Impact of Monetary & Fiscal Policies on Economies
Foreign Policy
1) ∇i Exterior
This causes i > i*, leading to capital inflows into the EU (increasing demand for the Euro (€) and appreciating the exchange rate (E)).
- ∆E (€ appreciates, $ depreciates), the i-E curve shifts to the right (without changing our i).
- If € appreciates (∆E), the real exchange rate increases (Real exchange rate = E * p), leading to a decrease in net exports (∇XN) and a decrease in output (∇Y).
The current account balance worsens. If initially, XN is in equilibrium (XN=0), at ∆E, it worsens and will be in deficit (XN<0).
It shifts: XN to the left (∆E) / IS to the left (∇XN)
Effects: ∇Y (Yd, employment, I, SP), i=, ∇i* (€ appreciates, ∆E, ∇XN)
As income decreases, tax revenue decreases, worsening public savings (∇SP).
2) ∆Y*
If ∆Y*, this leads to an increase in our exports (∆XN), which improves our current balance.
∆Y* – ∆X – ∆XN – ∆Y
3) ∆p*
∇p – ∇Real exchange rate= E * p – ∆XN–∆Y
As prices rise more abroad, we gain competitiveness, and our current account balance improves.
Common Part
If we consider that at the initial point, XN is in equilibrium (XN=0), at ∆Y*/∆p*, the situation improves and generates a surplus. It shifts: XN to the right (∆Y/p*) / IS to the right (∆XN)
We consider that the Central Bank (CB) controls the interest rate according to Taylor’s rule. It doesn’t change the interest rate and, hence, the exchange rate.
Effects: ∆Y (Yd, employment, I, SP), i=, E=, ∆exports (∆XN)
Open Economy
Expansionary Monetary Policy
1) We consider that the CB controls the interest rate according to Taylor’s rule.
i = i* + a … equation
∇i*
∆infl* – ∇i. The CB will lower the interest rate.
∆ut – The CB will conduct an expansionary monetary policy.
As i decreases (LM shifts downwards):
∇i – ∆I – ∆AD – ∆Y
2) As i decreases (i<i*) – capital outflows – increasing demand for $
Causing the € to depreciate (∇E) to return to interest parity (we don’t shift the i-E line, we go over it).
3) At ∇E (€ depreciates) – ∇Real exchange rate= E * p – ∆XN. We gain competitiveness.
If we consider that at the initial point, XN is in equilibrium, at the final equilibrium, XN will be in surplus. It shifts: XN to the right / IS to the right.
Expansionary Fiscal Policy
1) If ∆G
∆Tr – ∆AD – ∆Y
∇T
∆Autonomous expenditure – ∆AD – ∆Y
Interest doesn’t change because we consider that the CB controls the interest rate according to Taylor’s rule.
2) On the i-E line, as i doesn’t change, the exchange rate (E) doesn’t change. Expansionary fiscal policy worsens public savings.
3) At ∆Y – ∆Imports – ∇XN
The current account balance worsens. We move over the XN to the new equilibrium. If we consider that initially it is in equilibrium (XN=0), at ∆Y, it will be in deficit (XN<0).
Effects: ∆Y (Yd, employment, I), i=, E=, ∇SP, ∇XN
Closed Economy
1) If the ECB Lowers its Interest Target (∇i*)
We consider that the ECB controls the interest rate according to Taylor’s rule. By lowering the target interest rate (∇i*), the ECB is conducting an expansionary monetary policy, which:
∇i* – ∇i – ∆I – ∆AD – ∆Y
By lowering the interest rate, investment, demand, and income are stimulated.
GRAPH + Effects: ∆Y (Yd, employment), ∆I, ∆SP, ∇i
By increasing income, tax revenue will increase, and therefore, public savings will improve (∆SP).
2) If the ECB Raises its Inflation Target (∆inf*)
We consider that the ECB controls the interest rate according to Taylor’s rule. By increasing the inflation target (∆inf*), the ECB is conducting an expansionary monetary policy, which:
∆infl* – ∇i – ∆I – ∆AD – ∆Y
COMMON PART: sentence 1, graph, effects, sentence 2
3) Faced with a Sharp Rise in Unemployment
We consider that the ECB controls the interest rate according to Taylor’s rule. In an economic context of high unemployment, the ECB will conduct an expansionary monetary policy by lowering the interest rate so that indebtedness will be cheaper, and therefore, ∆I – ∆AD – ∆Y. In this way, by increasing production, employment will increase.
∆ut: – ∇i – ∆I – ∆AD – ∆Y – ∆employment
GRAPH + Effects: same as 1) and 2), and the last sentence.
4) Faced with a Sharp Rise in Inflation
We consider that the ECB controls the interest rate according to Taylor’s rule. In an economic context of high inflation, the ECB will conduct a contractionary monetary policy and will, therefore, raise the interest rate and slow down economic growth. In this way, it will reduce inflation.
∆infl t: – ∆i – ∇I – ∇AD – ∇Y
GRAPH + Effects: ∇Y (Yd, infl t), ∇I, ∇SP, ∆i
The contractionary effect of the policy will cause public savings to worsen and unemployment to rise.
Closed Economy: Expansionary Fiscal Policy
If ∆G
∆Tr – ∆AD – ∆Y
∇T
By increasing G, it leads to an increase in autonomous demand expenditure and, hence, income. It shifts the IS horizontally to the right. We consider that the ECB controls the interest rate according to Taylor’s rule, so we draw LM horizontally, and interest doesn’t change, making expansionary fiscal policy maximally effective. Fiscal policies worsen public savings.
As income increases, investment, employment, and disposable income increase, which will increase consumption and private savings.
Effects: ∆Y (Yd, employment, I), i=, ∇SP