Topic 11 - Adjustment Policies

Topic Eleven
Adjustment
Policies
(Chapter 18, Salvadore, 10
th
ed.)

ECO561 - International Economics/Topic 11
Nov 2013/SHWong
11.1 Expenditure-Changing Policies
11.2 Expenditure-Switching Policies
11.3 Direct Control
ECO561 - International Economics/Topic 11
Nov 2013/SHWong
11.0 Adjustment Policies
The need for adjustment policies arises
because the automatic adjustment
mechanisms have serious unwanted side
effects

Adapted from Salvatore: International Economics, 10th Edition
2010 John Wiley & Sons, Inc.
for ECO561 - International Economics/Topic 11
Nov 2013/SHWong
Introduction
Adjustment policies are necessary & carried
out to achieve the national objectives of
Internal & external balance
Reasonable rate of growth
Equitable distribution of income
Adequate environmental protection

Nov 2013/SHWong
Introduction (cont)
Expenditure-changing policies
Fiscal and monetary policy tools to alter the
level of aggregate expenditures in the
economy
Expenditure-switching policies
Devaluation or revaluation of the exchange
rate to alter the balance of spending on
domestic and foreign goods and services
Nov 2013/SHWong
Internal & External Balance with
Expenditure-Changing & Expenditure-
Switching Policies
Internal imbalances
Inflation imbalance assumed to be caused
by excess aggregate demand
Recession imbalances caused by
insufficient aggregate demand
External imbalances
A deficit in the balance of payments
A surplus in the balance of payments

Nov 2013/SHWong
Internal & External Balance
Possible situations
External surplus and internal unemployment
External surplus and internal inflation
External deficit and internal inflation
External deficit and internal unemployment
It is possible that the policies available for
correcting the imbalances may improve one
situation only at the expense of worsening
another

Nov 2013/SHWong
Internal & External Balance (cont)
The vertical axis measures the exchange
rate while the horizontal axis real
domestic expenditure, or absorption
Points on EE curve refer to external
balance, with points to the left indication
external surplus & points to the right
indication external deficit
Points on the YY curve refer to internal
balance, with points to the right indication
internal unemployment & points to the
right indicating internal inflation
The crossing of the EE & YY curves defines
the four zones of external & internal
imbalance & helps us determine the
appropriate policy mix to reach external &
internal balance simultaneously at point F

Nov 2013/SHWong
Swan Diagram
Goods market equilibrium when quantities
of goods and services demanded and supplied
are equal
Money market equilibrium when quantity of
money demanded for transactions and
speculation is equal to given supply of money
BoP equilibrium when trade deficit is
matched by an equal net capital inflow or
trade surplus is matched by equal net capital
outflow

Nov 2013/SHWong
Equilibrium in the Goods Market,
Money Market & Balance of Payments
The Mundell-Fleming model shows how
nation can use monetary and fiscal policy to
achieve internal and external balance without
a change in exchange rates
Nov 2013/SHWong
The IS, LM and BP curves show various
combinations of interest rates and national
income at which the goods market, the
money market and the balance of payments,
respectively, are in equilibrium
Nov 2013/SHWong
The IS curve is negatively inclined because
lower rates of interest (& higher investments)
are associated with higher incomes (& higher
savings and imports) for the quantities of
goods & services demanded and supplied to
remain equal
Nov 2013/SHWong
the IS Curve
The LM curve is positively inclined because
higher income (& a larger transaction demand
for money) must be associated with higher
interest rates (& a lower demand for
speculative money balances) for the total
quantity of money demanded to remain equal
to the given supply of money
Nov 2013/SHWong
Equilibrium in the Money Market,
the LM curve
The BP curve is also positively inclined
because higher incomes (& imports) require
higher rates of interest (& capital inflows) for
the nation to remain in balance-of-payments
equilibrium
Nov 2013/SHWong
Equilibrium in the Balance of Payments,
the BP curve
The goods market, the
money market & the
balance of payments
are in equilibrium at
point E, where the IS,
LM, & BP curves cross at
i = 5.0%, and Y
e
= 100
However, Y
e
< Y
f

Nov 2013/SHWong
Achieving internal & external balance
From unemployment / external balance
Expansionary fiscal policy
Tight monetary policy
No change in exchange rate
Nov 2013/SHWong
Fiscal & Monetary Policies
for Internal & External Balance
with Fixed Exchange Rates
Nov 2013/SHWong
Fiscal & Monetary Policies from
Domestic Unemployment & External
Balance
Starting from point E with domestic
unemployment & external balance, the
nation can reach the full employment
level of national income of Y
f
= 1500
with external balance by pursuing the
expansionary fiscal policy that shifts
the IS curve to the right to IS and the
tight monetary policy that shifts the
LM curve to the left to LM, while
holding the exchange rate fixed
All three markets are then in
equilibrium at point F, where curves IS
and LM cross on the unchanged BP
curve at i = 8.0% and Y
f
= 1500
Achieving Internal and External Balance
From unemployment / external deficit

Nov 2013/SHWong
Fiscal & Monetary Policies
for Internal & External Balance
with Fixed Exchange Rates
Inelastic capital
mobility
Elastic (high) capital
mobility
Perfect capital mobility
Expansionary fiscal
policy
Tight monetary policy
Expansionary fiscal
policy
Easy monetary policy
Expansionary fiscal
policy
Monetary policy is
ineffective
Nov 2013/SHWong
Fiscal & Monetary Policies from
Domestic Unemployment & External
Deficit
unemployment & external deficit, the nation
can reach the full employment level of
national income of Y
f
= 1500 with external
balance by pursuing the expansionary fiscal
policy that shifts the IS curve to the right to
IS and the tight monetary policy that shifts
the LM curve to the left to LM, while
keeping the exchange rate fixed
All three markets are then in equilibrium at
point F, where curves IS and LM cross on
the unchanged BP curve at i = 9.0% and Y
f
=
1500
Because of the original external deficit, the
nation now requires a higher interest rate to
reach external and internal balance
Nov 2013/SHWong
Fiscal and Monetary Policies with
Elastic Capital Flows
unemployment & external deficit, the
nation can reach the full employment
level of national income of Y
f
= 1500
with external balance by pursuing the
expansionary fiscal policy that shifts
the IS curve to the right to IS and the
easy monetary policy that shifts the LM
curve to the right to LM, while keeping
the exchange rate fixed
All three markets are then in
equilibrium at point F, where curves IS
and LM cross on the unchanged BP
curve at i = 6.0% and Y
f
= 1500
Nov 2013/SHWong
Fiscal & Monetary Policies with
Perfect Capital Mobility & Fixed
Exchange Rates
unemployment & external balance
and perfect capital mobility & a fixed
exchange rate, the nation can reach
the full employment level of national
income of Y
f
= 1500
With the expansionary fiscal policy
that shifts the IS curve to the right to
IS and with the LM curve shifting to
the right to LM because of capital
inflows that the nation is unable to
neutralize
Achieving Internal and External Balance
From unemployment / external balance

Nov 2013/SHWong
The IS-LM-BP Model with Flexible
Exchange Rates
Imperfect capital mobility Perfect capital mobility
Expansionary fiscal policy
Expansionary monetary policy
Fiscal policy is ineffective
Nov 2013/SHWong
The IS-LM-BP Model with Flexible
Exchange Rates
Starting from point E with all three markets
in equilibrium with an external balance &
domestic unemployment, the nation could
use easy monetary policy to shift the LM
curve to the right to LM so as to cross the IS
curve at point U and reach the full-
employment level of Y
f
= 1500
However, since point U is to the right of the
BP curve, the nation has an external deficit
With flexible exchange rates, the nations
currency depreciates and this causes the BP
& IS curves to shift to the right and the LM
curve to the left until curves BP, IS, and LM
cross at at E, with Y
e
= 1400
The process can be repeated with additional
doses of easy monetary policy until all three
markets are in equilibrium at Y
f
= 1500
Nov 2013/SHWong
Adjustment Policies with Perfect
Capital Flows & Flexible Exchange
Rates
unemployment & external balance, &
perfectly elastic capital flows & flexible
exchange rates, the nation can reach the
full-employment level of national income of
Y
f
= 1500 with easy monetary policy to shift
the LM curve to the right to LM.
This causes the IS curve to shift to the right
to IS (because the tendency of the currency
to depreciate improves the nations trade
balance) and the LM curve back part of the
way to LM (because of the reduction in real
money supply resulting from an increase in
domestic prices)
The final equilibrium is at point F where IS
and LM curves cross on the BP curve at Y
f
=
1500
Nov 2013/SHWong
Policy Mix & Price Changes
Inflation & Surplus Recession & Surplus
Contractionary fiscal policy
Expansionary Fiscal policy
Inflation & Deficit Recession & Deficit
Contractionary fiscal policy
Expansionary fiscal policy and
Contractionary monetary policy
With fixed exchange rates, fiscal policy tends
to be more effective than monetary policy
With flexible exchange rates, monetary policy
tends to be more effective than fiscal policy
Nov 2013/SHWong
Policy Mix & Price Changes (cont)
Nov 2013/SHWong
Effective Market Classification and the
Policy Mix
Moving to the right refers to expansionary
fiscal policy, whole moving upward refers to
tight monetary policy & higher interest rates
The various combinations of fiscal &
monetary policies that result in internal
balance are given by the IB line while
external balance are given by the EB line
The EB line is flatter than the IB line because
monetary policy also induces short-term
international capital flows
Starting from point C in zone IV, the nation
should use expansionary fiscal policy to
reach point C1 on the IB line & then tight
monetary policy to reach point C2 on the EB
line, on its way to point F, where the nation
is simultaneously in internal & external
balance
If the nation did the opposite, it would
move to point C1 on the EB line & then to
point C2 on the IB line, thus moving farther
& farther away from point F
Tariffs, quotas & other quantitative
restrictions on the flow of international trade
An import tariff & export subsidy of a given
percentage applied across the board on all
goods are equivalent to a devaluation of the
currency by the same percentage
Import tariffs & export quotas are
expenditure-switching policies, stimulate
domestic production
Nov 2013/SHWong
Direct Controls
Restrictions on international capital flows,
multiple exchange rates
Developed nations sometimes restrict capital
exports when in balance of payments deficit
and capital imports when in surplus
Higher exchange rates on luxuries and
nonessentials discourages their importation,
while lower exchange rates on essential
imports encourage their import
Nov 2013/SHWong
Direct Controls (Exchange Controls)
For direct controls to be effective, a great deal
of international cooperation is required
Imposition of import quotas may result in
retaliation if affected nations are not
consulted
Further, the use of many direct controls (for
instance, tariffs & non-tariff barriers) is
constrained by international treaties such as
GATT
Nov 2013/SHWong
Direct Controls (Effectiveness)

Topic 11 - Adjustment Policies

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