Chapter 9 Short Run Macroeconomic …...parity, monetary policy is either ineffective or locomotive under fixed exchange rates (see Figure 9.5). It becomes locomotive if the rules

George Alogoskoufis, International Macroeconomics and Finance

Chapter 9 Short Run Macroeconomic Interdependence and the Exchange Rate Regime

Open economies are interdependent, in the sense that developments and policies in one country affect macroeconomics developments in both the country itself, and other countries. The larger the economy, the larger the spillovers to the rest of the world. Thus, developments and policies in large economies have significant effects on the path of the global economy. On the other hand, is small open economies, the spillovers are negligible.

Up to now, our analysis was based on the implicit assumption of a single small open economy, since we ignored spillovers to the rest of the world. Essentially a small open economy takes developments in the rest of the world as exogenously given, and not dependent on domestic developments.

In this chapter we abandon the small open economy assumption, and examine macroeconomic interdependence among large economies. Macroeconomic interdependence works through a number of channels, such as the market for goods and services (exports and imports) and financial markets (interest rates and exchange rates). In rare cases it could work through labor markets as well (migration).

How macroeconomic policies in one economy affect others, depends on the characteristics of the international monetary system, the exchange rate regime, the nature of convertibility, international currencies and whether or not there are trade barriers and capital controls.

9.1 Short Run Macroeconomic Interdependence under Floating Exchange Rates

In order to study macroeconomic interdependence we shall employ the simplest possible model, which is a model of a two country world under perfect capital mobility. There are two large interdependent open economies, the home economy, and the foreign economy (rest of the world). We shall focus on the short run, and make the assumptions of the short run keynesian model for each of those economies. Foreign economy variables are denoted by a star (*).

In a two country world, the short run exchange rate is determined so as ensure that product and financial markets are in simultaneous equilibrium in both economies. Given that the exchange rate in the home country (units of foreign currency per unit of domestic currency) is the inverse of the exchange rate in the foreign country (rest of the world), this simultaneous short run equilibrium at home and abroad is as depicted in Figure 9.1. Note that because the exchange rate in the foreign economy is the inverse of the exchange rate in the domestic economy, the output market equilibrium condition (DD*) is upward sloping in the foreign economy, and the financial markets equilibrium condition (AA*) is downward sloping. The exchange rate S0 is determined so that all

George Alogoskoufis, International Macroeconomics and Finance Chapter 9

markets are in short run equilibrium in both economies. In this short run equilibrium output in the domestic economy is at Y0 and output in the foreign economy is at Y0*.

Under floating exchange rates, monetary policy has international spillovers through both the exchange rate and the change in domestic output. These spillovers feed back to the home economy.

A home monetary expansion can be beggar-thy-neighbor, in the sense that it may expand output and employment at home, but reduce output and employment in the rest of the world. The reason is that a monetary expansion in one country causes a depreciation of the domestic currency, which is the same as an appreciation for the currency of the foreign economy. Thus, if the trade balance and aggregate demand improves in the home country, causing an increase in output, while the trade balance and aggregate demand deteriorates in the rest of the world, causing a contraction in output, a home monetary policy will be beggar-thy-neighbor (see Figure 9.2).

However, a home monetary expansion can be locomotive, in the sense that it may expand output and employment both at home and abroad. If the expansion of home output has such a large direct effect on the demand for foreign exports, then foreign output may also increase, despite the appreciation of the foreign exchange rate. This requires a particular configuration of parameters, but cannot be excluded on theoretical grounds (see Figure 9.3).

Fiscal policy also has international spillovers under floating exchange rates, again through changes in both the exchange rate and output. These spillovers feed back to the home economy.

A fiscal expansion is always locomotive, in the sense that it expands output and employment both at home and in the rest of the world (Figure 9.4). This is because a fiscal expansion causes an appreciation and not a depreciation of the exchange rate. Thus, it causes an increase in aggregate demand in the home country, but a deterioration in its trade balance. The deterioration in the trade balance of the home country is an improvement in the trade balance of the foreign country, which causes an increase in aggregate demand and output. Hence, output and employment increase both at home and in the rest of the world following a home fiscal expansion.

9.2 Short Run Macroeconomic Interdependence under Fixed Exchange Rates

Under a fixed exchange rate regime, monetary and fiscal policies have international spillovers only through changes in output, as either the home country or the foreign country, or both, intervene to keep the exchange rate fixed. These spillovers feed back to the home economy.

The effects of monetary policy in a fixed exchange rate regime, depends on the rules envisaged in the regime, as to which country intervenes to keep the exchange rate fixed.

If intervention has to take place by the home country central bank, then the home country cannot use monetary policy under fixed exchange rates, as any attempt at monetary expansion would require foreign exchange market interventions to stop the exchange rate from depreciating. These interventions would neutralize the monetary expansion, as in the small economy case.

If interventions take place through the central bank of the foreign country, or by the central banks of both countries, then a monetary expansion at home would also trigger a monetary expansion in the foreign country, as its central bank would have to intervene to stop its exchange rate from

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appreciating. Thus, a monetary expansion in the home country would trigger a foreign monetary expansion as well, and a short run increase in output and employment in both countries. A home monetary expansion, would be locomotive under these circumstances.

Thus, depending on the rules regarding who intervenes to maintain the exchange rate at the fixed parity, monetary policy is either ineffective or locomotive under fixed exchange rates (see Figure 9.5). It becomes locomotive if the rules of the fixed exchange rate regime imply that a monetary expansion at home triggers foreign exchange market interventions in the rest of the world, which result in triggering a monetary expansion in the rest of the world. As we shall see below, the rules of the Bretton Woods system of fixed exchange rates were such that a monetary expansion in the USA caused a monetary expansion in the rest of the world, but not vice versa. Thus, in the 1960s, during which the Bretton Woods system was not operating under capital controls, a US monetary expansion was locomotive, but monetary policy was ineffective for all other countries, as the US did not have the obligation to intervene and stop the dollar from appreciating against other currencies.

Under fixed exchange rates, the spillover effects of fiscal policy again depend on the regime rules with regard to who intervenes to maintain the fixed exchange rate.

If the central bank of the home country has to intervene to maintain the fixed exchange rate, a fiscal expansion at home, has to be accompanied by a monetary expansion, because of foreign exchange market interventions to stop the home currency from appreciating. The increase in output at home, causes an increase in the exports of the rest of the world, causing output in the rest of the world to increase as well. Hence, output and employment rise both at home and abroad, and a fiscal expansion in locomotive (see Figure 9.5).

If the foreign country has to intervene to maintain the fixed exchange rate, then a fiscal expansion at home triggers a monetary contraction in the rest of the world, which causes a smaller output expansion both at home and abroad. A temporary fiscal expansion remains locomotive but its effects on output and employment are lower because it is combined with a monetary contraction in the rest of the world.

9.3 Macroeconomic Interdependence and the Coordination of Macroeconomic Policy

We have seen that macroeconomic interdependence implies spillovers from policies in one country, to output and employment in other countries. Through the Phillips curve in each country, this also implies spillovers to inflation in other countries.

If monetary and fiscal policy is chosen at the national level, policy makers would tend to disregard these spillovers in their decisions about macroeconomic policy. This, in the context of our previous examples, would mean that there would be too much reliance on policies which are beggar-thy-neighbor, and too little reliance on policies which are locomotive.

In the presence of international spillovers from macroeconomic policy, policies chosen purely at the national level will in general be suboptimal, as they will tend to ignore these spillovers. One solution which ensures that domestic policy choices are optimal from the view point of the world economy is the coordination of macroeconomic policies among interdependent economies.

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Institutions such as the G-7, the meetings of the heads of state and government, the finance ministers and the central bank governors of the seven largest industrial economies, which take place since 1975, are one such institution. The annual meetings of the International Monetary Fund (IMF) are another such institution, involving many more countries. In the presence of coordination mechanisms, which are much more demanding under regimes of fixed exchange rates, such as the Bretton Woods system, the spillover effects of macroeconomic policies can be assessed and discussed, and thus countries can address the suboptimality of national macroeconomic policy choices.

9.4 Conclusions

Macroeconomic interdependence, in the short run, works through a number of channels, such as the market for goods and services (exports and imports) and financial markets (interest rates and exchange rates).

How macroeconomic policies in one economy affect another depends on the characteristics of the international monetary system, the exchange rate regime, the nature of convertibility, international currencies and whether or not there are trade barriers and capital controls.

In this chapter we have analyzed macroeconomic interdependence in a two country world, for the case where both the home and the foreign country are characterized by the assumptions of the short run keynesian model with perfect capital mobility.

We have shown that, under floating exchange rates, monetary policy has international spillovers through both the exchange rate and the change in domestic output. These spillovers feed back to the home economy.

A home monetary expansion can be beggar-thy-neighbor, in the sense that it may expand output and employment at home, but reduce output and employment in the rest of the world. However, a home monetary expansion can also be locomotive, in the sense that it may expand output and employment both at home and abroad. If the expansion of home output has such a big effect on the demand for foreign exports, then foreign aggregate demand will also rise, despite the appreciation of the foreign exchange rate.

The effects of monetary policy in a fixed exchange rate regime, depends on the rules envisaged in the regime as to which country intervenes to keep the exchange rate fixed.

If intervention has to take place by the home country central bank, then the home country cannot use monetary policy under fixed exchange rates. If interventions take place through the central bank of the foreign country, or by the central banks of both countries, then a monetary expansion at home would also trigger a monetary expansion in the foreign country, and would be locomotive under these circumstances.

Under fixed exchange rates, the exact spillover effects of fiscal policy again depend on the regime rules with regard to who intervenes to maintain the fixed exchange rate. However, fiscal policy would be locomotive under fixed exchange rates, whatever the intervention rules.

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In the presence of international spillovers from macroeconomic policy, policies chosen purely at the national level will in general be suboptimal, as they will tend to ignore these spillovers. One solution which ensures that domestic policy choices are optimal from the view point of the world economy is the coordination of macroeconomic policies among interdependent economies.

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Figure 9.1 Short Run Macroeconomic Equilibrium in a Two Country World

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Figure 9.2 A Beggar-thy-Neighbor Home Monetary Expansion

under Floating Exchange Rates

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Figure 9.3 A Locomotive Home Monetary Expansion


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Figure 9.4 A Home Fiscal Expansion is Always Locomotive


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Figure 9.5 Both Monetary and Fiscal Expansions are Locomotive

under Fixed Exchange Rates

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Chapter 9 Short Run Macroeconomic …...parity, monetary policy is either ineffective or locomotive under fixed exchange rates (see Figure 9.5). It becomes locomotive if the rules