Fiscal and Monetary Policy in an Open Economy

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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...
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