International Finance

Third edition

by Keith Pilbeam

Chapter 4 - Macroeconomic Policy in an Open Economy

Jump to Revision Questions for chapter 4

Chapter Introduction
In Chapter 3 we looked at some of the fundamental identities for an open economy and considered the possible effect of devaluation on the current account. It was noted that the ultimate impact of a devaluation will in large part be dependent upon the economic policies that accompany the devaluation. In this chapter we shall be examining how both exchange rate changes and macroeconomic policies impact upon an open economy. A fundamental difference between an open economy and a closed economy is that over time a country has to ensure that there is an approximate balance in its current account. This is because no country can continuously build up a stock of net liabilities to the rest of the world by running a continuous current account deficit. Conversely, it does not make sense for a surplus country to continuously build up a stock of net claims on the rest of the world. Eventually it will wish to spend those claims.

The need for economic policy-makers to pay attention to the implications of changes in monetary and fiscal policy on the balance of payments is an important additional dimension for consideration in the formulation of economic policy in an open economy.Ensuring a sustainable balance of payments position over time is an important economic objective to go along with those like high economic growth, low unemployment and low inflation.

One of the additional policy choices that has to be made by the authorities of an open economy is to decide whether to fix the exchange rate, allow it to float, or perhaps choose some arrangement between these two extremes. The choice between these two regimes is the focus of analysis of Chapter 10; in this chapter we concentrate upon how fiscal and monetary policy operate under both regimes.

Revision Questions
  1. Using IS-LM-BP analysis compare and contrast the effectiveness of fiscal and monetary policies at influencing the level of real output in an open economy under floating exchange rates. Discuss the limitations of the IS-LM-BP framework.
  2. Using the IS/LM/BP model explain what is likely to happen following (i) a monetary contraction and (ii) a fiscal contraction under floating exchange rates. Discuss the main limitations of the IS/LM/BP model.
  3. "Although authorities can achieve both internal and external balance without resort to exchange rate adjustment, this does not mean that exchange rate changes are undesirable." Discuss.
  4. "Both monetary and fiscal policies must be actively used if an economy is to achieve both internal and external balance." Discuss.
  5. Explain with the aid of diagrams the difference between Tinbergen's instruments-targets rule and Mundell's principle of effective market classification.
  6. Discuss the importance of the degree of international capital mobility in determining the appropriate policy mix for the achievement of internal and external balance in an economy.
  7. "Tinbergen's instruments-targets rule and the IS-LM-BP model show us how we can theoretically achieve simultaneous internal and external balance. However, their practical application to the real world is limited." Discuss.
  8. "Not only do the authorities need to employ as many policy instruments as they have targets, they need to get the pairing of instruments to targets correct." Discuss this statement with regard to the formulation of economic policy in an open economy.