Chapter Four

Macroeconomic Policy
in an Open Economy
 What is Open – Economy
Macroeconomics?
Closed and Open Economies
A Closed economy is one that does not
interact with other economies in the world.
 There are no exports, no imports, and no
capital flows.
Spending equal output Y = C + I + G
Saving is equal to investment S=I
An Open economy is one that interacts freely with
other economies around the world
An open economy interacts with other countries
in two ways.
It buys and sells goods and services in world
product markets.
 Spending need not equal output
It buys and sells capital assets in world financial
markets.
 Saving need not equal investment
  The Flow of Goods:
Exports, Imports, Net Exports

 Exports are goods and services that are produced

domestically and sold abroad.
 Imports are goods and services that are produced
abroad and sold domestically.
 Net exports (NX) are the value of a nation’s exports
minus the value of its imports.
 Net exports (NX) are also called the trade balance.
• In an open economy, some output is sold

domestically and some is exported to be sold

abroad.

• Y = Cd + I d + Gd + X

• Where, Cd + Id + Gd is domestic spending on

domestic goods and services and X, is foreign

spending on domestic goods and services.

 C = C d + Cf

I = I d + If

G = G d + Gf
 We substitute these three equations into the identity
above:

Y = (C – Cf) + (I – If) + (G – Gf) + X

 We can rearrange to obtain

Y = C + I + G + X – (Cf + If + Gf)
 The sum of domestic spending on foreign goods and
services (Cf + If + Gf) is expenditure on imports (M).
• Y=C+I+G+X–M
 Defining net exports to be exports minus imports (NX = X
− IM), the identity becomes
• Y = C + I + G + NX

§ The national income accounts identity shows how

domestic output, domestic spending, and net exports are
related.
§ In particular,

NX = Y – (C + I + G)

Net Export = Output – Domestic Spending

 A trade deficit is a situation in which net exports (NX) are
negative.
 Imports > Exports
 A trade surplus is a situation in which net exports (NX) are
positive.
 Exports > Imports
 Balanced trade refers to when net exports are zero—exports
and imports are exactly equal.

 Factors that Affect Net Exports

The tastes of consumers for domestic and foreign

goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The incomes of consumers at home and abroad.
The costs of transporting goods from country to
country.
The policies of the government toward
international trade.
  The Flow of Financial Resources:
Net Capital Outflow
 Net capital outflow refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by
foreigners.
 Its relationship with flow of goods is
Y = C + I + G + NX
 Subtract C and G from both sides to obtain
Y – C – G = I + NX
• Where, Y − C − G is national saving S, which equals the sum of
private saving, Y− T− C, and public saving, T – G.
 Cont.….
• The difference between domestic saving and
domestic investment, S − I, is called net capital
outflow (or net foreign investment).
 Positive net capital outflow - lending the excess to
foreigners.

 Negative net capital outflow - financing extra

investment by borrowing from abroad.

The Equality of Net Exports and Net
Capital Outflow
 For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
 This holds true because every transaction that
affects one side must also affect the other side by the
same amount.
• The national income accounts identity shows that
net capital outflow always equals the trade balance.
• Net Capital Outflow = Trade Balance

• S − I = NX

• S − I and NX are positive- Trade Surplus

• S − I and NX are negative- Trade Deficit

• S − I and NX are exactly zero- Balanced Trade

 Variables that Influence Net Capital Outflow

The real interest rates being paid on foreign and

domestic assets.
The perceived economic and political risks of
holding assets abroad.
The government policies that affect foreign
ownership of domestic assets.
Macroeconomic Policy Goals in an Open Economy

Objectives of macroeconomic policy

Internal balance
External balance
Long-term economic growth
Reasonably equitable distribution of
national income
 Internal balance
o Economic stability at full employment
• A fully employed economy
• No inflation
 External balance
o When it realizes neither deficits nor
surpluses in its current account
 Overall balance
o Internal balance and external balance
 Policy Instruments
Expenditure-changing policies
Adjust the level of total spending (aggregate
demand) for goods and services
• Produced domestically and imported
Fiscal policy
• Changes in government spending and taxes
Monetary policy
• Changes in the money supply and interest
rates
 Central bank
Expenditure-switching policies
Modify the direction of demand

• Shifting it between domestic output and imports

Under fixed exchange rates and trade deficit

• Devalue its currency

Under managed floating exchange-rate and to increase
its competitiveness
• Depreciate its currency
Direct controls
Government restrictions on the market economy
To control particular items in the current account
To restrain capital outflows
To stimulate capital inflows
 Stabilization Policies
 Trade cycles cause many difficulties to the
population
 During upswing inflation occurs, this affects low
and middle income groups, people with fixed
income.
 During recession and depression the entire
economy suffers due to unemployment.
 What is Stabilization Policy ?
 Stabilization Policy is a set of measures
introduced by the government to stabilize the
economy.
It includes
 Business cycle Stabilization Policy and
 Crises stabilization.
 Counter cyclical measures to control and to
prevent fluctuation in national income,
employment and out put.
 objectives
 Price policy:- to stabilize price. i.e. prevent
and control wide fluctuations in the price level
 Employment policy:- to achieve full
employment or to prevent involuntary
unemployment
 Growth policy:-to achieve steady growth,
ensure that the economy grows steadily.
 Monetary Policy:
Tools of Monetary Policy
 Monetary Policy or Central bank policy: should be
used to avoid the occurrence of booms and slumps
It includes
 Banking and credit policy
 Loans and interest rates
 The monetary standards
 Public debt and its management
 Quantitative measures
 Change in bank rate: increase the rate of
interest during inflation, decreasing during
recession.
 Reserve ratio: increase during inflation,
decreasing during recession.
 Open market operation: central bank buys bond
and shares to release money in to the market
during recession. During inflation it sells its
shares and bonds to remove excess money from
the market.
 Qualitative measures
 The qualitative or selective measures seeks to
regulate particular type of credit.
 Its object is to stimulate, restrict or stabilize
bank advances for specific business schemes.
 Deficit financing
 Means filling the gap between government revenue
and government expenditure in a government budget
by borrowing funds from central bank or public.
 On the request of the central government the central
bank can increase the supply of currency during
deflation.
 Deficit financing is done so that overall government
expenditures matches with overall government
income.

 Limitation of Monetary policy

Reading Assignment
 Fiscal Policy:
Tools of Fiscal Policy
 Keynesians suggested increasing government
spending and decreasing tax rates to stimulate
aggregate demand.
 Fiscal policy also known as the contra – cyclical
management of public finance, may be operated
both through public revenues and public
expenditures.
 Elements of Fiscal Policy
Public Expenditure or policy of public
works
 During depression
 Private investment is low
 So government or autonomous investment has
to increase through large capital outlay by the
state. This will lead to recovery.
 In depression the government have a deficit
budget.
 During the upward swing of the cycle.
 The state will have to cut down its spending
program.
 During recovery or inflation, government
should reduce expenditure and can have
surplus budget.
Taxation
During depression: taxes should be lowered.
 To stimulate business investment more liberal
allowances for depression and obsolescence
should be granted.
During boom: taxes should be raised
  International Measures

 Trade cycle is an important phenomenon.

 International aspect creates complications and
makes crisis control more difficult.
 Import export policy: during depression, the
economy should export goods for which there is
no internal demand. This will increase incomes
and expenditure.
 Devaluation: to encourage trade, local currency is
devaluated to make its goods cheaper in the
international market.
 International Macroeconomic
Policy Coordination

• Fiscal policy refers to the government’s use of

taxation and spending to regulate the aggregate level
of economic activity.
• The use of fiscal policy consists of changes in the
level or composition of taxation or government
spending, and hence in the government’s financial
position relative to the rest of the economy.
• Key policy variables include government deficits
and debt, as well as tax and expenditure types and
levels, fiscal deficits, and public debt.
 Monetary policy refers to the central bank’s control
of the availability of credit in the economy to
achieve the broad objectives of economic policy.
 Control can be exerted by operating on such
aggregates as the level and structure of interest
rates, the money supply, and other conditions
affecting credit.
 Cont.…
 The most important objective of most central
banks is price stability, but there can be others such
as promoting economic development and growth,
stabilizing the exchange rate, safeguarding the
balance of external payments, and maintaining
financial stability.
 Key variables in this policy area include interest
rates, money and credit supply, and the exchange
rate.
 While fiscal and monetary policies are implemented
by different institutions, national ministries of
finance and central banks, these policies are closely
interlinked.
 A change in fiscal policy impacts the effectiveness
of monetary policy and thereby affects the overall
macroeconomic policy stance.
 The opposite is also true, as any changes in
monetary policy have an impact on fiscal policies
and therefore on the overall effectiveness of
macroeconomic policies.
 That is why it is crucial to pursue a consistent
fiscal-monetary policy mix to avoid tensions and
achieve optimal impact.
 Credibility of the overall policy mix depends on
credibility of each of the policies.
 This policy mix is a key component of the IMF’s
macroeconomic policy advice.
 So International macroeconomic policy
coordination refers to the modifications of
national economic policies in recognition of
international interdependence.
 Reasons for Macroeconomic Policy
Coordination
 During recent decades, the world has become much
more integrated, and industrial countries have
become increasingly interdependent.
 The increased interdependence in the world
economy today has sharply reduced the
effectiveness of national economic policies and
increased their spillover effects on the rest of the
world.
 With increased interdependence, international
macroeconomic policy coordination becomes more
 Obstacles
There are several obstacles to successful and
effective international macroeconomic policy
coordination
 The lack of consensus about the functioning of
the international monetary system
 The lack of agreement on the precise policy mix
required
 There is the problem of how to distribute the
gains from successful policy coordination among
the participants and how to spread the cost
negotiating and policing agreements
 Potential Benefits of Policy Coordination

 The benefit of policy coordination is the

improvement of welfare for the participating
countries.
 Meanwhile, the cost of policy coordination is the
loss of flexibility for the central bank of the
participating country to conduct monetary policy
in the presence of a shock.
 Potential Impediments to Policy
Coordination
There are three obstacles to successful
international coordination:
 uncertainty as to the correct initial position of the
economy,
 uncertainty as to the correct objective, and
 uncertainty as to the correct model linking policy
actions to their effects in the economy.
THE END