Fiscal Policy purpose of fiscal policy is to by alicejenny

VIEWS: 4 PAGES: 4

									International Finance—Georgetown University—October 16, 2008
“Monetary and Fiscal Policy in Pegged Exchange Rate (XR) Systems where capital
mobility is present”
Page 1 of 4

Fiscal Policy purpose of fiscal policy is to increase GDP
    1. in a closed economy, expansionary fiscal policy consists of lowering taxes or
        raising government spending
    2. this leads to an initial increase in the aggregate demand and an initial increase in
        real GDP
    3. However, expansionary fiscal policy also leads to a shift toward a budget deficit,
        which leads to more borrowing by the government and leads to an increase in
        interest rates
    4. the increase in interest rates chokes off private investment and partially reverses
        the rise in real GDP (crowding out effect)
    5. in an open, developed country’s economy, the rise in interest rates causes an
        increase in capital inflows which keeps interest rates from rising as much and
        reduces the crowding out effect
    6. therefore, in a developed country’s open economy, fiscal policy is made more
        effective than in a closed economy
    7. Conclusion: fiscal policy is more effective in an open economy than in a closed
        economy if there is capital mobility—otherwise, neither had an advantage
    8. (5A) in an open LDC/EME country the rise in interest rate “would, in theory”
        cause more capital in, but…the higher budget deficit increases the perception of
        default risk which leads to capital outflows and increase the crowding out effect
            a. Developing countries have less room to run a budget deficit because there
                are perceptions of default risk
    9. (6A) In an LDC/EME, expansionary fiscal policy is “hurt (made less effective)”
        by having an open economy

Monetary Policy
  1. in a closed economy, an expansionary monetary policy would work first by
      lowering interest rates
  2. lower interest rates increase aggregate demand and increase real GDP
  3. but in an open economy, as interest rates fall, capital goes out and reduces the fall
      in interest rates and so reduces the rise in real GDP (this is true for the Developed
      country, Emerging Market Economy, AND LDC—no default risk here based on
      actions of the central bank)
  4. therefore, for all countries, an open economy with capital mobility reduces
      effectiveness of monetary policy
International Finance—Georgetown University—October 16, 2008
“Monetary and Fiscal Policy in Pegged Exchange Rate (XR) Systems where capital
mobility is present”
Page 2 of 4




Examples:

Examine impacts of fiscal policy in pegged XR with sterilization and capital mobility
What does it do to…
GDP :
Interest rates:
Current Account (CA) Credits (CR):
Current Account (CA) Debits (DB):
Financial Account (FA) CR:
FA DB:
Changes in reserves:
XR:
Monetary supply:


Situation: contractionary fiscal policy in a developed country with pegged XR
GDP : decrease
Interest rates: decrease
Current Account (CA) Credits (CR) aka WHAT YOU’RE EXPORTING: no change
        Deals with what is happening in the rest of the world’s economy, not internal
Current Account (CA) Debits (DB) aka WHAT YOU’RE IMPORTING: decrease
Financial Account (FA) CR: decrease
        Less money comes into country because there is less of a reward (lower interest
        rates)
FA DB: increase
        Foreigners are taking money out of the country, so why shouldn’t I? put it
        elsewhere in places that have higher interest rates
Changes in reserves: ambiguous
International Finance—Georgetown University—October 16, 2008
“Monetary and Fiscal Policy in Pegged Exchange Rate (XR) Systems where capital
mobility is present”
Page 3 of 4

      Overall impact on CA is pushing it toward surplus (debit is decreasing and NC in
      credits) and FA is a deficit…depends which is bigger
XR: no change
      It is pegged
Monetary supply: no change
      Because of sterilization

If there is no capital mobility, FA changes are both “no change” in financial account.
Reserves will clearly go up. XR won’t change. Money supply won’t change.

In a pegged XR with sterilization and capital mobility, an expansionary (contractionary)
fiscal policy causes:
     CA to go to deficit (surplus)
     FA to go to surplus (deficit)
     Small pressure on XR and small change in reserves
     ** so a pegged XR does not majorly inhibit fiscal policy in a developed country

In a LDC/EME, pegged XR with sterilization and capital mobility
Expansionary (contractionary) fiscal policy causes:
     CA to go to deficit (surplus)
     FA to go to deficit (surplus)
     Leads to large pressure on XR and larger changes in reserves

LDC pegged XR rate DOES inhibit fiscal policy
-----it inhibits it more if you’re doing an expansionary fiscal policy ‘cause this
expansionary fiscal policy makes reserves decrease…it inhibits it less if reserve change
doesn’t affect you that much (for example, pressure in an upwards direction, which the
Central Bank can address indefinitely)


Contractionary monetary policy in pegged XR with sterilization:
GDP: decrease (cause by interest rate increase)
Interest rates: increase
CA CR: (not much) no change
        My exports are their imports which are affected by THEIR GDP
CA DB: decrease (‘cause GDP goes down)
        Pushes CA to surplus
FA CR: increase (higher interest rates)
FA DB: decrease (higher interest rates)
        FA surplus
Change in reserves: increase (caused by holding XR down)
XR: wants to appreciate, but cannot because it is pegged so NO CHANGE
International Finance—Georgetown University—October 16, 2008
“Monetary and Fiscal Policy in Pegged Exchange Rate (XR) Systems where capital
mobility is present”
Page 4 of 4

Monetary supply: decreases (because they are using local currency [LC] to buy foreign
exchange and hold down the XR---pushes increase in monetary supply but won’t happen
because of sterilization?)
    Contractionary monetary policy is generally used to combat inflation
    Overall, BoP surpluses apply upward pressure on the XR (in this case it won’t
       change ‘cause it’s pegged and pressure to appreciate is soaked up in reserves)


Remember, the economy can change for policy reasons or non-policy reasons.

Ex) Political instability…what happens without sterilization
GDP: decrease
Interest Rates: increase (if monetary supply decreases) decrease (if interest rate increases)
CA CR: NC (decrease if interest rates increase)
CA DB: NC
FA CR: decrease ----- deficit in overall FA balance because XR
FA DB: increase ----- (continued) should depreciate but it doesn’t cause it is pegged
(reserves change instead)
Change in reserves: decrease
XR: No change
Monetary supply: decrease

Pushing BoP back toward balance..
Downside of not sterilizing = not doing anything to alleviate problems
    Doesn’t allow BoP to return to balance
    But it insulates the domestic economy

								
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