International Monetary Systems

Lecture 9
Chapter 19

Macroeconomic Policy Goals in an Open Economy

Internal Balance
 Full employment of a country’s resources and domestic price level stability.
 Waste of recourses could be due to under-employment or over-employment.
 Waste leads to general price level movements that reduce the economy’s efficiency by
making the real value of the monetary unit less certain and thus a less useful guide for
economic decisions.
 To avoid price level instability, therefore, the government must prevent large fluctuations in
output. In addition, it must avoid inflation and deflation by ensuring that the money supply
does not grow too quickly or too slowly.
External Balance
 Country’s current account is neither so deeply in deficit that the country may be unable to
repay its foreign debts in the future nor so strongly in surplus that foreigners are put in that
position.
 The goal is to find the optimal current account levels that could help the country benefits
from trade.
 It’s all about the optimal external balance that help the country benefit from deficit (attract
productive debts) or surplus (export).
Problems with Current Account
 Deficit
 Current account deficit = borrowing from abroad.
 There will be no problem if the debt taken is channeled towards productive investment
opportunities that pays back the installments + revenues.
 Sometimes, however, large current account deficits represent temporarily high consumption
resulting from misguided government policies or some other malfunction in the economy.
 Large current account deficit + caused by expansionary fiscal policy + domestic investment
opportunities less profitable = restore external balance.
 Inter-temporal budget constraint that limits its spending over time to levels that allow it to
pay the interest and principal on its foreign debts.
 Sudden Stop: When countries begin to have trouble meeting their payments on past foreign
loans, foreign creditors become reluctant to lend them new funds and may even demand
immediate repayment of the earlier loans.
 A large current account deficit can undermine foreign investors’ confidence and contribute to
a sudden stop.
 Surplus
▫ A surplus in the current account implies that a country is accumulating assets located abroad.
▫ Several factors might lead policy makers to prefer that domestic saving be devoted to higher
levels of domestic investment and lower levels of foreign investment.
 First, the returns on domestic capital may be easier to tax than those on assets located abroad.
 Second, an addition to the home capital stock may reduce domestic unemployment and
therefore lead to higher national income than an equal addition to foreign assets.
 Third, domestic investment by one firm may have beneficial technological spillover effects
on other domestic producers that the investing firm does not capture.
 If a large home current account surplus reflects excessive external borrowing by foreigners,
the home country may in the future find itself unable to collect the money it is owed.
▫ Put another way, the home country may lose part of its foreign wealth if foreigners find
they have borrowed more than they can repay.
▫ In contrast, non-repayment of a loan between domestic residents leads to a redistribution
of national wealth within the home country but causes no change in the level of national
wealth.
 Countries with large surpluses can become targets for discriminatory import barriers imposed
by trading partners with external deficits.
▫ Japan has been in this position in the past, and China’s surpluses inspire the most
visible protectionist threats today.
 To avoid such damaging restrictions, surplus countries may try to keep their surpluses from
becoming too large.
 The Open Economy Trilemma
• The policy makers in an open economy face
an inescapable trilemma in choosing the
monetary arrangements that best enable
them to attain their internal and external
balance goals.
1. Exchange rate stability.
2. Monetary policy oriented toward
domestic goals (i).
3. Freedom of international capital
movements (Inflow of money).
• At most 2 could coexist.