MBA Global Economy

Session 8A

Macroeconomic Policy
in an
Open Economy

Session 8A-09 1
 Introduction

Š Macroeconomic policy in an open economy

ƒ Monetary and fiscal policy in a closed economy
ƒ Effect of an open economy on monetary and fiscal
policy

Session 8A-09 2
 Economic Objectives of Nations

Š Internal balance:
ƒ Goal of economic stability at full employment
à A fully employed economy
à No inflation—or a reasonable amount of
inflation.
Š External balance
ƒ Realizes neither deficits nor surpluses in its
current account
Š Overall balance
ƒ Attains internal balance and external balance

Session 8A-09 3
 Economic objectives and macro policy

Session 8A-09 4
 Policy Instruments

Š Expenditure-changing policies
ƒ Alter the level of total spending for goods and
services
ƒ Fiscal policy - changes in government spending
and taxes
ƒ Monetary policy - changes in the money supply and
interest rates by a nation’s central bank
ƒ Expenditure increasing or reducing

Session 8A-09 5
 Policy Instruments
Continued
Š Expenditure-switching policies
ƒ Modify the direction of demand, shifting it between
domestic output and imports
ƒ Success largely depends on
à Switching demand in the proper direction and
amount
à Capacity to meet additional demand
Š Direct controls
ƒ Government restrictions on the market economy

Session 8A-09 6
 Aggregate Demand and Aggregate Supply

Š Aggregate demand-aggregate supply model

ƒ Used to analyze the output and price level of an economy in the
short run
ƒ Characteristics of this model - Canada (Figure 16.1)
à Aggregate demand curve (AD)
• Level of real output that Canadians will
purchase at alternative price levels during a
given year
à Aggregate supply curve (AS)
• Relationship between the level of prices and
amount of real output that will be produced
during a given year
à Equilibrium when aggregate demand equals aggregate
supply - The two lines intersect in the figure

Session 8A-09 7
Session 8A-09 8
 Monetary and Fiscal Policy in a Closed Economy

Š If aggregate output is too low and unemployment is too high

ƒ Increase aggregate demand for real output through
expansionary policies
à Effects of an expansionary monetary or fiscal policy in a
closed Canadian economy (Figure 16.2(a))
Š If inflation is troublesome
ƒ Reduce level of aggregate demand through contractionary
policies

Session 8A-09 9
Session 8A-09 10
 Monetary and Fiscal Policy in an Open Economy

Š Fixed or floating exchange rates

ƒ Extend exchange-rate intervention
ƒ Effects of expansionary monetary or fiscal policy
à Single effect on aggregate demand in a closed
economy

• Aggregate demand expands

à Second effect in an open economy
• Causes aggregate demand to increase or decrease by
changing net exports and other determinants
ƒ Strengthening and weakening of the expansionary effect of
the policy

Session 8A-09 11
 Effect of Fiscal Policy Under Fixed Exchange Rates

Š Expansionary fiscal policy

ƒ Initial and secondary effects reinforce each other
(Figure 16.2(b-1))
à Real GDP increases by a greater amount than in
a closed economy
ƒ More successful than it is in a closed economy

Session 8A-09 12
 Effect of Monetary Policy Under Fixed Exchange Rates

Š Expansionary monetary policy

ƒ Weakened when its initial and secondary effects
conflict with each other (Figure 16.2(b-2))
ƒ Less successful than it is in a closed economy
ƒ Conclusion summarized (Table 16.1)

Session 8A-09 13
Session 8A-09 14
 Effect of Fiscal and Monetary Policy Under Floating
Exchange Rates

Š Expansionary monetary policy

ƒ Initial and secondary effects are complementary (Figure 16.2(b-1))
ƒ Policy is strengthened
à More effective than it is in a closed economy
Š Expansionary fiscal policy
ƒ Initial and secondary effects are conflicting (Figure 16.2(b-2))
ƒ Policy’s expansionary effect is weakened
à Less effective than it is in a closed economy

Session 8A-09 15
 Policy Agreement Versus Policy Conflict

Š Policy-conflict
ƒ Monetary policy (or fiscal policy) alone will not restore both
internal and external balance
ƒ A combination of policies is needed
à Each economic objective is matched with an
appropriate policy instrument

Session 8A-09 16
 Inflation with Unemployment

Š Demand-pull inflation
ƒ Internal balance as a single target that requires but one policy
instrument
Š Inflation with unemployment
ƒ Achieving overall balance: Targets
à Current account equilibrium
à Full employment
à Price stability
ƒ A problem for the United States
à Wage and price controls
à Exchange-rate realignments: Depreciation of the
dollar

Session 8A-09 17
 Policy in an open economy

Š Countries which are open to the world economy

cannot make domestic economic policy choices
without considering the impact on trade and
payments and their international relationships
Š Nor can open economies entirely insulate themselves
from other countries’ policy choices
Š As a result, nations make efforts to coordinate their
international economic policies
Š Economic policies are also subject to domestic and
foreign institutional constraints

Session 8A-09 18
 International Economic Policy Coordination

Š Attempt to significantly modify national policies in

recognition of international economic
interdependence
ƒ Visualized along a spectrum (Figure 16.3)
ƒ Ranges from open conflict to integration

Session 8A-09 19
Session 8A-09 20
 Policy Coordination in Theory

Š Economic disruptions transmitted rapidly from one nation to

another
ƒ Benefits of coordination obvious
ƒ Several obstacles

Session 8A-09 21
 Does Policy Coordination Work?

Š Successful initiatives
ƒ G-5 Plaza Agreement of 1985
ƒ Louvre Accord of 1987
Š Unsuccessful moves
ƒ G-7 initiatives in 2000
à Intervention to boost value of euro

Session 8A-09 22
 Fiscal & Monetary Policy
Singapore

Š Fiscal Policy
Š Role of FDI & Capital Inflows
Š Monetary & Exchange Rate Policy

Session 8A-09
 High Growth and Low Inflation

25

20 CPI Inflation
YOY % Growth

15 GDP

10

5
0

-5
65 68 71 74 77 80 83 86 89 92 95 98 1 4
Session 8A-09 24
 How did Singapore sustain high and non-
inflationary growth?

i Honest, efficient government

i Tripartite cooperation: government,
labor & management
i Openness to capital, technology and
know-how from abroad
i Sound fiscal, exchange rate & monetary
policies
i Flexi-wages

Session 8A-09 25
 Fiscal Policy of Singapore

Basic Principles
Š stable and conducive environment for
the private sector
Š operating revenues exceed expenditure,
to produce a modest budget surplus over
the long run
Š internationally competitive and socially
equitable tax regime
Š broad revenue base
Š from direct taxes to indirect [GST]
Session 8A-09
 Fiscal Policy of Singapore

Basic Principles…….

Š total expenditures kept below 20% of GDP

Š Allocations
1. infrastructure for economic growth
2. national security
3. housing
4. education and health

Session 8A-09
 Fiscal Policy of Singapore

Basic Principles….
Š Growth Oriented
Š Private Sector—engine of growth
Š Focus therefore on: incentives for saving,
investment and enterprise
Š Counter-cyclical role: limited due to high
import leakages

Session 8A-09
 High Import Requirements

Imports per Dollar of Final Expenditure (1990)

Total 0.54
Private Consumption 0.34

Government Consumption 0.30

Gross Fixed Capital Formation 0.63

Exports 0.60
Source: 1990 Input-Output Tables
Session 8A-09 29
 Cross-Country Comparison of Tax Rates 2003
Top Marginal Corporate Capital
VAT (%)
Tax Rate (%) Tax Rate (%) Gains
Singapore 20 18 7 No
US 35.01 35.02 0-7.253 Yes
UK 40 30 17.5 Yes
Japan 50 30 5 Yes
Germany 47 27.95 16 Yes
Hong Kong 17.5 15 No No

Australia 47 30 10 Yes

Taiwan 40 25 5 No
1. +0-11% state from US$311,950
2. +0-12% state
3. 0% federal + 0-7.25 state Sources: worldwide-tax.com; Joint Economic Committee
US Congress “How Competitive Is The US Tax System?”

Session 8A-09 30
 Fiscal Policy of Singapore

Session 8A-09
 Fiscal Policy of Singapore

Structural Surpluses
Š Land sales revenue and Investment income
earned by Government do not enter into
operating revenue
Š Power of Elected President Over Reserves:
Government is allowed to spend only
surpluses over its 5-year tenure. Any
drawing down of other reserves would
require Presidential approval
Š Problem: electoral cycle does not coincide
with economic cycle
Š Problem: built-in deflation

Session 8A-09
 Fiscal Policy of Singapore

Implications of Fiscal Surplus

Š Deflationary
Š Together with excess private savings,
create huge current account surplus
Š Tendency for S$ to appreciate
Š MAS intervenes, increasing forex reserves

Session 8A-09
 Fiscal Policy of Singapore

Role of FDI & Capital Inflows

Š absorb deflationary impact of fiscal surplus

Š employment
Š technology transfer
Š access to world markets

Session 8A-09
 Fiscal Policy of Singapore

FDI....

Š Enough?
Š Changing nature?

Session 8A-09
 Monetary & Exchange Rate Policy

Š MP centered on exchange rate

Š S$ managed against a basket of
currencies of main trading partners and
competitors
Š S$ floats within an undisclosed band
Š Level & width of band adjustable

Session 8A-09
 Monetary & Exchange Rate Policy
Rationale for Exchange Rate Policy
Š Trade/GDP = 250%
Š Imports = 55% of total expenditure
Š Imports = 60% of exports
Š 1% increase in import prices = 0.7%
increase in CPI
Š openness to capital flows, both short-term
and FDI
Š no capital or exchange controls
Š high savings rate, presence of MNCs: high
percentage of foreign liabilities & assets
Š interest rates determined by foreign

Session 8A-09
 The Eurocurrency [Asian Dollar] Market

Š Financial intermediary, bringing together lenders and

borrowers
ƒ Eurocurrencies: Deposits, denominated and
payable in dollars and other foreign currencies in
banks outside the U.S.
ƒ Much trading occurs in non-European centers
à Eurodollars: Dollar deposits located in banks
outside the U.S.
à Eurobanks: Banks that conduct trading in the
markets for eurocurrencies

Session 8A-09 Professor Augustine H H Tan MBA Global Economy 38

 Development of the Eurocurrency Market

Š Reasons for the market’s growth

ƒ Fear that deposits held in the U.S. would be frozen
in the event of an international conflict
ƒ Ceilings on interest rates that U.S. banks could pay
on savings deposits
à Regulation Q ceilings
ƒ Risk-adjusted interest-rate advantage relative to
domestic deposits

Session 8A-09 Professor Augustine H H Tan MBA Global Economy 39

 Financial Implications

Š Implications of Eurocurrencies
ƒ Facilitate the financing of international trade and
investment
ƒ May reduce the need for official reserve financing
ƒ May undermine a nation’s efforts to implement its
monetary policy
ƒ Does not face the same financial regulations as do
the domestic banking systems
à Fear of collapse

Session 8A-09 Professor Augustine H H Tan MBA Global Economy 40