© 2003 McGraw-Hill Ryerson Limited.

International International Dimensions of Dimensions of

Monetary and Fiscal Monetary and Fiscal PolicyPolicy

Chapter 17Chapter 17

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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy Macroeconomics’ international goals

are less straightforward than its domestic goals.

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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy There is great debate about how

Canada should maintain its position in the world economy.

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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy Do we want a high or a low value for our

currency? Do we want a balance of trade surplus

or a trade deficit? Should we even pay attention to the

balance of trade?

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The Exchange Rate The Exchange Rate GoalGoal A high value for a currency has

advantages and disadvantages. Depending on the state of the economy,

there are arguments both for high and low exchange rates.

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Advantages of a High Advantages of a High Value for the DollarValue for the Dollar It makes foreign currencies cheaper. It lowers the price of imports.

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Advantages of a High Advantages of a High Value for the DollarValue for the Dollar Lower import prices puts competitive

pressure on domestic firms and helps to keep down inflation.

Canadian residents’ living standards are enhanced.

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Advantages of a High Advantages of a High Exchange RateExchange Rate A low value for the dollar has the

opposite effect.

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Disadvantages of a Disadvantages of a High Value for the High Value for the DollarDollar A high value for a currency encourages

imports and discourages exports. It can cause a trade deficit that can

have a contractionary effect of the economy by decreasing aggregate demand for domestic output.

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© 2003 McGraw-Hill Ryerson Limited.

Disadvantages of a Disadvantages of a High Value for the High Value for the DollarDollar A low exchange rate has the opposite

effect.

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The Exchange Rate The Exchange Rate GoalGoal Because of the divergent views, some

economists argue that government should simply accept whatever exchange rate exists and not consider it in its conduct of monetary and fiscal policies.

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The Trade Balance GoalThe Trade Balance Goal

A deficit in the trade balance means that, as a country, we are consuming more than we are producing. Trade balance – the difference

between imports and exports.

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The Trade Balance GoalThe Trade Balance Goal

There is a debate about whether we should worry about a trade deficit or not.

A trade deficit is not without costs. We pay for a trade deficit by selling off

Canadian assets to foreigners.

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The Trade Balance GoalThe Trade Balance Goal

All the future interest and profits on those assets will flow to foreigners, not Canadian citizens.

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The Trade Balance GoalThe Trade Balance Goal

Eventually, we will have to produce more than we consume so that we can pay them their profit and interest on their assets.

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The Trade Balance GoalThe Trade Balance Goal

In the short-run a trade deficit allows more current consumption, in the long run it presents problems.

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International versus International versus Domestic GoalsDomestic Goals Domestic goals generally dominate

international goals. International goals are ambiguous.

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International versus International versus Domestic GoalsDomestic Goals International goals affect a country’s

population indirectly. In politics, indirect effects take a back

seat.

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International versus International versus Domestic GoalsDomestic Goals When a nation is forced to face certain

economic facts (threats by other countries that they must limit their imports), international goals can become its primary goals.

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International versus International versus Domestic GoalsDomestic Goals As countries become more

economically integrated, these pressures from other countries become more important.

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Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates An economy with fixed exchange rates

is much more restricted in its monetary and fiscal policies than one with flexible exchange rates.

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Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates The reason is that the amount of

currency stabilization that can be achieved with direct intervention is quite small, since a country's foreign reserves are limited.

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© 2003 McGraw-Hill Ryerson Limited.

Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates If foreign reserves are limited, a country

must adjust its economy to maintain the value of its currency.

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© 2003 McGraw-Hill Ryerson Limited.

Raising the Value of Raising the Value of the Euro Using the Euro Using Monetary and Fiscal Monetary and Fiscal PolicyPolicy There are three options for raising the

value of the euro: Increase the private demand for euros

via contractionary monetary policy. Decrease the private supply of euros via

contractionary monetary and fiscal policy.

Use some combination of both.

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© 2003 McGraw-Hill Ryerson Limited.

Increase the Private Increase the Private Demand for EurosDemand for Euros The primary way to increase the

demand for euros in the short run is through contractionary monetary policy.

The interest rate will increase which increases the demand for the countries’ interest-bearing assets.

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Increase the Private Increase the Private Demand for EurosDemand for Euros The problem? The area can achieve an interest rate

target or an exchange rate target, but not both at the same time.

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Decrease the Private Decrease the Private Supply of EurosSupply of Euros The private supply of euros can be

decreased via contractionary monetary and fiscal policy.

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© 2003 McGraw-Hill Ryerson Limited.

Decrease the Private Decrease the Private Supply of EurosSupply of Euros Contractionary monetary and fiscal

policy will create a recession. The demand for imports will decrease,

thereby decreasing the private supply of euros.

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© 2003 McGraw-Hill Ryerson Limited.

Decrease the Private Decrease the Private Supply of EurosSupply of Euros The problem? A purposely induced recession for political

reasons is not a very popular decision.

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© 2003 McGraw-Hill Ryerson Limited.

S0

D0

Price of euros (in dollars)

$0.30

0.20

Quantity of euros

D1

S1

Targeting an Exchange Targeting an Exchange Rate with Monetary and Rate with Monetary and Fiscal Policy, Fiscal Policy, Fig. 17-1, p 419Fig. 17-1, p 419

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Monetary and Fiscal Monetary and Fiscal Policy with Flexible or Policy with Flexible or Partially Flexible Partially Flexible Exchange RatesExchange Rates Many countries choose flexible or

partially flexible exchange rate regimes to avoid the constraints that a fixed exchange rate regime places on domestic monetary and fiscal policy.

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© 2003 McGraw-Hill Ryerson Limited.

Monetary Policy’s Monetary Policy’s Effect on Exchange Effect on Exchange RatesRates Monetary policy's effect on exchange

rates is felt in three ways: Through its effect on the interest rate. Through its effect on income. Through its effect on price levels and

inflation.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates An expansionary monetary policy

pushes down the Canadian interest rate.

Lower interest rates decrease foreign capital inflow into Canada.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Less foreign capital inflow decreases

the demand for dollars. Lower demand for Canadian dollars

decreases the exchange.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates A contractionary monetary policy does

the opposite. It raises Canadian interest rate, bringing

in the capital from abroad, increasing the demand for dollars and increasing the value of the dollar.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Monetary policy affects income in a

country. As money supply rises, income

expands. When money supply falls, income

contracts.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Rising Canada’s income increases the

demand for imported goods. To buy imported goods, Canadian

citizens need foreign currency that they must buy with dollars.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income The supply of dollars in the foreign

exchange market increases as Canadian citizens sell dollars to buy foreign currencies to pay for the imports.

The increase in the supply of dollars causes its value to decrease.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Expansionary monetary policy pushes

up the Canadian price level. As the prices rise relative to foreign

prices, Canadian exports become more expensive and goods Canadian imports become cheaper.

17 - 40

© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels The demand for foreign currencies

increases and the demand for dollars decreases, pushing the value of the dollar down.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Contractionary monetary policy puts

downward pressure on Canadian price level and slows down any existing inflation.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels As a result, contractionary monetary

policy pushes the value of the dollar up via the price path.

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© 2003 McGraw-Hill Ryerson Limited.

The Net Effect of The Net Effect of Monetary Policy on Monetary Policy on Exchange RatesExchange Rates Expansionary monetary policy lowers

exchange rates. It decreases the relative value of a

currency.

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© 2003 McGraw-Hill Ryerson Limited.

The Net Effect of The Net Effect of Monetary Policy on Monetary Policy on Exchange RatesExchange Rates Contractionary monetary policy

increases exchange rates. It increases the relative value of a

country's currency.

17 - 45

© 2003 McGraw-Hill Ryerson Limited.

M

Competi-tivenessExpansionary

monetary policy

i

P

Y

Net Effect of Monetary Net Effect of Monetary Policy on Exchange Policy on Exchange RatesRates

Value of domestic currency

Value of domestic currency

Value of domestic currency L-R effect

Value of domestic currencyImports

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© 2003 McGraw-Hill Ryerson Limited.

M

Competi-tiveness

Imports

Contractionary monetary

policy i

P

Y

Net Effect of Monetary Net Effect of Monetary Policy on Exchange Policy on Exchange RatesRates

Value of domestic currency

Value of domestic currency

Value of domestic currency L-R effect

Value of domestic currency

17 - 47

© 2003 McGraw-Hill Ryerson Limited.

Monetary Policy’s Monetary Policy’s Effect on the Trade Effect on the Trade BalanceBalance Monetary policy affects the trade

balance in three ways. Through income. Through price levels. Through the exchange rate.

17 - 48

© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income Expansionary monetary policy

increases income. When incomes rise, imports rise;

exports are unaffected.

17 - 49

© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income As imports rise, the trade balance shifts

in the direction of deficit. As a result, the trade balance shifts

toward a deficit.

17 - 50

© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income Contractionary monetary policy works in

the opposite direction. As a result, the trade balance shifts

toward a surplus.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Expansionary monetary policy pushes a

country’s price level up. This decreases it competitiveness. Trade deficits go up as residents

substitute imported for domestic goods.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Contractionary monetary policy works in

the opposite direction. As a result, contractionary monetary

policy decreases a trade deficit.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Monetary policy’s effect on the price

level is a long-run effect.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Expansionary monetary policy

decreases the interest rate. This tends to push the dollar exchange

rate down. This increases Canadian

competitiveness which decreases a trade deficit.

17 - 55

© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Contractionary monetary policy works in

the opposite direction. As a result, contractionary monetary

policy increases a trade deficit.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Like the price level effect, the effect of

the exchange rate on the trade deficit is a long-term effect.

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© 2003 McGraw-Hill Ryerson Limited.

The Net Effect of The Net Effect of Monetary Policy on the Monetary Policy on the Trade BalanceTrade Balance Expansionary monetary policy makes a

trade deficit larger. Contractionary monetary policy makes

a trade deficit smaller.

17 - 58

© 2003 McGraw-Hill Ryerson Limited.

M

Value of domestic currency

Expansionary monetary

policy

Net Effect of Monetary Net Effect of Monetary Policy on the Trade Policy on the Trade DeficitDeficit

Imports

Tradedeficit

Y

P

i

Competi-tiveness

Competi-tiveness

17 - 59

© 2003 McGraw-Hill Ryerson Limited.

M

Contractionary monetary

policy

Net Effect of Monetary Net Effect of Monetary Policy on the Trade Policy on the Trade DeficitDeficit

Imports

Competi-tiveness

Tradedeficit

Y

i

Competi-tiveness

P

Value of domestic currency

17 - 60

© 2003 McGraw-Hill Ryerson Limited.

Fiscal Policy’s Effect on Fiscal Policy’s Effect on Exchange RatesExchange Rates Fiscal policy affects exchange rates in

three ways. Through income. Through price. Through interest rates.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Expansionary fiscal policy increases

income. When incomes rise, imports rise;

exports are unaffected. As imports rise, the trade deficit

increases and the currency value drops.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Contractionary fiscal policy works in the

opposite direction. Imports decrease and the currency

value increases.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Expansionary fiscal policy increases

aggregate demand. The prices of a country’s exports

increases. The competitiveness of a country’s

exports decreases and the currency value drops.

17 - 64

© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Contractionary fiscal policy works in the

opposite direction. The price path is a long-run effect.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Expansionary fiscal policy increases

interest rates because the government sells bonds to finance the deficit.

Higher Canadian interest rates cause foreign capital to flow into Canada.

The dollar value goes up.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Contractionary fiscal policy works in the

opposite direction. Interest rates decrease, capital flows out of

Canada and the value of the dollar decreases.

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© 2003 McGraw-Hill Ryerson Limited.

The Net Effect of Fiscal The Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates The interest rate effect and the income

effect are both short-term effects. The two work in opposite directions, so

the net effect of fiscal policy is ambiguous.

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The Net Effect of Fiscal The Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates It is unclear what the effect of

expansionary or contractionary fiscal policy will be on exchange rates.

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© 2003 McGraw-Hill Ryerson Limited.

Net Effect of Fiscal Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates

Competi-tivenessExpansionary

fiscal policy

i

P

Y

Value of domestic currency

Value of domestic currency

Value of domestic currency L-R effect

Imports ?

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© 2003 McGraw-Hill Ryerson Limited.

Net Effect of Fiscal Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates

Competi-tiveness

Imports

Contractionary fiscal policy i

P

Y

Value of domestic currency

Value of domestic currency

Value of domestic currencyL-R effect

?

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© 2003 McGraw-Hill Ryerson Limited.

Fiscal Policy’s Effect on Fiscal Policy’s Effect on the Trade Deficitthe Trade Deficit Fiscal policy works on the trade deficit

through its effects on income and prices.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Deficit via IncomeDeficit via Income Expansionary fiscal policy increases

income. Imports go up, as does the trade deficit.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Deficit via IncomeDeficit via Income Contractionary fiscal policy works in the

opposite direction. It decreases the size of the trade deficit. These are the same effects as those of

monetary policy.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Deficit via PricesDeficit via Prices Expansionary fiscal policy increases the

price level. This increases the price of a country’s

exports and decreases it competitiveness.

This increases the trade deficit.

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© 2003 McGraw-Hill Ryerson Limited.

The Effect on the Trade The Effect on the Trade Deficit via PricesDeficit via Prices Contractionary fiscal policy works in the

opposite direction. It decreases the size of the trade deficit. These are the same effects as those of

monetary policy.

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The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit Expansionary fiscal policy increases a

trade deficit. Contractionary fiscal policy decreases a

trade deficit.

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Expansionary fiscal policy

The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit

Imports

Tradedeficit

Y

PCompeti-tiveness

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© 2003 McGraw-Hill Ryerson Limited.

Contractionary fiscal policy

The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit

Imports

Competi-tiveness

Tradedeficit

Y

P

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© 2003 McGraw-Hill Ryerson Limited.

Monetary and Fiscal Monetary and Fiscal Policy’s Effect on Policy’s Effect on International GoalsInternational Goals Trade

deficit Value of domestic currency

Expansionary monetary policy

UP DOWN

Expansionary fiscal policy

UP AMBIGUOUS

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© 2003 McGraw-Hill Ryerson Limited.

International International Phenomena and Phenomena and Domestic GoalsDomestic Goals Monetary and fiscal policy can work the

other way around. The monetary and fiscal policies of

other countries can have significant effects on Canadian domestic economy.

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© 2003 McGraw-Hill Ryerson Limited.

International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Governments try to coordinate their

monetary and fiscal policies because their economies are interdependent.

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International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Because of this interdependence, many

economists argue that all countries must work together to coordinate their monetary and fiscal policies.

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International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Because of the fear of retaliatory

measures, nations take their trading partners’ desires into account when making their monetary and fiscal policies.

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Coordination Is a Two-Coordination Is a Two-Way StreetWay Street If other nations are to take the needs of

Canadian economy into account, Canada must take the needs of other countries into account in determining its goals.

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© 2003 McGraw-Hill Ryerson Limited.

Coordination Is a Two-Coordination Is a Two-Way StreetWay Street Each country will likely do what is best

for the world economy as long as it is also best for itself.

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© 2003 McGraw-Hill Ryerson Limited.

Crowding Out and Crowding Out and International International ConsiderationsConsiderations There is another way to avoid crowding

out that results from financing the debt. Foreigners could buy the debt at the

existing interest rate. This is called internationalizing the debt.

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© 2003 McGraw-Hill Ryerson Limited.

Crowding Out and Crowding Out and International International ConsiderationsConsiderations Internationalizing a country’s debt may

help in the short run.

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© 2003 McGraw-Hill Ryerson Limited.

Crowding Out and Crowding Out and International International ConsiderationsConsiderations In the long run it presents potential

problems since foreign ownership of a country’s debts means the country must pay interest to those foreign countries and that debt may come due.

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Selecting Policies to Selecting Policies to Achieve Goals,Achieve Goals,Table17-1, p 429Table17-1, p 429

International Goal Policy Alternatives

Low value for domestic currency

Contractionary foreign monetary policy

Expansionary domestic monetary policy

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Selecting Policies to Selecting Policies to Achieve Goals, Achieve Goals, Table17-1, p 429Table17-1, p 429

International Goal Policy Alternatives Lower trade deficit Contractionary domestic

fiscal policy Expansionary foreign

fiscal policy Contractionary domestic

monetary policy Expansionary foreign

monetary policy

© 2003 McGraw-Hill Ryerson Limited.

International International Dimensions of Dimensions of

Monetary and Fiscal Monetary and Fiscal PolicyPolicy

End of Chapter 17End of Chapter 17