Ch.17: Macro Policy

(assuming floating exchange rates)

What this Chapter is all about

• Known concepts: fiscal and monetary policy. • New concepts: internal and external balance. • Today, internal balance is more important to

policymakers than external balance. Virtually ignoring external balance is historically new. Prior to the 1970s, policymakers considered external balance more important.

Policy Objectives

• Internal Balance– GDP (full employment)– P (keep inflation in check)

• External Balance– X-M (current account balance)

Policy Instruments

• Fiscal Policy– expansionary: higher G / lower T– contractionary: lower G / higher T

• Monetary Policy– expansionary: increase MS– contractionary: decrease MS

Fiscal Policy (expansionary)

(G and/or T) 1. direct effect: AD and P2. indirect effect: budget deficit Gov. must

borrow i attracts foreign capital (until i back at original level) XR (X-M) AD and P

3. net effect: ambiguous! Fiscal policy now used less as a means of stabilizing the economy than 30 years ago b/c of flexible exchange rates and increased international mobility of capital.

Monetary Policy (expansionary)

MS i1. direct effect: (C and I) (AD and P)2. indirect effect: outflow of capital XR

(X-M) (AD and P)3. net effect: clear!

monetary policy is more effective than fiscal policy as a stabilization tool b/c of flexible exchange rates.

Summary

Policy Effect Y P XR X-Mfiscal: expansion

Direct

Indirect

Net

fiscal: contraction

Direct

Indirect

Net

monetary: expansion

Direct

Indirect

Net

monetary: contraction

Direct

Indirect

Net

Policy Mixes

Fiscal

expansion

Fiscal

contraction

Monetary

expansion

Consistent

internal external ?

Inconsistent

internal ?external

Monetary

contraction

Inconsistent

internal ?external

Consistent

internal external ?

The J-curve

• Problem of time lag between change in XR and response in trade flows.

• Prices slow to adjust• Depreciation thus implies lower revenue

initially, but higher revenue later as export volume increases.

• This isn’t just theory. The phenomenon of the current account worsening for one or two quarters after a devaluation is practically the rule. People who don’t understand this effect are frequently fooled by the short-run reaction of the current account to changes in the exchange rate.