CHAPTER

18 International
Economics

Open – Economy Macroeconomics:

Adjustment Policies

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In this chapter:
Learning Goals: After reading this chapter, you
should be able to:
 Understand how a nation can achieve internal
and external balance with fiscal and monetary
policies under a fixed and flexible exchange rate
system
 Understand the difficulties and experiences in
achieving internal and external balance
 Understand the disadvantage of using direct
controls to achieve internal and external balance

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Economic Objectives of Nations
 Objectives of macroeconomic policy
 Internal balance
 External balance
 Reasonable rate of economic growth
 An equitable distribution of national income
 Adequate protection of the environment

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Economic Objectives of Nations
 Internal balance
Economic stability at full employment
 A fully employed economy (or rate of unemployment of no

more than, 4-5% per year).

 No inflation (or a rate of inflation of no more than 2 or 3%

per year)
 External balance
 Refers to equilibrium in the BOP (or desired temporary
disequilibrium)
 Overall balance
 Internal balance and external balance

(In general, nations place priority on internal over external balance).

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Policy Instruments
 To achieve objectives of macroeconomic
policy, Government can use a number of
policies to influence employment and the
BOP:
Expenditure – changing, or demand policies:
Fiscal policy
Monetary policy
Expenditure-switching policies:
A devaluation
A revaluation
Direct controls:
International trade policy tools: tariffs, quotas, price controls,…to restain
or stimulate export or import..or capital inflows or capital outflows 5
Policy Instruments
1/ Expenditure-changing policies
 Fiscal policy
 Refer to changes in government spending, taxes, or both
 Fiscal policy is expansionary if government expenditures are
increased and/or taxes reduced, leading to:
 An expansion of domestic production and income, and
 Induce a rise in imports
 Fiscal policy is contractionary if government expenditures are
reduced and/or taxes increased, leading to:
 Reduce domestic production and income and,

 Induce a fall in imports.

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 Policy Instruments
1/ Expenditure-changing policies (cont’d)
 Monetary policy:
 Refers to changes in the money supply that affects
domestic interest rates
 Easy monetary policy refers to an increase in monetary
supply and a reduction in interest rates, leading to:
 An increase in the level of investment and income in the
nation and induces imports to rise.
 The reduction in the interest rate induces a short-term
capital outflow or reduced capital inflow
 Tight monetary policy refers to a reduction in the nation’s
money supply and a rise in the interest rate, leading to:
 The reduction in investment, income and imports
 A short-term capital inflow or reduced capital outflow

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Policy Instruments
2/ Expenditure-switching policies
 Refer to changes in the exchange rate (i.e a
devaluation or revaluation).
 A devaluation switches expenditures from foreign
to domestic commodities and can be used to
correct a deficit in the nation’s BOP, and
 Increases domestic production, and a rise in imports,
which neutralizes a part of the original improvement in
the trade balance.
 A revaluation switches expenditures from domestic
to foreign products and can be used to correct a
surplus in the nation’s BOP, and
 Reduces domestic production and, consequently, induces a
decline in imports, which neutralizes part of the effect of the
revaluation.

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Policy Instruments
3/ Direct controls
 Direct controls include tariffs, quotas, and
other trade barriers, as well as exchange
controls, and wage and price controls.

 Government restrictions on the flow of

international trade and capital.
 Eg. To restrain capital outflows
 Eg. To stimulate capital inflows

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Principle of Effective Market
Classification (Mundell)
 Since each policy affects both internal and
external BOP, it is crucial that each policy
must be paired with and used for the
objective toward which it is most effective .

 If a nation does not follow this principle it

will move even farther from both balances.

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Internal and External Balance with Expenditure
Changing & Expenditure Switching Policies
(Salter-Swan model)

 How a nation can simultaneously attain

internal balance with expenditure changing
and expenditure-switching policies?
 See figure 18.1 the Swan Diagram.
 The Vertical Axis is the Exchange Rate and a
higher R means a Devaluation.
 The Horizontal Axis is Real Domestic
Expenditures (Absorption).

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Swan Diagram

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EE Curve in Swan Diagram
 See figure 18.1 the Swan Diagram (cont’d)
 EE Curve is for External Balance (BOP). It is positively
inclined because:
 Higher R (due to devaluation) improves the Nation’s trade
Balance and must be matched by an increase in D (spending)
to induce imports to rise sufficiently to keep the trade balance
in equilibrium and maintain external balance.
 YY Curve is Internal Balance. It is negatively inclined
because:
 Lower R (due to revaluation) worsens the trade balance and
must be matched with larger D (spending) is necessary to
maintain equilibrium

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Achieving Internal and External
Balance
 We can define the following four zones of
external and internal imbalance (Figure 18.1):
 Zone/Region I : External surplus and internal
unemployment
 Zone/Region II: External surplus and internal inflation
 Zone/ Region III: External deficit and internal inflation
 Zone/Region IV: External deficit and internal
unemployment

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Equilibrium in the Goods Market, in the Money
Market, and in the BOP (Mundell-Fleming model)

 How can a nation achieve both internal

and external balance without any change
in the exchange rate?
 How can this be done if it is assumed that
international capital flows do happen
(unlike with the Swan diagram earlier) ?
 Short term capital flows responsive to
interest rate differentials.

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Equilibrium in the Goods Market, in the
Money Market, and in the BOP (cont’d)

 The new tools of analysis take the form of

three curves:
 The IS curve, showing all points at which the
goods market is in equilibrium;
 The LM curve, showing equilibrium in the
money market;
 The BP curve, showing equilibrium in the
BOP.

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Figure 18.2: Equilibrium in the Goods
and Money Markets and in the BOP

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IS Curve (Figure 18.2)
 The various combinations of interest rates (i)
and national income (Y) that result in
equilibrium in the goods market.
 Negatively inclined because at lower interest
rates, investment is higher, so the level of
national income will be higher.
 Expansionary fiscal policy moves the IS curve
to the right.
 Contractionary fiscal policy moves it to the
left.
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LM Curve (Figure 18.2)
 The combinations of interest rates (i) and national
income (Y) at which the demand for money is in
equilibrium.
 The LM curves is positively inclined because:
 The higher rate of interest rate (i), a smaller the quantity of money
demanded for speculative purposes
 The remaining larger supply of money available for transaction
purposes will be held only at higher levels of national income (Y).

 Increase in money supply shifts LM to the right.

Decrease in the Money supply shifts LM to the left

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The BP Curve (Figure 18.2)
 Combinations of interest rates (i) and national
income (Y) at which the nation’s BOP is in
equilibrium at a given exchange rate.
 BOP is in equilibrium when a trade
deficit/surplus is matched by an equal net
capital inflow/outflow.
 BP is positively inclined because higher rates
of interest lead to greater capital flows, which
must be matched by greater national income
and imports for BOP to be in equilibrium.
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BP Curve - Cont’d
 A depreciation of the nation’s currency
moves the BP curve down. A currency
revaluation moves the BP curve up.
 Assuming the exchange rate is fixed, the BP
curve doesn't not shift.
 To the Left, the nation has a BOP Surplus
 To the Right, the nation has a BOP Deficit
 The inclination, the steepness, of the BP curve
is determined by the mobility of capital. The
more mobile, the flatter the BP curve.
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Perfect Capital Mobility &
Exchange Rates
 With Fixed exchange rates, and completely
elastic capital flows (perfectly mobile capital),
monetary policy is ineffective and the nation
may exhaust all its foreign exchange reserves
attempting to maintain the exchange rate.

 With Flexible exchange rates and elastic

capital flows, monetary policy is effective and
fiscal policy ineffective

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Fiscal and Monetary Policies from External
Balance and Unemployment with Fixed
Exchange Rates

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Fiscal and Monetary Policies for Internal and
External Balance with Fixed Exchange Rates
18.4A. Fiscal and Monetary Policies from External Balance and
Unemployment
 Figure 18.3: Fiscal and Monetary Policies from Domestic
Unemployment and External Deficit

18.4B. Fiscal and Monetary Policies from External Deficit and

Unemployment
 Figure 18.4: Fiscal and Monetary Policies from Domestic
Unemployment and External Deficit

18.4C. Fiscal and Monetary Policies with Elastic Capital Flows

 Figure18.5: Fiscal and Monetary Policies with Elastic Capital Flows

18.4D. Fiscal and Monetary Policies with Perfect Capital Mobility

 Figure 18.7: Fiscal and Monetary Policies with Perfect Capital Mobility
and Fixed Exchange Rates 24
Direct Controls

 Trade Controls:
 Tariffs
 Quotas etc.
 Exchange Controls
 Restrictions on international capital
movement
 Forward market intervention
 Multiple exchange rates
 Other Direct Controls and International
Cooperation 25
Chapter 18:

Q&A

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