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Open Economy Macroeconomics

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Open Economy Macroeconomics Powered By Docstoc
					The influence of monetary
     and fiscal policy

   On Aggregate Demand
Outline
 The influence of (expansionary)
  monetary policy on aggregate
  demand and on SR fluctuations
 The influence of (expansionary) fiscal
  policy on aggregate demand and on
  SR fluctuations
    Case of closed economy
    Case of open economy
Fiscal policy and monetary policy
   Fiscal policy: The use of the government’s
    tax and expenditure policies in an effort to
    influence the behavior of the economy (Ex:
    GDP and total employment).
   Monetary policy: The use of monetary
    variables such as the money supply , and
    rate of interest to influence the behavior of
    the economy.
How monetary policy influences aggregate
demand? Case of a closed economy
  Recap:
     Aggregate demand curve is downward
    sloping due to :
     Wealth effect
      Interest rate effect
      RER effect
     In the closed economy, interest effect is
    important
     In the open economy, RER effect is
    important
How monetary policy influences aggregate
demand? Case of a closed economy
    The most important reason for the down-
     ward sloping nature of aggregate demand
     is the interest rate effect.
    Theory of Liquidity Preference explains that
     the interest rate (real and nominal) adjusts
     to bring money supply and money demand
     into equilibrium. Real and nominal interest
     rates move together because the expected
     rate of inflation is constant in the SR.
Theory of Liquidity Preference:
    Money supply is fixed by the Central Bank and
     is independent of the rate of interest.
    Money is demanded for its liquidity (medium of
     exchange.
    Money demand is inversely related to interest
     rate at a given price level and output level .
     Interest rate represents the opportunity cost of
     holding money.
    Money is demanded for its capability to buy
     goods and services.
    The $ value of transactions (PY) is the other
     important determinant of money and causes
     shifts in money demanded at a given interest
     rate.
Equilibrium in the money market
    Interest rate adjusts to balance the supply and
     demand for money.
Theory of Liquidity Preference and
Aggregate Demand
    Increase in prices and interest rate effect:
       A higher price level increases $ value of
      transactions and shifts aggregate demand to the
      right. This in turn raises the interest rate and
      reduces investment in the economy, which in turn
      reduces the quantity of goods and services
      demanded.
    Interest effect and AD curve (demand for
     goods and services)
       Increase in prices ---- Increase in demand for
      money--- increase in interest rate--- decrease in qty of
      goods and services demanded.
Impact of monetary policy on aggregate
demand in the SR: Closed economy
    Recall:
       Shifts in aggregate demand occur with
      changes in consumption, Investment, and Govt
      expenditure, net exports at a given price level.
       In an open economy, NX=0
       Changes in C, I, G, and NX can occur through
      fiscal policy or monetary policy.
       The Central Bank can change money supply
      through:
        Open market operations in the bond market and/ or in
       the foreign currency exchange market
        Changes in the Bank Rate
Impact of monetary policy on aggregate
demand in the SR: Closed economy
    Expansionary monetary policy is implemented
     by the Central Bank by increasing the money
     supply.
    The expansionary monetary policy lowers the
     interest rate, and increases the quantity of
     goods and services demanded for a given
     price level.
    The contraction monetary policy (Central Bank
     contracts money supply) raises the interest rate
     and reduces the quantity of goods and
     services demanded for a given price level
How monetary policy influences aggregate
demand? Case of open economy
     Recap:
       Interest rate = world interest rate for a small open
      economy with perfect capital mobility.
       The most important reasons for the down-ward
      sloping nature of aggregate demand are the
      interest rate effect and the real exchange rate.
       Increase in prices and RER effect: A higher price
      level increases RER and decreases net exports,
      which in turn reduces the quantity of goods and
      services demanded.
Expansionary monetary policy in an open-
economy with flexible exchange rate
    Expansionary monetary policy by the Central
     Bank depreciates the RER causing net exports
     to rise. This increases the demand for goods
     and services and shifts the aggregate demand
     to the right.
    The effect of a monetary injection on
     aggregate demand is much stronger in an
     open economy as compared to a closed
     economy.
Expansionary monetary policy in an open-
economy with fixed exchange rate
    Expansionary monetary policy by the Central
     Bank depreciates the RER causing net exports
     to rise.
    Central bank through open market operations
     in the foreign- currency exchange market can
     hold the value of the domestic currency
     constant. This reduces money supply in the
     economy.
    The Central Bank cannot simultaneously
     choose the size of the money supply and the
     value of the currency.
Expansionary fiscal policy and aggregate
demand in the SR: Closed economy
    Recap:
      Shifts in aggregate demand at a given price level
     occur through changes in C, I, G, and NX.
      Fiscal policy influences C and I by altering spending
     decisions of households and firms.
      Changes in govt expenditure (G)alter aggregate
     demand directly.
      Increase in govt expenditure--- increases demand
     for goods and services- AD shifts to the right.
Govt expenditure and aggregate demand
(AD)
    Size of govt expenditure and size of shift in AD depend
     on :
       Multiplier effect (k)
       Crowding-out effect on investment
       Crowding-out effect on NX
    K effect: additional shifts in the AD that result when
     expansionary fiscal policy increases income and
     thereby increases consumer expenditure
    Crowding-out effect on investment: offset in the AD
     that results when expansionary fiscal policy raises the
     interest rate and thereby reduces investment
     expenditure
    Crowding-out effect on NX: offset in the AD that results
     when expansionary fiscal policy in a small open
     economy with flexible exchange rate raises the RER
     and thereby reduces net exports
Multiplier effect
    Increase in income is spent on consumption and
     savings.
    K= 1/1-MPC in a closed economy
    MPC= Marginal propensity to consume
    In a closed economy, k is directly proportional to MPC
    K= 1/1-MPC+MPI in an open economy
    MPI= Marginal propensity to import
    In an open economy, k is indirectly proportional to MPI
    In general, the aggregate demand for goods and
     services rises by more than the govt expenditure due to
     the k effect
    Illustration: see example done in class
Crowding-out effect on investment
    Increase in govt expenditure causes rise in rate
     of interest and reduces residential and business
     investment expenditure thus choking off
     aggregate demand.
    If crowding out effect on investment is larger
     than the k effect, then AD for goods and
     services will rise by less than govt purchases.
Crowding-out effect on NX
    In a small open economy with perfect capital
     mobility, increase in govt expenditure causes a
     rise in the rate of interest thus raising domestic
     interest rate above the world interest rate.
    If the exchange rate is flexible, this causes an
     appreciation in the RER and reduces net
     exports and thereby the aggregate demand
     for goods and services.
Fiscal policy and effect on aggregate demand in
a closed economy
    Expansionary fiscal policy is undertaken
     through an increase in govt expenditure on
     public works/ job creation programs.
    The size of shift in AD depends on the size of the
     k and the size of the crowding-out effect on
     investment.
    An increase in govt purchases increases the
     demand for goods and services by the value
     of the k thus raising the demand for money
     and interest rate. The rise in interest rate crowds
     out investment and AD shifts to the left at a
     given price level.
Fiscal policy and effect on aggregate demand in
an open economy: Flexible exchange rate
    In a small open economy, expansionary fiscal
     policy causes
      Crowding out effect on investment due to an
      increase in domestic interest rate (> than world
      interest rate)
       crowding out effect on NX due to an appreciation
      in the RER.
    Expansionary fiscal policy has no lasting effect
     on on the position of the aggregate demand
     curve
Fiscal policy and effect on aggregate demand in
an open economy: Fixed exchange rate
    In a small open economy, expansionary fiscal policy
     causes domestic interest rate to rise above world
     interest rate. This appreciates the RER.
    The Central Bank through open market operations in
     the foreign currency exchange market (purchase of
     foreign currency) increases the supply of domestic
     currency and prevents changes in the exchange rate.
    Thus, the Bank prevents crowding out effect on NX.
    The supply of domestic currency by the Central bank
     causes domestic interest rate to fall and equal world
     interest rate.
    Thus, the Bank prevents crowding out effect on
     investment.
    The increase in money supply shifts the AD curve even
     farther to the right.
Fiscal policy and effect on aggregate demand in
an open economy: Fixed exchange rate
    With a fixed exchange rate, an expansionary
     fiscal policy will have no crowding-out effects
     and will therefore cause a large increase in the
     demand for goods and services.
Coordination of Monetary and Fiscal policy

    For fiscal policy to have a lasting effect on the
     AD curve, the Central Bank must choose the
     appropriate exchange rate policy.
    Changes in taxes: reduction in taxes
      stimulates consumer expenditure through the
      multiplier effect
      crowds out net exports by increasing RER
    Deficit reduction
       Balanced budget limits the government’s options to
      increase AD.
       Deficit reduction will have no long lasting impact on
      AD in the event of a flexible exchange rate policy.
Stabilization Policy

 •   In theory, monetary policy and fiscal policy can be
     used to stabilize (offset) the effects of shocks to the
     Canadian economy.
 •   Identifying the shock and its affects and
     determining an appropriate response is often
     difficult.
 •   Monetary policy, although quickly implemented,
     affects the economy with considerable lags ( 1/2 to
     1 1/2 years).
 •   Fiscal policy has a long implementation lag. Effects
     of policies are themselves uncertain.
Stabilization Policy: Current situation
•   Active fiscal policy rarely used for aggregate demand
    management.
•   Monetary policy’s primary focus is to maintain an
    inflation target while minimizing the effects of
    monetary policy on aggregate demand.
•   Automatic stabilizers in place to minimize AD
    fluctuations.
•   Taxes and transfers: when AD is low, taxes fall and
    transfers increase offsetting some of the low AD.
•    Flexible exchange rate: an external AD shock
    (fall/rise in NX) is offset by exchange rate
    adjustment.

				
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