ECONOMIC POLICIES IN OPEN ECONOIMIES
A. Aggregate Demand and Aggregate Supply in an Open Economy
X and M are components of AD and real GDP
GDP = C + I + G + (X – M)
Autonomous M
If M is autonomous with respect to the level of real GDP, the multiplier is:
1 / 1 – b or 1 / 1 - MPC
If M is not autonomous, the multiplier is:
1 / 1- (b (1 –m)) where m = marginal propensity to import
Level of X
Autonomous in relation to domestic real GDP as it is a function of income level in economy to which X are sold
Effect on real GDP
· An increase in X or a decreases in M or m will increases real GDP by shifting AD to right
· A decrease in X, or an increase in M or m will decrease real GDP by shifting AD to left.
2. Exchange rates and AD
Exchange rates show the effect of relative prices in countries which trade
Depreciation of domestic currency (dc)—same amount of dc buys less of a foreign currency (fc) and the fc will buy a larger amount of the dc:
· Domestic produced goods (X) cost less in fc
· Foreign produced goods (M) cost more in dc
· AD shifts to right as X increases and M decreases
· GDP increases
Appreciation of domestic currency (dc)—same amount of dc buys more of a foreign currency (fc) and the fc will buy a smaller amount of the dc:
· Domestic produced goods (X) cost more in fc
· Foreign produced goods (M) cost less in dc
· AD shifts to left as X decreases and M increases
· GDP decreases
3. Exchange rates and AS
Countries also X and M raw materials which are components of AS
An appreciation of dc means it will take fewer units of dc to buy imported raw materials so AS shifts right
A depreciation of the dc means it will take more units to buy imported raw materials so AS will shift left
4. Combined effects of X, M on AS and AD
A dc depreciation shifts AD right, but shifts AS left
A dc appreciation shifts AD left, shifts AS right
Change amount and direction of real GDP depends on the relative sizes of the shifts of AD and AS which can occur independently of one another.
A country’s demand for raw materials can shift independent of the demand for its finished products as different products or different countries can be involved.
AD = AS to AD’ = AS’ is a decrease in real GDP;
AD = AS to AD” = AS’ is an increase in real GDP
5. Capital flows
Movement of financial capital among countries must also be considered:
Financial capital will be attracted by relatively high interest rates
Interest payments are income to owners of the financial capital
However foreign direct investment (FDI) will be attracted by lower interest rate,
Interest payments on any borrowed funds are a cost to investors
Capital flows affects dc/fc for both financial capital and FDI:
Rise in domestic interest rates (relative to interest rates in foreign countries) increases the demand for debt denominated in domestic currency, but discourages FDI
Fall in domestic interest rates reverses the above FDI, dc/fc, real GDP
6. Interest rates and dc/fc
An increase or decrease in interest rates can be associated with an increase in dc/fc or a decrease in dc/fc through changes in I and FDI
An increase in dc/fc can be associated with an increase or decrease in real GDP through changes in X and M
Whether change in interest rate or change in dc/fc dominates the change in real GDP depends on the relative size of the shifts as well as the economic conditions in the countries involved.
The main reason why prediction of the direction and amount of change in real GDP is complex in open economies
B. Fiscal and Monetary Policies in an Open Economy
Fiscal policy (FP) and monetary policy (MP) of each nation (and changes in institutions and supply side policies) affect not only the domestic components (C, I , M) but also X and FDI of countries with which they trade
FP and MP seek to balance efficiency, equity, growth and stability objectives for the domestic economy, but mustr consider dc/fc and international interest rtaes as well as foreign GDP (income) levels and growth rates.
1. Fiscal Policy
If expansionary discretionary fiscal policy is used to stimulate (G > T and borrowing increases) the effect on domestic interest rates and whether crowding out of domestic private investment (I) must be considered.
If domestic interest rates rise relative to the rest of the world and crowding out occurs:
· G increases or T decreases
· I, C (tied to interest rates) and FDI decrease
· dc/fc appreciates
· X decrease, M increases
· AD decreases (shifts left), real GDP decreases
· raw material M increase
· AS increases (shifts right), real GDP increases
Increase in G, decline in T, M offset by decrease in I, X, C, and FDI
Actual change in real GDP depends on the relative size and direction of the shifts in AD and AS
If I, X, FDI demands decrease more than M increases, real GDP will decrease
Expansionary FP will not have the desired effect because of crowding out and dc/fc appreciation
Application to US
In the 1980s when a stimulative fiscal policy (largely simultaneous increase in G and a reduction in T) increased the trade deficit (X - M) by more than I (both domestic and FDI) increased
The opposite effects can occur when implementing a contractionary fiscal
policy real GDP may not decrease if (X – M) is less than increase in I,
FDI
A slightly different version may be happening in 2004-2005;
decrease in T, increase in G is not producing as much growth in real GDP as expected
an increase in X – M occurred because of low cost raw materials (except petroleum) and finished goods from countries where dc/fc has been more stable than against major western currencies (e.g. euro, pound, Canadian $) against which US $ has depreciated because of relatively low US interest rates
Chinese and Japanese are willing to buy US Treasury bonds because of their low risk and liquidity which offset the X-M even though US interest rates were relatively low.
2. Monetary policy
A contractionary monetary policy to raise interest rates by reducing money supply (M2) will raise domestic interest rates
Domestic and foreign behaviors re-enforce each other
The domestic and foreign re-enforcing effects of monetary policy is the reason economists tend to prefer monetary policy to fiscal policy to achieve real GDP as well as interest rate (money supply) targets.
C. Deficits: Budget, Deficit and Savings-Investment
1. Linkages
GDP = C + I + G + (X –M)
Also, GDP = Y in equilibrium and Y = C + S + T
So: C + S + T = C + I + G + (X – M)
Subtracting C from both sides and re-arranging:
· (G – T) = (S - I) + (X – M) or
· (X – M) = (S – I) + (G – T) or
· (S – I) = (G – T) + (X – M)
Deficits must offset each other to achieve equilibrium real GDP \
2. Interpreting the significance of deficits
The outflow of income, transfer of currency or slower growth are detrimental to domestic economy
If foreign central banks and private sectors are willing to purchase domestic gov’t debt with the income earned then households in the domestic economy will have even less income available to save and invest in the domestic economy
This is the current situation in US. Purchases of gov’t debt and FDI by foreign firms financed by US budget and trade deficits reduce the long term growth prospects of US economy and income available to US households.
If foreign gov’t private sectors stop buying US gov’t bonds, US $ will depreciate making trade deficit worse and if no other changes reducing I and leading to higher levels of gov’t debt merely to finance (X- M)
Higher (G –T) increases the level of debt sold to foreigners.
Eventually, US will have to raise interest rates to continue to attract foreign purchases of US gov’t debt which can reduce US I.
D. Remedies
There are no easy policy answers to this situation. It is the open economy equivalent of stagflation (high unemployment and inflation) in the domestic economy.
1. Reduce the (G – T)
This would involve reducing G or increasing T neither of which may be popular politically
Past (future) increases in G are often undertaken, proposed based on non-policy grounds (e.g. military necessity, equity)
US Policy
The politically attractive argument to reduce G is an attmpt to address this issue, but it would take a sustained, multi-year, multi-Congress effort and would not have an immediate affect on the (G – T) as discretionary spending is a relatively small part of federal spending and State and Local spending is also not very discretionary. Also, there is not enough ‘waste’ or ‘inefficiency’ in gov’t to make a difference.
Increases in T are never popular unless they can be tied directly to some critical policy (funding social security, highway trust funds, reducing the deficit in the 1990s was an exception)
Very hard to get elected to any office without a political promise to reduce taxes
One way to reduce the (X – M) is to stimulate economies of trading partners so they will buy more X from domestic economy.
This is hard to do as small economies M from domestic economy will not make much of a difference and to stimulate large economies whose imports might make a difference involves a transfer of purchasing power to those economies.
Another way is to erect trade barriers for M, but to continue to X.
Contrary to reducing trade barriers and only likely to invoke retaliation
US Policy
The US has advocated trading partners stimulate their economies (e.g. Japan) and has selectively sought to increase trade barriers (Canadian lumber) within the context of the WTO and other trade agreements,
The US has sought to open trade barriers for services in previously closed economies, (China, Japan, Brazil, India) with mixed success.
Also the US has argued for a reduction of subsidies in industries where US can compete (passenger aircraft, agriculture)
The US has a traditionally had a relatively strong bias toward free trade to add income to various sectors of the economy where X are significant (agriculture, financial services, entertainment, some high tech manufactured goods, higher education)
None of these have reduced the willingness of US households to purchase lower cost M and to go into debt to do so.
The reaction against globalization especially as it applies to slow domestic job growth is partly a backlash effect of these initiatives which have not and are not likely to improve the (X – M)
3. Increase (S – I)
An increase in S would and I (and/or reduction of (G –T) and (X – M)), but the economic incentive to increase S is higher interest rates which reduces I
US Policy
Current proposals to institute private accounts to replace not augment social security, education, health care do not (have not so far) resulted in or will be likely to result in higher overall level of saving.
They will decrease T, but increasing (G – T) while increasing S and possibly I (depending on how S are handled
In 1980s, decreases in T ended up increasing prices of financial assets and real estate rather than leading directly to job growth. The same is likely to occur again and is already occurring for real estate values which are rising augmented by low interest rates
E. Resolution
Fiscal and Monetary policies may not be the primary factors
When somewhat similar macroeconomic dilemmas occurred in the late 1970s-1980-81 and again in the 1990-91 period, it was a change I n expectations of households and firms which in turn led them to change their behavior
In the late 197s to 1980-81period, the end of Communism and the sense of trust the country had in Reagan helped to change the much more pessimistic attitude of the post-Watergate, Vietnam, Iranian Hostage era.
In the 1990-91 period, the increases in technology and productivity allowed the US economy to change structurally and generate large amounts of income for well educated and those attuned to take advantage of rapid changes in a telecommunication and information based economy.
Not all household participated and the income distributed became more skewed as the Gini coefficient increased throughout the decades of the 1980s, 1990s and into the current century.
Change of a similar nature and magnitude or a steady, multi-Congress, multi-Administration commitment to policies attractive to holders and prospective purchasers of US gov’t debt as well as to US households and firms will be likely.
What these policies are may be less important than the perception and expectation that the US will manage its economic affairs in ways which facilitate both domestic and foreign growth
April 17, 18, 20, 2005