International_Economics_Tenth_Edition (1)

floating exchange-rate system, however, the central bank does nothing to offset this appreciation. By making the nation less competitive, the appreciation leads to falling exports and rising imports; the ensuing decrease in aggregate demand, output, and employment offsets the initial gains of the fiscal expansion. The expansionary fiscal policy is thus unable to mitigate the economy's recession. Adjustment following an increase in government spending under floating exchange rates is summarized in Figure 16.2(b).

Monetary Policy with Fixed Exchange Rates and Floating Exchange Rates

Suppose that a nation experiences domestic recession and that it allows its currency to float in the

foreign-exchange market. To stimulate domestic output, assume that the central bank adopts an expansionary monetary policy. By increasing the supply of money relative to the money demand, the monetary policy leads to lower interest rates, which stimulate aggregate demand and output. Lower interest rates also discourage foreigners from investing in the home country and encourage its residents to invest abroad. The resulting net capital outflows induce a depreciation of the nation's currency and an improvement in its international competitiveness. The subsequent rise in exports and fall in imports lead to further increases in output and employment; the expansionary monetary policy thus promotes internal balance. Adjustment following an expansionary monetary policy under floating exchange rates is summarized in Figure 16.3(a) on page 480.

Contrast this outcome with the effects of monetary policy under a system of fixed exchange rates. The monetary expansion reduces interest rates, leading to rising aggregate demand, output, and employment. Lower interest rates result in net capital outflows and a depreciation in the currency's exchange value. To maintain a fixed exchange rate, however, the central bank intervenes on the foreign-exchange market and purchases the home currency with foreign currency. This decreases the money supply and offsets the initial increase in the money supply. The initial output and employment expansion resulting from the expansionary monetary policy is thus blunted, and internal balance is not attained. Adjustment following an expansionary monetary policy under fixed exchange rates is summarized in Figure 16.3(b).

Monetary and Fiscal Policies: Effects on External Balance

What are the effects of monetary policy and fiscal policy on a nation's external balance? We assume that the exchange rate is fixed, because BOP surpluses and BOP deficits are issues only when the exchange rate is fixed; recall that floating exchange rates automatically adjust to promote BOP equilibrium.

The short-run effects of monetary policy on the BOP are definite: An expansion in the money supply worsens the BOP, whereas a contraction in the money supply improves the BOP.These effects are illustrated in Figure 16.4.

To illustrate, assume the central bank increases the money supply, relative to the money demand, which pushes interest rates downward. Falling interest rates encourage additional investment spending, which leads to an increase in aggregate demand, output, and income. The rise in income, in turn, increases imports and worsens the trade balance. At the same time, falling interest rates (relative to those abroad) induce net investment outflows and a deterioration in the capital account. By worsening the trade balance and the capital account balance, the monetary expansion worsens overall BOP. In the long run, the overseas investments will be repaid with interest, resulting in a positive feedback into the BOP; however, the negative effect on the trade balance will persist.

The short-run effects on the BOP of expansionary fiscal policy are not as clear as those of monetary policy. Assume the government increases its purchases of goods and services, leading to increases in aggregate demand, output, and income. Rising income, in turn, induces rising imports and a worsening trade balance. Meanwhile, increased government spending leads to increased money demand and rising interest rates. The higher interest rates, in turn, induce net investment inflows and an improvement in the capital account. If capital mobility is sufficiently high, the improvement in the capital account more than offsets the tradeaccount deterioration, and the overall BOP improves. Eventually, however, foreign investors must be repaid with interest, and this more than

482 Macroeconomic Policy in an Open Economy

offsets the investment inflows caused by higher interest rates. As a result, the fiscal expansion probably worsens the overall BOP in the long run, albeit improving it in the short run if enough investment inflows occur in response to higher interest rates.

Monetary Policy and Fiscal

Policy: Policy Agreement

and Policy Conflict

With fixed exchange rates, let us consider monetary policy and fiscal policy and see what effects they have on a nation's internal balance and external balance.

Consider monetary policy first. Referring to Figure 16.1, suppose that a nation experiences unemployment with BOP surplus, shown by point

B. The previous section suggested that if the central bank increases the money supply, which leads to rising aggregate demand, unemployment will fall and the BOP surplus will decrease. In this case, the expansionary monetary policy clearly promotes overall balance. Alternatively, suppose that a country experiences inflation with BOP deficit, shown by point D in Figure 16.1. A reduction in the money supply, which reduces aggregate demand, decreases the inflation rate as well as the BOP deficit, thus promoting overall balance. These two disequilibrium zones illustrate policy agreement for monetary policy. Changes in the money supply move the economy toward both internal balance and external balance.

Not all disequilibrium zones, however, are as favorable for monetary policy. Suppose now that a nation experiences unemployment with BOP deficit, shown by point C in Figure 16.1. The previous section suggested that an expansionary monetary policy, which raises aggregate demand, will reduce unemployment-but at the cost of a larger BOP deficit (southeast from point C). If a country experiences inflation with BOP surplus, shown by point A in Figure 16.1, a contractionary monetary policy leads to less inflation but increased BOP surplus (northwest from point A). These disequilibrium zones imply policy conflict for monetary policy. Although changes in the

money supply improve one economic objective, they detract from another objective. A dilemma thus exists for monetary authorities concerning which objective to pursue.

Instead of utilizing monetary policy in policyconflict zones, suppose a nation resorts to fiscal policy. Assume, for example, that a country experiences unemployment and BOP deficit, as shown by point C in Figure 16.1. Recall that an expansionary fiscal policy, which raises aggregate demand, promotes full employment; however, it reduces a nation's BOP deficit only if the ensuing improvement in the capital account more than offsets the deterioration in the trade account. If a country experiences inflation and BOP surplus, shown by point A in Figure 16.1, a contractionary fiscal policy lessens inflation; whether the BOP surplus rises or falls depends on whether the worsening of its capital account more than offsets the improvement of its trade account. It is thus not clear whether fiscal policy is able to promote overall balance for a nation situated in one of these policy-conflict zones.

When a nation finds itself in a policy-conflict zone, fiscal policy or monetary policy alone will not necessarily restore both internal and external balance. A combination of policies is generally needed. Suppose, for example, that a nation experiences unemployment with BOP deficit, shown by point C in Figure 16.1. An expansionary monetary policy to combat unemployment might be accompanied by tariffs or quotas, or possibly currency devaluation, to reduce imports and improve the BOP. Each economic objective is matched with an appropriate policy instrument so that both objectives can be attained at the same time.

In U.S. history, the Federal Reserve has attempted to line up policy instruments with targets during conflict situations. During the early 1960s, the conflict was domestic recession with BOP deficit. The Federal Reserve attempted to match instruments with targets by manipulating the structure of domestic interest rates in a program called Operation Twist. Under this program, the u.s. interest-rate structure was modified so that shortterm rates were used primarily to promote external balance whereas long-term rates were used primari-

ly for internal balance. By keeping short-term interest rates high, the United States could expect to experience net investment inflows, thereby improving its BOP position. Low long-term rates would presumably stimulate domestic investment, output, and employment, thus correcting the recession. At best, Operation Twist was only partially successful in promoting overall balance. The policy was initially successful in keeping short-term rates above longterm rates. As time passed, however, the differential between them disappeared as inflation pushed both short-term and long-term rates upward, thus moderating the program's success.

Inflation with

Unemployment

The analysis so far has looked at internal balance under special circumstances. It has been assumed that as the economy advances to full employment, domestic prices remain unchanged until full employment is reached. Once the nation's capacity to produce has been achieved, further increases in aggregate demand pull prices upward. This type of inflation is known as demand-pull inflation. Under these conditions, internal balance (full employment with stable prices) can be viewed as a single target that requires but one policy instrument: reductions in aggregate demand via monetary policy or fiscal policy.

A more troublesome problem is the appropriate policy to implement when a nation experiences inflation with unemployment. Here the problem is that internal balance cannot be achieved just by manipulating aggregate demand. To decrease inflation, a reduction in aggregate demand is required; to decrease unemployment, an expansion in aggregate demand is required. Thus, the objectives of full employment and stable prices cannot be considered as one and the same target; rather, they are two independent targets, requiring two distinct policy instruments.

Achieving overall balance thus involves three separate targets: (1) BOP equilibrium, (2) full employment, and (3) price stability. To ensure that all three objectives can be achieved simulta-

neously, monetary/fiscal policies and exchangerate adjustments may not be enough; direct controls may also be needed.

Inflation with unemployment has been a problem for the United States. In 1971, for example, the U.S. economy experienced inflation with recession and BOP deficit. Increasing aggregate demand to achieve full employment would presumably intensify inflationary pressures. The president therefore implemented a comprehensive system of wage and price controls to remove the inflationary constraint. Later the same year, the United States entered into exchange-rate realignments that resulted in a depreciation of the dollar's exchange value by 12 percent against the trade-weighted value of other major currencies. The dollar depreciation was intended to help the United States reverse its BOP deficit. In short, it was the president's view that the internal and external problems of the United States could not be eliminated through expenditure-changing policies alone.

International Economic-

Policy Coordination

Policy makers have long been aware that the welfare of their economies is linked to that of the world economy. Because of the international mobility of goods, services, capital, and labor, economic policies of one nation have spillover effects on others. This spillover is especially true for the larger industrial economies, but even here, the linkages are stronger among some nations, such as those within Western Europe, than for others. Recognizing these spillover effects, governments have often made attempts to coordinate their economic policies.

Economic relations among nations can be visualized along a spectrum, illustrated in Figure 16.5 on page 484, ranging from open conflict to integration, where nations implement policies jointly in a supranational forum to which they have ceded a large degree of authority, such as the European Union. At the spectrum's midpoint lies policy independence: Nations take the actions of other nations as a given; they do not attempt to

influence those actions or be influenced by them. Between independence and integration lie various forms of policy coordination and cooperation.

Cooperative policy making can take many forms, but in general it occurs whenever officials from different nations meet to evaluate world economic conditions. During these meetings, policy makers may present briefings on their individual economies and discuss current policies. Such meetings represent a simple form of cooperation. A more involved format might consist of economists' studies on a particular subject, combined with an in-depth discussion of possible solutions. True policy coordination, however, goes beyond these two forms of cooperation; policy coordination is a formal agreement among nations to initiate particular policies.

International economic-policy coordination is the attempt to significantly modify national policies-monetary policy, fiscal policy, exchangerate policy-in recognition of international economic interdependence. Policy coordination does not necessarily imply that nations give precedence to international over domestic concerns. It does recognize, however, that the policies of one nation can spill over to influence the objectives of others; nations should therefore communicate with one another and attempt to coordinate their policies so as to take these linkages into account. Presumably, they will be better off than if they had acted independently.

There are many examples of international economic-policy coordination. The Smithsonian Agreement of 1971 was a coordinated attempt by the major industrial nations to realign the exchange values of their currencies using currency devaluations and revaluations. The 1978 Bonn Summit resulted in the enactment by Germany and japan of expansionary fiscal and monetary policies to stimulate their demand for U.S. goods and reduce the u.S. trade deficit; in return, the United States raised its price of oil to the world level.

To facilitate policy coordination, economic officials of the major governments talk with one another frequently in the context of the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD). Also, central-bank senior officials meet monthly at the Basel meetings of the Bank for International Settlements (BIS). Since 1975, government officials of the seven largest industrial economies (United States, Canada, japan, United Kingdom, Germany, France, and Italy), known as the Group of Seven (G-7), have met in annual economic summits to discuss economic issues of common concern. Not only do the G-7 nations initiate dialogues concerning economic objectives and policy, but they also devise economic indicators that provide a framework for multilateral surveillance of their economies and help monitor the international consequences of domestic policies.

Policy Coordination in Theory

If economic policies in each of two nations affect the other, then the case for policy coordination would appear to be obvious. Policy coordination is considered important in the modern world because economic disruptions are transmitted rapidly from one nation to another. Without policy coordination, national economic policies can destabilize other economies. The logic of policy coordination is illustrated in the following basketball-spectator problem."

Suppose you are attending a basketball game between the Seattle Supersonics and the Chicago Bulls. If everyone is sitting, someone who stands has a superior view. Spectators usually can see well if everyone sits or if everyone stands. Sitting in seats is more comfortable than standing. When there is no cooperation, everyone stands; each spectator does what is best for herselflhimself given the actions of other spectators. If all spectators sit, someone, taking what the others will do as a given, will stand. If all spectators are standing, then it is best to remain standing. With spectator cooperation, the solution is for everyone to sit. The problem is that each spectator may be tempted to get a better view by standing. The cooperative solution will not be attained, therefore, without an outright agreement on coordination-in this situation, everyone remains seated.

Consider the following economic example. Suppose the world consists of just two nations, Germany and japan. Although these nations freely trade goods with each other, they desire to pursue their own domestic economic priorities. Germany wants to avoid trade deficits with japan, while achieving full employment for its economy; japan desires full employment for its economy, while avoiding trade deficits with Germany. Assume that both nations achieve balanced trade with each other, but each nation's economy operates below full employment. Germany and japan contemplate enacting expansionary government spending policies that would stimulate demand, output, and

'See S. Fischer, "International Macroeconomic Policy Coordination," in M, Feldstein, International Economic Cooperation (Chicago: University of Chicago Press, 1988), p. 19.

employment. But each nation rejects the idea, recognizing the policy's adverse impact on the trade balance. Germany and japan realize that bolstering domestic income to increase jobs has the side effect of stimulating the demand for imports, thus pushing the trade account into deficit.

The preceding situation is favorable for successful policy coordination. If Germany and japan agree to simultaneously expand their government spending, then output, employment, and incomes will rise concurrently. While higher German income promotes increased imports from japan, higher japanese income promotes increased imports from Germany. An appropriate increase in government spending results in each nation's increased demand for imports being offset by an increased demand for exports, which leads to balanced trade between Germany and japan. In our example of mutual implementation of expansionary fiscal policies, policy coordination permits each nation to achieve full employment and balanced trade.

This is an optimistic portrayal of international economic-policy coordination. The synchronization of policies appears simple because there are only two economies and two objectives. In the real world, however, policy coordination generally involves many countries and many diverse objectives, such as low inflation, high employment, economic growth, and trade balance.

If the benefits of international economic-policy coordination are really so obvious, it may seem odd that agreements do not occur more often than they do. Several obstacles hinder successful policycoordination. Even if national economic objectives are harmonious, there is no guarantee that governmentscan design and implement coordinated policies. Policy makers in the real world do not alwayshave sufficient information to understand the nature of the economic problem or how their policies will affecteconomies. Implementing appropriate policies when governmentsdisagreeabout economic fundamentals is difficult.

Policy coordination is also complicated by different national starting points:'

'See R. Putnam and C. R. Henning, "The Bonn Summit of 1978: A Case Study in Coordination," in R. Cooper et al.. CanNations Agree? (Washington, DC: The Brookings Institution, 1989), p. 17.

486 Macroeconomic Policy in an Open Economy

Different economic objectives. Some nations give higher priority to price stability, for instance, or to full employment, than others.

Different national institutions. Some nations have a stronger legislature, or weaker trade unions, than others.

Different national political climates. The party pendulums in different nations, for example, shift with elections occurring in different years.

Different phases in the business cycle. One nation may experience economic recession while another nation experiences rapid inflation.

Although the theoretical advantages of international economic-policy coordination are fairly clearly established, attempts to quantify their gains are rare. Skeptics point out that in practice, the gains from policy coordination are smaller than what is often suggested. Let us consider some examples of international economic-policy coordination.

Does Policy

Coordination Work?

Does coordination of economic policies improve the performance of nations? Proponents of policy coordination cite the examples of the Plaza Agreement of 1985 and the Louvre Accord of 1987.

By early 1984, the U.S. economy was recovering from the recession of 1981-1983; domestic output was rising and unemployment was falling. While an expansionary fiscal policy contributed to economic recovery, growing U.S. government budget deficits were causing concern about the stability of the world financial system. Equally problematic was the appreciation in the dollar's exchange value, which encouraged U.S. consumers to purchase cheaper imports, and resulted in large U.S. current account deficits. By 1985, it was estimated that the dollar was overvalued by about 30 to 35 percent. As the U.S. recovery slowed, protectionist pressures skyrocketed in the U.S. Congress.

Fearing a disaster in the world trading system, government officials of the Group of Five (G-5) nations-the United States, japan, Germany, Great Britain, and France-met at New York's Plaza Hotel in 1985. There was widespread agreement

that the dollar was overvalued and that the twin U.S. deficits (trade and federal budget) were too large. Each country made specific pledges on economic policy: The United States promised to reduce the federal deficit, japan pledged a more expansionary monetary policy and a host of financial-sector reforms, and Germany offered tax reductions. All countries agreed to intervene in currency markets as needed to shove the dollar downward. Although not all the pledges were fully honored, especially the United States on deficit reduction, the plan turned out to be successful. By 1988, the dollar had fallen by 54 percent against the currencies of Germany and japan from its peak of 1985.

However, the sharp decline in the dollar's exchange value set off a new concern, an uncontrolled dollar plunge. So in 1987 another round of policy coordination occurred to stabilize the dollar. At the Louvre Accord, specific policy promises were made: the United States to adopt a restrictive fiscal policy and japan to ease monetary policy. Meanwhile, the current-account deficit of the United States began to decline, aided by the large depreciation of the dollar and even more by relatively faster economic growth overseas. In the late 1980s, domestic demand slowed in the United States but remained strong in japan and Germany. In 1990, the current-account deficit of the United States was down to 1 percent of GDP and a year later, after a modest recession, it was in surplus.

Although the episodes of the Plaza Agreement and Louvre Accord point to the success of policy coordination, by the early 2000s government officials were showing less enthusiasm for policy coordination. They felt that coordinating policy had become much more difficult because of the way policy is made, especially given the rise of independent central banks. Back in the 1980s, the governments of japan and Germany could dictate what their central banks would do. Now, the Bank of japan and the European Central Bank maintain their independence and see themselves as protectors of discipline against high-spending government officials. That makes domestic fiscal and monetary coordination difficult, and international efforts to coordinate policies even more difficult. Also, the huge growth in global financial markets has made currency intervention much less effective. Today, more

than $1 trillion in foreign exchange crosses borders every day, up from $200 billion in 1985. Economists generally think that official currency intervention works at best at the margin, and then only if it is used to reinforce existing economic trends. Moreover, major changes in the structure of u.s. trade patterns mean that more countries would have to be involved in any adjustment process. During the 1980s, Japan accounted for 16 percent of u.s. trade; today, that share is about 9 percent. Meanwhile, Mexico, China, and other Asian coun-

tries have become much more important trading partners. Generally speaking, the more nations involved in policy coordination, the more difficult it is to achieve. Finally, the sluggish economies of Japan and Germany in the early 2000s prevented them from being engines of economic growth for the world, while Asian countries refused to allow their currencies to appreciate against the dollar. That made the prospects of policy coordination much dimmer than they were earlier.

1.International economic policy refers to various government activities that influence trade patterns among nations, including (a) monetary and fiscal policies, (b) exchange-rate adjustments, (c) tariff and nontariff trade barriers,

(d)foreign-exchange controls and investment controls, and (e) export-promotion measures.

2.Since the 1930s, nations have actively pursued internal balance (full employment without inflation) as a primary economic objective. Nations also consider external balance (balance-of-payments equilibrium) as an economic objective. A nation realizes overall balance when it attains internal balance and external balance.

3.To achieve overall balance, nations implement expenditure-changing policies (monetary and fiscal policies), expenditure-switching policies (exchange-rate adjustments), and direct controls (price and wage controls).

4.Although exchange-rate adjustments primarily influence a nation's BOP position, they have secondary impacts on the domestic economy. A nation with a BOP deficit and high unemployment could devalue its currency to resolve these problems; a nation with a BOP surplus and inflation could revalue its currency. Such policies are dependent upon the willingness of other nations to refrain from implementing offsetting exchange-rate adjustments. International economic-policy cooperation is thus essential when nations are economically interdependent.

5.Under a fixed exchange-rate system, fiscal policy is successful in promoting internal balance, whereas monetary policy is unsuccessful. Under a floating exchange-rate system, monetary policy is successful in promoting internal balance, whereas fiscal policy is unsuccessful.

6.Given a fixed exchange-rate system, in the short run, an expansionary monetary policy worsens the BOP position, and a contractionary monetary policy improves the BOP position. An expansionary fiscal policy leads to a worsening of the trade account and an improvement in the capital account; the impact on the overall BOP depends on the relative strength of these opposing forces.

7.Policyagreement occurs when an economic policy helps eliminate internal disequilibrium and external disequilibrium, thus promoting overall balance for the nation. Policy conflict occurs when an economic policy helps eliminate one economic problem (such as internal disequilibrium), but aggravates another economic problem (such as external disequilibrium).

8.Given a fixed exchange-rate system, for monetary policy the disequilibrium zones of unem- ployment-with-BOP-surplus and inflation- with-BOP-deficit are zones of policy agreement. The disequilibrium zones of unemployment- with-BOP-deficit and inflation-with-BOP-sur- plus are zones of policy conflict; a dilemma exists for monetary authorities concerning which objective to pursue. A combination of policies may be needed to resolve these economic problems.

9.When a nation experiences inflation with unemployment, achieving overall balance involves three separate targets: BOP equilibrium, full employment, and price stability. Three policy instruments may be needed to achieve these targets.

10.International economic-policy coordination is the attempt to significantly modify national policiesin recognition of international economic interdependence. Nations regularly consult with each other in the context of the IMF, OEeD, Bank for International Settlements,

and Group of Seven. The Plaza Agreement and Louvre Accord are examples of international economic-policy coordination.

11.Several problems confront international economic-policy coordination: (a) different national economic objectives, (b) different national institutions, (c) different national political climates, (d) different phases in the business cycle.Moreover, there is no guarantee that governments can design and implement policies that are capable of achieving the intended results.

1.Distinguish among external balance, internal balance, and overall balance.

2.What are the most important instruments of international economic policy?

3.What is meant by the terms expenditurechanging policy and expenditure-switching policy? Give some examples of each.

4.What institutional constraints bear on the formation of economic policies?

5.Assume that a nation faces a BOP deficit with high unemployment. What exchange-rate adjustment can be made to resolve these problems? What if the nation experiences a BOP surplus with inflation?

6.Under a system of fixed exchange rates, is monetary policy or fiscal policy better suited for promoting internal balance? Why?

7.Under a system of floating exchange rates, is monetary policy or fiscal policy better suited for promoting internal balance? Why?

8.With fixed exchange rates, what impact does an expansionary monetary policy have on the nation's BOP? What about a contractionary monetary policy?

9.With fixed exchange rates, when does an expansionary fiscal policy improve the nation's BOP? When does it worsen the BOP?

10.What is meant by the terms policy agreement and policy conflict?

11.Given a system of fixed exchange rates, for monetary policy, is unemployment-with-BOP- surplus a zone of policy agreement or policy conflict? What about inflation-with-BOP- deficit, unemployment-with-BOP-deficit, or inflation-with-BOP-surplus?

12.What are some obstacles to successful international economic-policy coordination?