topic 11 - adjustment policies

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Topic ElevenAdjustment

Policies(Chapter 18, Salvadore, 10thed.)

ECO561 - International Economics/Topic 11Nov 2013/SHWong


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11.1 Expenditure-Changing Policies

11.2 Expenditure-Switching Policies11.3 Direct Control

ECO561 - International Economics/Topic 11Nov 2013/SHWong

11.0 Adjustment Policies


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The need for adjustment policies arisesbecause the automatic adjustmentmechanisms have serious unwanted sideeffects

Adapted from Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

for ECO561 - International Economics/Topic 11Nov 2013/SHWong

Introduction


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Expenditure-changing policies Fiscal and monetary policy tools to alter the

level of aggregate expenditures in theeconomy

Expenditure-switching policies Devaluation or revaluation of the exchange

rate to alter the balance of spending ondomestic and foreign goods and services



Internal & External Balance withExpenditure-Changing & Expenditure-

Switching Policies


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Internal imbalances Inflation imbalanceassumed to be caused

by excess aggregate demand Recession imbalances caused by

insufficient aggregate demand External imbalances A deficit in the balance of payments A surplus in the balance of payments



Internal & External Balance


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Possible situations External surplus and internal unemployment External surplus and internal inflation External deficit and internal inflation External deficit and internal unemployment

It is possible that the policies available for

correcting the imbalances may improve onesituation only at the expense of worseninganother



Internal & External Balance (cont)


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Goods market equilibrium when quantitiesof goods and services demanded and suppliedare equal

Money market equilibrium when quantity ofmoney demanded for transactions andspeculation is equal to given supply of money

BoP equilibrium when trade deficit is

matched by an equal net capital inflow ortrade surplus is matched by equal net capitaloutflow



Equilibrium in the Goods Market,Money Market & Balance of Payments


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TheMundell-Fleming model shows how

nation can use monetary and fiscal policy toachieve internal and external balance withouta change in exchange rates





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The IS, LMand BPcurves show variouscombinations of interest rates and national

income at which the goods market, themoney market and the balance of payments,respectively, are in equilibrium





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The IScurve is negatively inclined because

lower rates of interest (& higher investments)are associated with higher incomes (& highersavings and imports) for the quantities ofgoods & services demanded and supplied to

remain equal



Equilibrium in the Goods Market,the ISCurve


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The LMcurve is positively inclined because

higher income (& a larger transaction demandfor money) must be associated with higherinterest rates (& a lower demand forspeculative money balances) for the total

quantity of money demanded to remain equalto the given supply of money



Equilibrium in the Money Market,the LMcurve


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The BPcurve is also positively inclined

because higher incomes (& imports) requirehigher rates of interest (& capital inflows) forthe nation to remain in balance-of-paymentsequilibrium



Equilibrium in the Balance of Payments,the BPcurve


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The goods market, themoney market & thebalance of paymentsare in equilibrium atpoint E, where theIS,LM, & BPcurves cross at

i = 5.0%, and Ye= 100 However, Ye< Yf





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Achieving internal & external balance

From unemployment / external balance Expansionary fiscal policy Tight monetary policy No change in exchange rate



Fiscal & Monetary Policiesfor Internal & External Balance

with Fixed Exchange Rates


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Fiscal & Monetary Policies fromDomestic Unemployment & External

Balance Starting from point Ewith domestic

unemployment & external balance, thenation can reach the full employmentlevel of national income of Yf= 1500

with external balance by pursuing theexpansionary fiscal policy that shiftsthe IScurve to the right to IS and thetight monetary policy that shifts theLMcurve to the left to LM, whileholding the exchange rate fixed

All three markets are then inequilibrium at point F, where curves ISand LM cross on the unchanged BPcurve at i = 8.0% and Yf= 1500


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Achieving Internal and External Balance

From unemployment / external deficit



Fiscal & Monetary Policiesfor Internal & External Balance

with Fixed Exchange Rates

Inelastic capitalmobility

Elastic (high) capitalmobility

Perfect capital mobility

Expansionary fiscal

policyTight monetary policy

Expansionary fiscal

policyEasy monetary policy

Expansionary fiscal

policyMonetary policy isineffective


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Fiscal & Monetary Policies fromDomestic Unemployment & External

Deficit Starting from point Ewith domestic

unemployment & external deficit, the nationcan reach the full employment level ofnational income of Yf= 1500 with externalbalance by pursuing the expansionary fiscal

policy that shifts the IScurve to the right toIS and the tight monetary policy that shiftsthe LMcurve to the left to LM, whilekeeping the exchange rate fixed

All three markets are then in equilibrium atpoint F, where curves IS and LM cross onthe unchanged BP curve at i = 9.0% and Yf=

1500 Because of the original external deficit, the

nation now requires a higher interest rate toreach external and internal balance


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Fiscal and Monetary Policies withElastic Capital Flows

Starting from point Ewith domesticunemployment & external deficit, thenation can reach the full employmentlevel of national income of Yf= 1500

with external balance by pursuing theexpansionary fiscal policy that shiftsthe IScurve to the right to IS and theeasy monetary policy that shifts the LMcurve to the right to LM, while keepingthe exchange rate fixed

All three markets are then inequilibrium at point F, where curves ISand LM cross on the unchanged BPcurve at i = 6.0% and Yf= 1500


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Fiscal & Monetary Policies withPerfect Capital Mobility & Fixed

Exchange Rates Starting from point Ewith domestic

unemployment & external balanceand perfect capital mobility & a fixedexchange rate, the nation can reach

the full employment level of nationalincome of Yf= 1500

With the expansionary fiscal policythat shifts the IScurve to the right toIS and with the LMcurve shifting tothe right to LMbecause of capital

inflows that the nation is unable toneutralize


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Achieving Internal and External Balance

From unemployment / external balance



The IS-LM-BPModel with FlexibleExchange Rates

Imperfect capital mobility Perfect capital mobility

Expansionary fiscal policyEasy monetary policy

Expansionary monetary policyFiscal policy is ineffective


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The IS-LM-BPModel with FlexibleExchange Rates

Starting from point Ewith all three marketsin equilibrium with an external balance &domestic unemployment, the nation coulduse easy monetary policy to shift the LMcurve to the right to LM so as to cross the IScurve at point Uand reach the full-

employment level ofYf= 1500 However, since pointU is to the right of theBPcurve, the nation has an external deficit

With flexible exchange rates, the nationscurrency depreciates and this causes the BP& IScurves to shift to the right and the LMcurve to the left until curves BP, IS, and LMcross at at E, with Y

e

= 1400 The process can be repeated with additional

doses of easy monetary policy until all threemarkets are in equilibrium at Yf= 1500


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for ECO561 - International Economics/Topic 11

Nov 2013/SHWong

Adjustment Policies with PerfectCapital Flows & Flexible Exchange

Rates Starting from point Ewith domestic

unemployment & external balance, &perfectly elastic capital flows & flexibleexchange rates, the nation can reach thefull-employment level of national income ofYf= 1500 with easy monetary policy to shift

the LMcurve to the right to LM. This causes the IScurve to shift to the right

to IS (because the tendency of the currencyto depreciate improves the nations tradebalance) and the LM curve back part of theway to LM (because of the reduction in realmoney supply resulting from an increase indomestic prices)

The final equilibrium is at point F where ISand LM curves cross on the BP curve at Yf=1500


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Policy Mix & Price Changes

Inflation & Surplus Recession & Surplus

Contractionary fiscal policyEasy monetary policy

Expansionary Fiscal policy

Inflation & Deficit Recession & Deficit

Contractionary fiscal policyExpansionary fiscal policy and

Contractionary monetary policy


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Effective Market Classification and thePolicy Mix

Moving to the right refers to expansionaryfiscal policy, whole moving upward refers totight monetary policy & higher interest rates

The various combinations of fiscal &monetary policies that result in internalbalance are given by the IBline whileexternal balance are given by the EBline

The EBline is flatter than the IBline becausemonetary policy also induces short-terminternational capital flows

Starting from point Cin zone IV, the nationshould use expansionary fiscal policy toreach point C1on the IBline & then tightmonetary policy to reach point C2on the EBline, on its way to pointF, where the nationis simultaneously in internal & externalbalance

If the nation did the opposite, it wouldmove to point C1on the EB line & then topointC2 on theIB line, thus moving farther& farther away from point F


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Tariffs, quotas & other quantitativerestrictions on the flow of international trade

An import tariff & export subsidy of a given

percentage applied across the board on allgoods are equivalent to a devaluation of thecurrency by the same percentage

Import tariffs & export quotas areexpenditure-switching policies, stimulatedomestic production



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Direct Controls


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Restrictions on international capital flows,multiple exchange rates

Developed nations sometimes restrict capital

exports when in balance of payments deficitand capital imports when in surplus

Higher exchange rates on luxuries andnonessentials discourages their importation,while lower exchange rates on essentialimports encourage their import



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Direct Controls (Exchange Controls)


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For direct controls to be effective, a great dealof international cooperation is required Imposition of import quotas may result in

retaliation if affected nations are notconsulted

Further, the use of many direct controls (forinstance, tariffs & non-tariff barriers) isconstrained by international treaties such asGATT



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Direct Controls (Effectiveness)

topic 11 - adjustment policies

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