Macroeconomic Policies in an Open Economy

  1. Keynesian Model of a Closed Economy
Classical model

Classical economists assumed that economies would operate at the full employment level because prices and wages are flexible. (e.g., the oil price reached the peak of $145 in July 2008, but fell below $40 in 2015.)

If unemployment exists in the labor market, wages and prices would fall until full employment is restored. The classical economists wrote this idea in the 19th century.

Empirical evidence shows that prices were indeed flexible during that period. Extreme upward and downward movements in prices took place regularly. This was due to the greater importance of agriculture in the 19th century. Agricultural prices were flexible in both directions. During WWI, increased demand (from Europe and Japan) for American goods raised the price level. The 1920-21 depression hit American farmers very hard, causing a dramatic fall in the price of raw agricultural products.

This situation was worsened in the 1930s (Great Depression).

The Keynesian Model is more appropriate for describing the world economy since 1930s. (Manufacturing was becoming more important. Manufacturing share was 30% of GDP in 1930, 25% in 1970, but is now 12% (total industry's share = 20%.)

Labor share of agriculture: 74% in 1800, 40% in 1890.

Today, the classical model may be more relevant now than before.

As income grows, the service share of GDP increases, and the economy eventually behaves like a closed economy.

US service share = 79% (Industry = 20%, ag = 1.1%) in 2013.
China = 43%, dependent on exports.
Japan = 73%.
Sub-Saharan Africa = below 50%.

(i) prices and wages are inflexible, sticky downwards
(ii) unemployment exists in the labor market.
The Model Y = C + I + G + (X - M)

C = C(Y), C' > 0

I = Io

G = Go

(ii) Y = C + S + T

Paradox of Saving
Equilibrium condition

I + G + X = S + T + M

(a) No government:

I + X = S + M

(b) No foreign sector

I = S = -a + sY. (s = 1- b).

A decrease in a (the vertical intercept of the consumption function) only reduces Y without raising total savings. (S = I remains unchanged) ⇒ Paradox of Saving.

Multiplier: ΔY/ΔI

Y = a + bY + I,

Y = (a + I)/(1 - b)

multiplier = 1/(1 - b)

b = marginal propensity to consume

MPC = 0.77 (US)


  2. Open Economy
(i) small country
Y = a + bY + I + X - mY
Y = (a + I + X)/(1 - b + m)

Foreign trade multiplier

mX = 1/(1 - b + m)

= 1/(s + m) < 1/(1 - b)
For instance, if b = 0.9, the multiplier is 10 in a closed economy. If m = 0.1, then it reduces to 5. Thus, the open economy multiplier is very sensitive to the marginal propensity to import.
Exercise C = 1.5 + 0.6Y
I = .5, X = .5, M = .1Y

Y = 5, multiplier = 2

(ii) large country Y = a + bY + I + m*Y* - mY

Y* = a* + b*Y* + I* + mY - m*Y*

multiplier = 1/[s + m - mm*/(s* + m*)] > 1/(s + m)

The multiplier for a large country is greater than that for a small country.

  3. A General Model of the Closed Economy

A simple model of the domestic economy consists of the product market and money market.

Product market equilibrium

(unemployment still exists)

Y= C(Y) + I(r) + G

When the aggregate demand is equal to the current output, actual inventories are exactly equal to the planned inventories. Since there is no unintended inventory build-up, the product market is in equilibrium.

This yields IS curve, which is the locus of income and interest rate that clears the product market.

IS curve is negatively sloped. An increase in r lowers investment, which reduces GDP (through the multiplier effect).

Shifts of IS curve

Since this graph has only two dimensions, r, Y, only their relationship can be shown. If any other factor varies, it causes a shift in the IS curve.

(i) an expansionary fiscal policy, or an increase in foreign borrowing increases income at a given interest rate.

Money Market

Real Money supply

Ms/P = speculative + transactions + precautionary demand.

Transations demand for money is proportional to income, and hence can be expressed as k(Y+). Precautionary demand is also proportional to income, and hence can be included in k(Y+).
Speculative demand is inversely related to interest rate, L(r).
  two components: (Nominal) Money demand = L(r¯) + kPY

(Real) Money demand = ℓ(r¯) + kY, k > 0.

Money market equilibrium requires:

Ms/P = ℓ(r¯) + kY

LM curve is positively sloped.

Since the left hand side is fixed, an increase in r lowers the speculative balance, which requires an increase in the transactions balance.

Shifts of LM curve

Rightward shifts:

(i) M increases
(ii) P decreases



Keynesian equilibrium

Unemployment exists.

The labor market does not clear (not shown here). Accordingly, GDP is less than the full employment rate of output).

What to do

To attain FE in a closed economy, shift IS or LM curve or both.

A monetary or fiscal expansion is needed to stimulate the economy. Keynesians argue fiscal policy is more effective, while monetarists recommends monetary policy to cure unemployment. A fiscal expansion raises the interest rate, while a monetary expansion lowers it.



  4. A General Model of an Open Economy

The domestic economy consists of three markets:

(i) the product market

(ii) the money market, and

(iii) the external market.

 Product market Product market equilibrium requires

Y = C(Y) + I(r) + G + (X - M)

This yields the IS curve, which is the locus of income and interest rate that clears the product market.

Inclusion of the foreign sector makes the IS curve steeper, because import increases with income.


Shifts of IS curve

An expansionary fiscal policy, an increase in export sales, or devaluation, increases income at a given interest rate.

 Money Market

 Ms/P = ℓ(r) + kY

 External Market Current account + Capital Account
BP = X(P¯,e+,Y*+) ¯ M(P+,e¯,Y+) + F(r+)

X= exports

M= imports

P = domestic price level

Y= domestic output

Y* = foreign output

r = interest rate

e = exchange rate, the price of foreign currency = $/euro or $/yen

F(r) = Capital inflow

BP curve is positively sloped.

An increase in r, capital inflow occurs and F(r) increases. The current account must decrease to achieve BP equilibrium. That is, income must increase. Thus, there is a positive relationship between r and y.
Shifts of BP curve

an increase in X ⇒ BP curve shifts to the right

an increase in foreign income.

devaluation increases X.

  5. Domestic Equilibrium with BP equilibrium

Under clean float (without intervention by any government) exchange rates are determined at the rates where BP equilibrium occurs.

A Balance of Payments disequilibrium occurs under the fixed exchange rate system, or under dirty float.

 BP Equilibrium The economy might be in balance of payments equilibrium as shown below:

Figure 6.

 BP surplus However, there is no reason for the economy to be in such an equilibrium state. For example, an economy may have a BP surplus or deficit as shown below.

Figure 7. Balance of Payments surplus

If the intersection of IS and LM is above the BP curve, there is a surplus. (a regular pyramid)

If it is below the BP curve, there is a deficit in the balance of payments. (an upside down pyramid)

 BP deficit  

Figure 8. Balance of payments deficit

  6. Automatic Adjustment in the BP surplus
 Policy options in a Closed economy  In a closed economy, policymakers can use monetary or fiscal policies, or a suitable combination of both policies to correct unemployment in the labor market and reach the full employment output in the product market.
 Open Economy

In an open economy, policy makers still have the option of using monetary and fiscal policies. However, openness also means a possible disequilibrium in the foreign sector.

To correct a problem in the balance of payments, there are four policy options:

(i) monetary policy,

(ii) fiscal policy,

(iii) balance of payments policy,

(iv) laisses-faire (nonintervention, do-nothing).

Lao Zi (or Lao Tsu), a Chinese philosopher around 550 BC, advocated for non-intervention. Later, the classical economists of the 19th century called it laissez-faire.


From the "Sayings of Lao Zi" (by Tsai Chih Chung), Courtesy of

  7. BP surplus and Nonintervention
  The Figure below illustrates what happens when the policymaker does nothing. whereas BP deficit gradually raises interest rate. This explains for instance why interest rate in Japan is lower than in the US. 
 BP surplus

In a full employment economy, BP surplus lowers the interest rate.


(i) initially the internal economy attains its full employment equilibrium at point e.
(ii) There is a BP surplus.

Policymakers in surplus countries often do not feel obligated to do anything to correct surpluses in their balance of payments. They think that deficit countries should cure their deficit problems, even though the policies of surplus countries may cause deficits of their trading partners.

Thus, consider the effect of "do nothing" (nonintervention) policy of a surplus country.

(i) BP surplus increases money supply since commercial banks experience an increase in reserves (exporters convert foreign currency earnings into the domestic currency) and the monetary base increases, which through the money multiplier, increases money supply. The LM curve shifts to right.

(ii) Interest rate falls along the IS curve, which has an expansionary effect on the economy. However, due to full employment, price rises.

(iii) A price increase shifts the LM curve to the left a little, and shifts the IS curve to the left, since due to inflation imports become relatively cheaper. Increased imports and decreased exports also shift the BP curve upward.

Automatic adjustment to BP surplus  

  8. Adjustments in the BP through Monetary Policy
 BP Deficit

cut money supply.

Cutting money supply will defnitely raise the interest rate and reduce the BP deficit.

However, policies are not always symmetric.

Increasing money supply may not be effective in the presence of a liquidity trap (when increasing money supply does not lower interest rate).


In recent years, since Alan Greenspan became the chairman of the Board of Governors for Federal Reserve System, the US has adopted interest rate fixing policy, which meant flat LM curves for all operational purposes.

or cut interest rate 


The deflationary policy increases unemployment. This policy might be unpopular when the country has both unemployment and BP deficit.

A decrease in money supply or a rise in the interest rate increases unemployment. (Not a good option during recession)

It might be acceptible if the economy is overheated and the inflation rate is high.


  9. Fiscal Policy
 Deficit Deficit: decrease Government spending? Not when unemployment is a problem.
Assume: interest rates are fixed (US, Europe or Japan)  

  10. Curing BP Deficit 

Neither monetary nor fiscal policies are effective to cure BP deficits, as they could cause a more serious problem in the domestic economy. The best remedy is found at the source.

To cure a deficit, you have the following 5 options:
(a) devaluation
(b) foreign exchange control
(c) control of capital movement (For example, Renminbi is not freely convertible into dollar for capital movement)
(d) deplete gold stock

(e) increase liabilities to foreign central banks.

In addition, to control trade deficits

(f) tariffs and quotas


For instance, devaluation improves the country's balance of payments.

Developed economies: Japan permitted a rise in yen (USD fell to about 110 yen from 280 yen in 1985). This move reduced Japan's BP surplus while reducing US BP deficit.

LDCs: Exchange controls are often used in LDCs.