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Understanding Interaction Between Monetary and Fiscal Policy in Open Economies

Explore the impact of monetary and fiscal policies on the open economy, examining case studies like UK's monetary policy shift and Brazil's government purchases increase. Learn how interactions between policies influence outcomes.

sigourney-wyatt
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Understanding Interaction Between Monetary and Fiscal Policy in Open Economies

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  1. Review last week Another case study or 2 The open economy: Introduction What determines NX? Macro in Action

  2. LM2 r LM1 r2 r 1 IS Y1 Y2 Y Monetary policy: UK decrease in M • M < 0 shifts the LM curve inward 2. …causing the interest rate to rise 3. …which decreases investment, causing output & income to fall.

  3. LM r r2 r1 IS2 IS1 Y1 Y2 Y 2. 1. 3. Brazil: increase in government purchases • IS curve shifts right causing output & income to rise. 2. This raises money demand, causing the interest rate to rise… 3. …which reduces investment, so the final increase in Y

  4. Interaction between monetary & fiscal policy • Model: Monetary & fiscal policy variables (M, G, and T) are exogenous. • Real world: Monetary policymakers may adjust Min response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change.

  5. The Fed’s response to expansionary fiscal policy • 2001 U.S. recession • Bush cut T & increased G. • Possible Fed responses: 1.hold M constant 2.hold r constant 3.hold Y constant • In each case, the effects of the Gare different:

  6. LM1 r r2 r1 IS2 IS1 Y1 Y2 Y Response 1: Hold M constant Higher G and lower T, the IS curve shifts right. If Fed holds M constant, then LM curve doesn’t shift. Results:

  7. LM1 r LM2 IS2 IS1 Y3 Y1 Y2 Y Response 2: Hold r constant Higher G and lower T, the IS curve shifts right. To keep r constant, Fed increases Mto shift LM curve right. r2 r1 Results: Accommodating monetary policy. (In fact, the Fed actively cut r, as we discussed.)

  8. LM2 LM1 r r3 r1 IS2 IS1 Y1 Y2 Y Response 3: Hold Y constant Higher G and lower T, the IS curve shifts right. To keep Y constant, Fed reduces Mto shift LM curve left. r2 Results: Offsetting monetary policy

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