy. As these funds are chan- neled into domestic spending, aggregate demand increases again, from AD1 to AD2 , and equilibrium real GDP increases to $800 trillion. Because the initial and secondary effects of the expansionary fiscal policy reinforce each other, real GDP increases by a greater amount than in the example of expansionary fiscal policy in a closed economy. The effect of an expansionary fiscal policy is more pronounced in an economy with capital mobility and fixed exchange rates than it is in a closed economy. Monetary Policy Is Weakened under Fixed Exchange Rates Contrast this outcome with monetary policy. As we will learn, in an open economy with capital mobility and fixed exchange rates, an expansionary monetary policy is less effective in increasing real GDP than it is in a closed economy. Referring to Figure 15.2(b-2), assume that Canada suffers from recession. To combat the recession, suppose the Bank of Canada implements an expansionary monetary policy. The initial effect of the monetary expansion is to reduce the domestic interest rate, resulting in increased consumption and investment that expand aggregate demand from AD0 to AD1. This expansion causes equilibrium real GDP to rise from $500 trillion to $700 trillion. The second effect of the monetary expansion is that a lower Canadian interest rate dis- courages foreign investors from placing their funds in Canadian capital markets. As the demand for Canadian dollars decreases, its exchange value is under pressure to depreciate. To maintain a fixed exchange rate, the Bank of Canada intervenes in the foreign exchange market and purchases dollars with foreign currency. This purchase causes the domestic money supply to decrease as well as the availability of loanable funds in the economy. The resulting decrease in domestic spending leads to a decrease in aggregate demand from AD1 to AD3 that causes equilibrium real GDP to decline from $700 trillion to $600 trillion. This contraction in aggregate demand counteracts the initial expansion that was intended to stimulate the economy. An expansionary monetary policy is weakened when its initial and secondary effects conflict with each other. Under a system of fixed exchange rates and cap- ital mobility, monetary policy is less effective in stimulating the economy than it is in a closed economy. Effect of Fiscal and Monetary Policies under Floating Exchange Rates We will now modify our example by replacing Canada’s fixed exchange rate system with a system of floating exchange rates. The conclusion that emerges from this discussion is that with high capital mobility and floating exchange rates, an expansionary monetary policy is more successful in stimulating the economy, and an expansionary fiscal policy is less suc- cessful than they are in a closed economy. Monetary Policy Is Strengthened under Floating Exchange Rates Again assume that Canada suffers from recession. To stimulate its economy, suppose the Bank of Canada adopts an expansionary monetary policy. As in a closed economy, an increase in the supply of money results in a lower domestic interest rate that initially generates more spending on consumption and investment and causes aggregate demand to increase. Referring to Figure 15.2(b-1), as aggregate demand increases from AD0 to AD1, equilibrium real GDP rises from $500 trillion to $700 trillion. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 501 8/7/18 5:30 PM  502 Part 2: International M ­ onetary Relations The second effect of the expansionary monetary policy is that because investment is highly mobile between countries, the decreasing Canadian interest rate induces investors to place their funds in foreign capital markets. As Canadian investors sell dollars to purchase foreign currency used to facilitate foreign investments, the dollar depreciates. This depre- ciation results in an increase in exports, a decrease in imports, and an improvement in Canada’s current account. The improving current account provides an extra boost to aggre- gate demand that expands from AD1 to AD2. This expansion causes equilibrium real GDP to increase from $700 trillion to $800 trillion. Because the initial and secondary effects of the expansionary monetary policy are com- plementary, the policy is strengthened by increasing Canada’s output and employment. In an economy with capital mobility and floating exchange rates, an expansionary monetary policy is more effective in stimulating the economy than it is in a closed economy. Fiscal Policy Is Weakened under Floating Exchange Rates The result is different if the Canadian government uses fiscal policy to combat recession. Referring to Figure 15.2(b-2), the initial effect of a rise in government spending is to increase aggregate demand from AD0 to AD1, which causes equilibrium real GDP to increase from $500 trillion to $700 trillion. As the increased government spending causes the government’s budget to go into deficit, the ­Canadian interest rate rises. A higher interest rate causes an inflow of investment from ­foreigners, which results in an increase in the demand for Canadian dollars in the foreign exchange market. The exchange value of the dollar thus appreciates, which results in falling exports, rising imports, and a deterioration of Canada’s current account. As the current account worsens, aggregate demand decreases from AD1 to AD3 and equilibrium real GDP contracts from $700 trillion to $600 trillion. Because the initial and secondary effects of the fiscal policy are conflicting, the policy’s expansionary effect is weakened. Therefore, an expan- sionary fiscal policy in an economy with capital mobility and floating exchange rates is less effective in stimulating the economy than it is in a closed economy. International Finance Application Monetary and Fiscal Policies Respond to Financial Turmoil in the Economy Following six consecutive years of expansion, the U.S. Stimulus Act of 2008. The act was designed to provide economy peaked in December, 2007, beginning a reces- temporary (one-time) tax rebates to those lower- and sion that continued throughout 2008 and middle-income individuals and households 2009. This was triggered by breakdowns in who would immediately spend it. About key credit markets that posed great risk to the $113 billion was dispensed, which amounted financial system and the broader economy. to about 0.8 percent of GDP. The government The Federal Reserve responded with hoped the tax rebates would burn such a hole unprecedented measures to unclog credit mar- in peoples’ pockets that they would not be able kets and free up the financial flows vital to a well-functioning to resist spending it, therefore adding to aggregate demand. economy. Besides lowering the federal funds rate target to This optimism was unwarranted. It turned out that only virtually zero, the Federal Reserve expanded its role as lender 10–20 percent of the tax rebate dollars were spent: Most of of last resort by providing credit to banks and other financial the money went into household saving or to paying down institutions as well as businesses that were unable to secure past debt such as credit card bills, neither of which directly adequate credit accommodations from banking institutions. expanded the economy. To provide additional stimulus to the weakening When Barack Obama became president in 2009, he economy, the U.S. government enacted the Economic inherited an economy that was falling deeper into (continued) Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 502 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 503 recession. Obama noted that decreases in consumption cement for a new highway or groceries paid for with a and investment spending continued to drag the household tax cut, there is less chance of decreasing economy downward. The result was a fiscal stimulus demand resulting in companies laying off workers, program of $789 billion, the most expansive unleashing which would result in greater declines in demand and of the government’s fiscal firepower in the face of a a deeper downturn. recession since World War II. The stimulus included What do you think? Does the U.S. government have enough $507 billion in spending programs and $282 billion in ammunition to combat a future economic downturn? tax relief, designed to increase aggregate demand: If more goods and services are being bought, whether Source: Economic Report of the President, 2009, 2010. Macroeconomic Stability and the Current Account: Policy Agreement versus Policy Conflict So far we have assumed that the goal of fiscal and monetary policies is to promote internal balance in Canada—that is, full employment without inflation. Besides desiring internal balance, suppose that Canadians want their economy to achieve current account (external) balance whereby its exports equal its imports. This balance suggests that Canada prefers to “finance its own way” in international trade by earning from its exports an amount of money necessary to pay for its imports. Will Canadian policy makers be able to achieve both internal and external balance at the same time, or will conflict develop between these two objectives? Again let’s assume that the Canadian economy suffers from recession. Suppose Canada’s current account realizes a deficit in which imports exceed exports. Given a system of floating exchange rates, recall that an expansionary monetary policy for Canada results in a depreciation of its dollar and therefore an increase in its exports and a decrease in its imports. This rise in net exports serves to reduce the deficit in Canada’s current account. The conclusion is that an expansionary monetary policy that is appropriate for combating Canada’s recession is also compatible with the objective of reducing Canada’s current account deficit. A single economic policy promotes overall balance for Canada. Instead let’s assume that Canada suffers from inflation and a current account deficit. When adopting a contractionary monetary policy to combat inflation, the Bank of Canada causes the domestic interest rate to increase, which results in an appreciation of its dollar. This appreciation results in a fall in Canada’s exports, a rise in its imports, and a larger ­current account deficit. The conclusion is that Canada’s contractionary monetary policy to combat inflation conflicts with its objective of promoting balance in its current account. Policy conflict prevails for the monetary policy. When Canada finds itself in a policy conflict zone, monetary policy (or fiscal policy) alone will not restore both internal and external balance. It is left for more advanced texts to further analyze this topic. Inflation with Unemployment This analysis so far has looked at the economy under special circumstances. It has been assumed that as the economy advances to full employment, domestic prices remain unchanged until full employment is reached. Once the nation’s capacity to produce has been achieved, further increases in aggregate demand pull prices upward. This type of infla- tion is known as demand-pull inflation. Under these conditions, internal balance Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 503 8/7/18 5:30 PM  504 Part 2: International M ­ onetary Relations (full employment with stable prices) can be viewed as a single target that requires but one policy instrument: a reduction in aggregate demand via monetary policy or fiscal policy. A more troublesome problem is the appropriate policy to implement when a nation experiences inflation with unemployment. Here the problem is that internal balance cannot be achieved just by manipulating aggregate demand. To decrease inflation, a reduction in aggregate demand is required; to decrease unemployment, an expansion in aggregate demand is required. The objectives of full employment and stable prices cannot be consid- ered as one and the same target; they are two independent targets, requiring two distinct policy instruments. Achieving overall balance involves three separate targets: current account equilibrium, full employment, and price stability. To ensure all three objectives can be achieved simulta- neously, monetary and fiscal policy may not be enough; direct controls may also be needed. Inflation with unemployment has been a problem for the United States. In 1971 the U.S. economy experienced inflation with recession and a current account deficit. Increasing aggregate demand to achieve full employment would presumably intensify inflationary pressures. The president implemented a comprehensive system of wage and price controls to remove the inflationary constraint. Later the same year, the United States entered into exchange rate realignments that resulted in a depreciation of the dollar’s exchange value by 12 percent against the trade-weighted value of other major currencies. The dollar deprecia- tion was intended to help the United States reverse its current account deficit. It was the president’s view that the internal and external problems of the United States could not be eliminated through expenditure changing policies alone. International Economic Policy Coordination Policy makers have long been aware that the welfare of their economies is linked to that of the world economy. Because of the international mobility of goods, services, capital, and labor, economic policies of one nation have spillover effects on others. Recognizing these spillover effects, governments have often made attempts to coordinate their economic policies. Economic relations among nations can be visualized along a spectrum, illustrated in Figure 15.3, ranging from open conflict to integration, where nations implement policies jointly in a supranational forum to which they have ceded a large degree of authority, such as the European Union. At the spectrum’s midpoint lies policy independence: Nations take the actions of other nations as a given; they do not attempt to influence those actions or be influenced by them. Between independence and integration lie various forms of policy coordination and cooperation. Figure 15.3 Relations among National Governments Cooperation Coordination Conflict Independence Integration Relations among national governments can be visualized along a spectrum ranging from policy conflict to policy integration. Between these extremes are a variety of forms of ­cooperation and coordination. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 504 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 505 Cooperative policy making can take many forms, but in general, it occurs whenever officials from different nations meet to evaluate world economic conditions. During these meetings, policy makers may present briefings on their individual economies and discuss current policies. Such meetings represent a simple form of cooperation. A more involved format might consist of economists’ studies on a particular subject, combined with an ­in-depth discussion of possible solutions. True policy coordination goes beyond these two forms of cooperation; policy coordination is a formal agreement among nations to initiate particular policies. International economic policy coordination is the attempt to significantly modify national policies—monetary policy, fiscal policy, and exchange rate policy—in recognition of international economic interdependence. Policy coordination does not necessarily imply that nations give precedence to international concerns over domestic concerns. It does rec- ognize, however, that the policies of one nation can spill over to influence the objectives of others; nations should therefore communicate with one another and attempt to coordinate their policies to take these linkages into account. Presumably, they will be better off than if they had acted independently. To facilitate policy coordination, economic officials of the major governments talk with one another frequently in the context of the International Monetary Fund and the Organi- zation for Economic Cooperation and Development. Also, central bank senior officials meet monthly at the Bank for International Settlements. Policy Coordination in Theory If economic policies in each of two nations affect the other, then the case for policy coordina- tion would appear to be obvious. Policy coordination is considered important in the modern world because economic disruptions are transmitted rapidly from one nation to another. Without policy coordination, national economic policies can destabilize other economies. The logic of policy coordination is illustrated in the following basketball spectator problem. Suppose you are attending a professional basketball game between the Los Angeles Lakers and the Chicago Bulls. If everyone is sitting, someone who stands has a superior view. Spectators usually can see well if everyone sits or if everyone stands. Sitting in seats is more comfortable than standing. When there is no cooperation, everyone stands; each spectator does what is best for her- or himself given the actions of other spectators. If all spectators sit, someone, taking what the others will do as a given, will stand. If all spectators are standing, then it is best to remain standing. With spectator cooperation, the solution is for everyone to sit. The problem is that each spectator may be tempted to get a better view by standing. The cooperative solution will not be attained without an outright agreement on coordination—in this situation, everyone remains seated. Consider the following economic example. Suppose the world consists of just two nations, Germany and Japan. Although these nations trade goods with each other, they desire to pursue their own domestic economic priorities. Germany wants to avoid trade deficits with Japan while achieving full employment for its economy; Japan desires full employment for its economy while avoiding trade deficits with Germany. Assume that both nations achieve balanced trade with each other, but each nation’s economy operates below full employment. Germany and Japan contemplate enacting expansionary government spending policies that would stimulate demand, output, and employment. Each nation rejects the idea, recognizing the policy’s adverse impact on the trade balance. Germany and Japan realize that bolstering domestic income to increase jobs has the side effect of stimu- lating the demand for imports, thus pushing the trade account into deficit. The preceding situation is favorable for successful policy coordination. If Germany and Japan agree to simultaneously expand their government spending, then output, employment, Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 505 8/7/18 5:30 PM  506 Part 2: International M ­ onetary Relations and incomes will rise concurrently. While higher German income promotes increased imports from Japan, higher Japanese income promotes increased imports from Germany. An appropriate increase in government spending results in each nation’s increased demand for imports being offset by an increased demand for exports that leads to balanced trade between Germany and Japan. In our example of mutual implementation of expansionary fiscal poli- cies, policy coordination permits each nation to achieve full employment and balanced trade. This is an optimistic portrayal of international economic policy coordination. The syn- chronization of policies appears simple because there are only two economies and two objec- tives. In the real world, policy coordination generally involves many countries and diverse objectives, such as low inflation, high employment, economic growth, and trade balance. If the benefits of international economic policy coordination are really so obvious, it may seem odd that agreements do not occur more often than they do. Several obstacles hinder successful policy coordination. Even if national economic objectives are harmonious, there is no guarantee that governments can design and implement coordinated policies. Policy makers in the real world do not always have sufficient information to understand the nature of the economic problem or how their policies will affect economies. Implementing appro- priate policies when governments disagree about economic fundamentals is difficult for several reasons. Some nations give higher priority to price stability, for instance, or to full employ- ment, than others. Some nations have a stronger legislature, or weaker trade unions, than others. The party pendulums in different nations, for example, shift with elections occurring in different years. One nation may experience economic recession while another nation experiences rapid inflation. Although the theoretical advantages of international economic policy coordination are clearly established, attempts to quantify their gains are rare. Skeptics point out that in prac- tice the gains from policy coordination are smaller than what is often suggested. Let us consider some examples of international economic policy coordination. Does Policy Coordination Work? Does coordination of economic policies improve the performance of nations? Proponents of policy coordination cite the examples of the Plaza Agreement of 1985 and the Louvre Accord of 1987. The deterioration of the U.S. trade balance was a disturbing feature of the economic recovery of the United States in the early 1980s. This deterioration was influenced by a dra- matic appreciation of the dollar that overwhelmed the other determinants of international cost competitiveness. Between 1980 and 1985, the dollar’s appreciation boosted the ratio of U.S. unit labor costs to foreign unit labor costs by 39 percent, detracting from the interna- tional competitiveness of U.S. manufacturers. American net exports of goods and services declined, resulting in large trade deficits. As the U.S. economic recovery slowed, protec- tionist pressures increased in Congress. Fearing a disaster in the world trading system, government officials of the Group of Five (G-5) nations—the United States, Japan, Germany, Great Britain, and France—met at New York’s Plaza Hotel in 1985. There was widespread agreement that the dollar was over- valued and that the twin U.S. deficits (trade and federal budget) were too large. Each country made specific pledges on macroeconomic policy and also agreed to initiate coordinated sales of the dollar to shove its exchange value downward. By 1986, the dollar had dramati- cally depreciated, especially against the German mark and the Japanese yen. Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 506 8/7/18 5:30 PM  Chapter 15: Macroeconomic Policy in an Open Economy 507 However, the sharp decline in the dollar’s exchange value set off a new concern: an uncon- trolled dollar plunge. So in 1987, another round of policy coordination occurred to put the brakes on the dollar’s decline. The G-5 financial ministers met in Paris and agreed in the Louvre Accord to pursue intervention policies curbing the pace of the dollar’s depreciation, to be accompanied by other macroeconomic adjustments. Although the episodes of the Plaza Agreement and Louvre Accord point to the success of policy coordination, by the first decade of the 2000s, government officials were showing less enthusiasm for it. They felt that coordinating policy had become much more difficult because of the way policy is made, especially given the rise of independent central banks. Back in the 1980s, the governments of Japan and Germany could dictate what their central banks would do. Since that time, the Bank of Japan and the European Central Bank have become more independent and see themselves as protectors of discipline against high- spending government officials. That role makes domestic fiscal and monetary coordination difficult and international efforts to coordinate policies even more difficult. The huge growth in global financial markets has made currency intervention much less effective. An example of unsuccessful international policy coordination occurred in 2000. At that time, the Group of Seven (G-7) industrial nations—the United States, Canada, Japan, the United Kingdom, Germany, France, and Italy—launched coordinated purchases of the euro to boost its value. Although the euro was launched in 1999, at an exchange value of $1.17 per euro, by mid-2000 its value had dropped to $0.84 per euro. Many economists feared that continued speculative attacks against the euro might result in a free fall of its value that could destabilize the international financial system. To prevent this from hap- pening, the G-7 nations enacted a coordinated intervention by purchasing euros with their currencies in the foreign exchange market. The added demand for the euro helped boost its value to more than $0.88 per euro. The success of the intervention was short lived. Within two weeks following the intervention, the euro’s value slid to an all-time low. Most econo- mists considered the coordinated intervention to be a failure. International Finance Application Does Crowding Occur in an Open Economy? In your principles of macroeconomics course, you learned increases the total demand for funds and pushes up about “crowding out” in the domestic economy. Crowding interest rates. Because of higher interest rates, busi- out refers to private consumption or invest- nesses will delay or cancel purchases of ment spending decreasing as a result of machinery and equipment, residential increased government expenditures and the housing construction will be postponed, and subsequent budget deficits. The source of consumers will refrain from buying interest- the decline in private spending is higher sensitive goods, such as major appliances interest rates caused by budget deficits. and automobiles. The higher interest rates Suppose that the government enacts an expansionary caused by government borrowing squeeze out private fiscal policy, say, an increase in defense spending. The sector borrowing. Crowding out lessens the effectiveness policy must be financed either by increased taxes or of an expansionary fiscal policy. through the borrowing of funds to permit the enlarged Although economists tend to accept the logic of the federal deficit. If the government borrows funds, the total crowding out argument, they recognize that government demand for funds will increase as the government com- deficits don’t necessarily squeeze out private spending. In petes with the private sector to borrow the available recessions, the main problem is that people are not supply of funds. The additional government borrowing spending all of the available funds. Typically, consumers (continued) Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 58938_ch15_hr_495-510.indd 507 8/7/18 5:30 PM