Fiscal and Monetary Policy in an Open Economy

Fiscal and Monetary Policy in an Open Economy
Professor Horst Loechel

MBA Class 2010 Shanghai, November 2010

Questions

What is the difference between a closed and an open economy with regards to the impact of fiscal and monetary policy? What are the current issues of fiscal and monetary policy on a global level? What is China’s fiscal and monetary policy?

IS-LM in an open economy

Appr.

Depr.

Fiscal policy in an open economy

LM
∆G>0 Interest rate, i NetE0 Interest rate, i M>0

LM’

i i’’ i’ IS Y Y’ Y’’
Output, Y

A A’’ A’ IS’ E E’’ E’
Exchange rate, E

Monetary policy under a final exchange rate

IS
Interest rate, i

LM
M>0

LM’ A

i i’

A A’

Y

Y’

E
Exchange rate, E

Output, Y

Foreign resources and money supply

Central bank balance sheet
Assets Domestic bonds (B) Foreign reserve (FX) Liabilities Money supply (M)

B + FX = M

1) B + FX↑ => M↑ 2) B↓+ FX↑ => dM=0 (Sterilization policy)

Take away
Fiscal policy (flexible exchange rate): • Higher demand (government + private through multiplier) • Lower trade surplus (due to currency appreciation triggered by higher interest rates + more demand for imports) => Demand ↑ + Trade surplus ↓ : ? • Higher demand (government + private through multiplier) • Increasing money supply (inflation?) => Demand ↑

Fiscal policy (fixed exchanged rate):

Monetary policy (flexible exchange rate): • Higher demand (esp. investment due to lower interest rates) • Higher trade surplus (due to depreciation triggered by lower interest rates) => Demand ↑ + Trade surplus ↑ Monetary policy (fixed exchanged rate): • Higher demand (esp. investment due to lower interest rates) • Decreasing money supply (deflation?) => Demand ↑

Take away: The Krugman Trilemma of open economies

Exchange rate stability

Ca pit al co nt ro ls

xe Fi d ex ch an ge te ra

Monetary Policy autonomy

Floating exchange rate

Free capital movement