Summary of week 2 of the course International Money and Finance. Including chapter 4 and 6 of the book International Finance by Keith Pilbeam and Franc Klaassen.
Chapter 4: Macroeconomic Policy in an Open Economy
A fundamental difference between an open economy and a closed economy is that over time a
country has to ensure that there is an approximate balance in its current account. This is because no
country can continuously build up a stock of net liabilities to the rest of the world by running a
continuous current account deficit. Conversely, it does not make sense for a surplus country to build
up continuously a stock of net claims on the rest of the world. One of the additional policy choices
that has to be made by the authorities of an open economy is to decide whether to fix the exchange
rate. In this chapter we concentrate upon how fiscal and monetary policy operate under both
regimes.
The Problem of Internal and External Balance
Between 1948 and 1973 the international monetary system was one of fixed exchange ratees, with
the major currencies being pegged to the US dollar. Only in cases of ‘fundamental disequilibrium’
were authorities allowed to devalue of revalue their currencies. This meant that there was
considerable interest in the relative effectiveness of fiscal and monetary policies as a means of
influencing the economy. The discussion in the 1950s and 1960s was primarily concerned with two
objectives. The principal goal was one of achieving full employment for the labour force along with
a stable level of prices, which may be termed ‘internal balance’. Although governments were
generally committed to achieving full employment it is widely recognized that expanding output in an
open economy will have implications for the balance of payments. Expanding output and
employment will result in greater expenditure on imports and consequently lead to a deterioration
of the current account. As authorities had agreed to maintain fixed exchange rates, they were
interested in running an equilibrium in the balance of payments, that is, in balancing the supply
and demand for their currency. This latter objective can be termed external balance.
Changes in fiscal and monetary policies which aim to influence the level of aggregate demand in the
economy are termed ‘expenditure changing’ policies. Policies such as devaluation/revaluation of the
exchange rate, which attempt to influence the composition of spending between domestic and
foreign goods, are known as ‘expenditure switching’ policies.
Figure 4.1 – The Swan diagram.
The policy problem of achieving both internal and external balance was conceptualized by Trevor
Swan in what is known as the Swan diagram. The vertical axis is the real exchange rate and the
horizontal axis the real domestic absorption. Real depreciation rises the price of imports, which
implies improved international competitiveness. The amount of real domestic absorption represents
the sum of consumption, investment and government expenditure.
The internal balance (IB) schedule represents combinations of the real exchange rate and domestic
absorption for which the economy is in internal balance, that is full employment with stable prices. It
is downward-sloping from left to right. This is because an appreciation of the real exchange rate will
reduce exports and increase imports; therefore to maintain full employment it is necessary for there
to be an increase in domestic expenditure. To the right of the IB schedule there are inflationary
pressure in the economy because for a given exchange rate domestic expenditure is greater than
required to produce full employment, while to the left there are deflationary pressures because
expenditure is short of that required to maintain full employment.
The external balance (EB) schedule shows combinations of the real exchange rate and domestic
absorption for which the economy is in external balance, that is equilibrium in the current account. It
is upward-sloping from left to right. This is because a depreciation of the exchange rate will increase
exports and reduce imports; so to prevent the current account moving into surplus requires
, increased domestic expenditure to induce an offsetting increase in imports. To the right of the EB
schedule domestic expenditure is greater than that required for current account equilibrium, so the
result is a current account deficit, while to the left there is a current account surplus.
There are 4 zones:
Zone 1: a deficit and inflationary pressures
Zone 2: a deficit and deflationary pressures
Zone 3: a surplus and deflationary pressures
Zone 4: a surplus and inflationary pressures.
Suppose that the economy for some reason finds itself in zone 1, experiencing both inflationary
pressures and a current account deficit. To achieve two targets, the use of two instruments is most
likely to be successful. To become in both internal and external equilibrium, the authorities need to
both deflate the economy by cutting back real domestic expenditure and try to tackle the deficit by
devaluing the exchange rate by appropriate amounts.
The Mundell-Fleming Model
Figure 4.2 – Derivation of the IS schedule
We shall now examine the main implications of the Keynesian model and the results of Fleming’s and
Mundell’s papers by using what is known as IS-LM-BP analysis (IS-investment-savings, LM-liquidity
preference – money and BP balance of payments). The IS curve for an open economy shows various
combinations of the level of output (Y) and the rate of interest that make leakage, that is savings and
import expenditure (S+M), equal to injections, that is investment, government expenditure and
exports (I+G+X). In an open economy we have the identity:
Y =C + I + G+ X−M
Since Y −C=S , we can rewrite the equation:
S+ M =I +G+ X
For simplicity the following linear relationships are assumed:
S=S a +sY
M =M a +mY
Where S are equal to autonomous savings ( Sa ) plus savings which are a positive function of income,
where s is the marginal propensity to save. Where M are equal to autonomous imports ( M a) plus
imports which are a positive function of income, where m is the marginal propensity to import.
I =I ( r ) dI /dr < 0
This equation says that investment is assumed to be an inverse function of the rate of interest. As far
as government expenditure and exports are concerned these are assumed to be autonomous with
respect to the rate of interest and level of national income.
Quadrant(1) depicts the relationship between leakage and income; it is an upward-sloping line
because increases in income lead to increased savings and imports, and the slope of the line is given
by 1/( s+ m). Quadrant (2) depicts the relationship between leakage and injection; which has a 45-
degree line. Quadrant(3) depicts the relationship between the rate of interest and the level of
injections. It is downward-sloping from left to right because investment is inversely related to the
rate of interest. We now know that the income level Y 1 generates leakage L1which will be equal to
injection ¿1 if the interest rate is r 1. This means that in quadrant (4) we can depict a point on the IS
curve for an open economy because at interest rate r 1and income level Y 1 we know that leakages
are equal to injections. By repeating the process we can obtain a large number of income and
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