International Dimensions
of Monetary and Fiscal
Policy
Chapter 17
© 2003 McGraw-Hill Ryerson Limited.
17 - 2
Ambiguous International
Goals of Macroeconomic
Policy

Macroeconomics’ international goals are
less straightforward than its domestic
goals.
© 2003 McGraw-Hill Ryerson Limited.
17 - 3
Ambiguous International
Goals of Macroeconomic
Policy

There is great debate about how
Canada should maintain its position in
the world economy.
© 2003 McGraw-Hill Ryerson Limited.
17 - 4
Ambiguous International
Goals of Macroeconomic
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?

© 2003 McGraw-Hill Ryerson Limited.
17 - 5
The Exchange Rate Goal
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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17 - 6
Advantages of a High Value
for the Dollar
It makes foreign currencies cheaper.
 It lowers the price of imports.

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17 - 7
Advantages of a High Value
for the Dollar
Lower import prices puts competitive
pressure on domestic firms and helps to
keep down inflation.
 Canadian residents’ living standards are
enhanced.

© 2003 McGraw-Hill Ryerson Limited.
17 - 8
Advantages of a High
Exchange Rate

A low value for the dollar has the
opposite effect.
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17 - 9
Disadvantages of a High
Value for the Dollar
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 10
Disadvantages of a High
Value for the Dollar

A low exchange rate has the opposite
effect.
© 2003 McGraw-Hill Ryerson Limited.
17 - 11
The Exchange Rate Goal

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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 12
The 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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 13
The 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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 14
The Trade Balance Goal

All the future interest and profits on
those assets will flow to foreigners, not
Canadian citizens.
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17 - 15
The 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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 16
The Trade Balance Goal

In the short-run a trade deficit allows
more current consumption, in the long
run it presents problems.
© 2003 McGraw-Hill Ryerson Limited.
17 - 17
International versus
Domestic Goals
Domestic goals generally dominate
international goals.
 International goals are ambiguous.

© 2003 McGraw-Hill Ryerson Limited.
17 - 18
International versus
Domestic Goals
International goals affect a country’s
population indirectly.
 In politics, indirect effects take a back
seat.

© 2003 McGraw-Hill Ryerson Limited.
17 - 19
International versus
Domestic 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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 20
International versus
Domestic Goals

As countries become more
economically integrated, these
pressures from other countries become
more important.
© 2003 McGraw-Hill Ryerson Limited.
17 - 21
Monetary and Fiscal Policy
with Fixed Exchange Rates

An economy with fixed exchange rates
is much more restricted in its monetary
and fiscal policies than one with flexible
exchange rates.
© 2003 McGraw-Hill Ryerson Limited.
17 - 22
Monetary and Fiscal Policy
with Fixed Exchange 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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 23
Monetary and Fiscal Policy
with Fixed Exchange Rates

If foreign reserves are limited, a country
must adjust its economy to maintain the
value of its currency.
© 2003 McGraw-Hill Ryerson Limited.
17 - 24
Raising the Value of the Euro
Using Monetary and Fiscal
Policy

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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 25
Increase the Private Demand
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 26
Increase the Private Demand
for Euros
The problem?
 The area can achieve an interest rate
target or an exchange rate target, but
not both at the same time.

© 2003 McGraw-Hill Ryerson Limited.
17 - 27
Decrease the Private Supply
of Euros

The private supply of euros can be
decreased via contractionary monetary
and fiscal policy.
© 2003 McGraw-Hill Ryerson Limited.
17 - 28
Decrease the Private Supply
of Euros
Contractionary monetary and fiscal
policy will create a recession.
 The demand for imports will decrease,
thereby decreasing the private supply of
euros.

© 2003 McGraw-Hill Ryerson Limited.
17 - 29
Decrease the Private Supply
of Euros
The problem?
 A purposely induced recession for
political reasons is not a very popular
decision.

© 2003 McGraw-Hill Ryerson Limited.
Targeting an Exchange Rate
with Monetary and Fiscal
Policy, Fig. 17-1, p 419
Price of euros
(in dollars)
S1
17 - 30
S0
$0.30
0.20
D1
D0
Quantity of
euros
© 2003 McGraw-Hill Ryerson Limited.
17 - 31
Monetary and Fiscal Policy
with Flexible or Partially
Flexible Exchange 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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 32
Monetary Policy’s Effect on
Exchange Rates

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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 33
The Effect on Exchange Rates
via Interest Rates
An expansionary monetary policy
pushes down the Canadian interest
rate.
 Lower interest rates decrease foreign
capital inflow into Canada.

© 2003 McGraw-Hill Ryerson Limited.
17 - 34
The Effect on Exchange Rates
via Interest Rates
Less foreign capital inflow decreases
the demand for dollars.
 Lower demand for Canadian dollars
decreases the exchange.

© 2003 McGraw-Hill Ryerson Limited.
17 - 35
The Effect on Exchange Rates
via Interest Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 36
The Effect on Exchange Rates
via Income

Monetary policy affects income in a
country.
 As
money supply rises, income expands.
 When money supply falls, income
contracts.
© 2003 McGraw-Hill Ryerson Limited.
17 - 37
The Effect on Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 38
The Effect on Exchange Rates
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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 39
The Effect on Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 40
The Effect on Exchange Rates
via Price Levels

The demand for foreign currencies
increases and the demand for dollars
decreases, pushing the value of the
dollar down.
© 2003 McGraw-Hill Ryerson Limited.
17 - 41
The Effect on Exchange Rates
via Price Levels

Contractionary monetary policy puts
downward pressure on Canadian price
level and slows down any existing
inflation.
© 2003 McGraw-Hill Ryerson Limited.
17 - 42
The Effect on Exchange Rates
via Price Levels

As a result, contractionary monetary
policy pushes the value of the dollar up
via the price path.
© 2003 McGraw-Hill Ryerson Limited.
17 - 43
The Net Effect of Monetary
Policy on Exchange Rates
Expansionary monetary policy lowers
exchange rates.
 It decreases the relative value of a
currency.

© 2003 McGraw-Hill Ryerson Limited.
17 - 44
The Net Effect of Monetary
Policy on Exchange Rates
Contractionary monetary policy
increases exchange rates.
 It increases the relative value of a
country's currency.

© 2003 McGraw-Hill Ryerson Limited.
17 - 45
Net Effect of Monetary Policy
on Exchange Rates
Value of
domestic
currency
i
M
Expansionary
monetary
policy
Y
P
Imports
Competitiveness
Value of
domestic
currency
Value of
domestic
currency
Value of
domestic
currency L-R
effect
© 2003 McGraw-Hill Ryerson Limited.
17 - 46
Net Effect of Monetary Policy
on Exchange Rates
Contractionary
monetary
policy
M
Value of
domestic
currency
i
P
Imports
Y
Competitiveness
Value of
domestic
currency
Value of
domestic
currency
Value of
domestic
currency L-R
effect
© 2003 McGraw-Hill Ryerson Limited.
17 - 47
Monetary Policy’s Effect on
the Trade Balance

Monetary policy affects the trade
balance in three ways.
 Through
income.
 Through price levels.
 Through the exchange rate.
© 2003 McGraw-Hill Ryerson Limited.
17 - 48
The Effect on the Trade
Balance via Income
Expansionary monetary policy
increases income.
 When incomes rise, imports rise;
exports are unaffected.

© 2003 McGraw-Hill Ryerson Limited.
17 - 49
The Effect on the Trade
Balance via Income
As imports rise, the trade balance shifts
in the direction of deficit.
 As a result, the trade balance shifts
toward a deficit.

© 2003 McGraw-Hill Ryerson Limited.
17 - 50
The Effect on the Trade
Balance via Income
Contractionary monetary policy works in
the opposite direction.
 As a result, the trade balance shifts
toward a surplus.

© 2003 McGraw-Hill Ryerson Limited.
17 - 51
The Effect on the Trade
Balance via Price Levels
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 52
The Effect on the Trade
Balance via Price Levels
Contractionary monetary policy works in
the opposite direction.
 As a result, contractionary monetary
policy decreases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited.
17 - 53
The Effect on the Trade
Balance via Price Levels

Monetary policy’s effect on the price
level is a long-run effect.
© 2003 McGraw-Hill Ryerson Limited.
17 - 54
The Effect on the Trade
Balance via Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 55
The Effect on the Trade
Balance via Exchange Rates
Contractionary monetary policy works in
the opposite direction.
 As a result, contractionary monetary
policy increases a trade deficit.

© 2003 McGraw-Hill Ryerson Limited.
17 - 56
The Effect on the Trade
Balance via Exchange Rates

Like the price level effect, the effect of
the exchange rate on the trade deficit is
a long-term effect.
© 2003 McGraw-Hill Ryerson Limited.
17 - 57
The Net Effect of Monetary
Policy on the Trade Balance
Expansionary monetary policy makes a
trade deficit larger.
 Contractionary monetary policy makes a
trade deficit smaller.

© 2003 McGraw-Hill Ryerson Limited.
17 - 58
Net Effect of Monetary Policy
on the Trade Deficit
M
Expansionary
monetary
policy
Y
Imports
P
Competitiveness
i
Value of
domestic
currency
Trade
deficit
Competitiveness
© 2003 McGraw-Hill Ryerson Limited.
17 - 59
Net Effect of Monetary Policy
on the Trade Deficit
Contractionary
monetary
policy
Y
M
P
i
Imports
Competitiveness
Value of
domestic
currency
Trade
deficit
Competitiveness
© 2003 McGraw-Hill Ryerson Limited.
17 - 60
Fiscal Policy’s Effect on
Exchange Rates

Fiscal policy affects exchange rates in
three ways.
 Through
income.
 Through price.
 Through interest rates.
© 2003 McGraw-Hill Ryerson Limited.
17 - 61
The Effect on Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 62
The Effect on Exchange Rates
via Income
Contractionary fiscal policy works in the
opposite direction.
 Imports decrease and the currency
value increases.

© 2003 McGraw-Hill Ryerson Limited.
17 - 63
The Effect on Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 64
The Effect on Exchange Rates
via Price Levels
Contractionary fiscal policy works in the
opposite direction.
 The price path is a long-run effect.

© 2003 McGraw-Hill Ryerson Limited.
17 - 65
The Effect on Exchange Rates
via Interest Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 66
The Effect on Exchange Rates
via Interest Rates
Contractionary fiscal policy works in the
opposite direction.
 Interest rates decrease, capital flows
out of Canada and the value of the
dollar decreases.

© 2003 McGraw-Hill Ryerson Limited.
17 - 67
The Net Effect of Fiscal
Policy on Exchange Rates
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 68
The Net Effect of Fiscal
Policy on Exchange Rates

It is unclear what the effect of
expansionary or contractionary fiscal
policy will be on exchange rates.
© 2003 McGraw-Hill Ryerson Limited.
17 - 69
Net Effect of Fiscal Policy on
Exchange Rates
Value of
domestic
currency
i
Y
Expansionary
fiscal policy
P
Imports
Competitiveness
Value of
domestic
currency
Value of
domestic
currency L-R
effect
?
© 2003 McGraw-Hill Ryerson Limited.
17 - 70
Net Effect of Fiscal Policy on
Exchange Rates
Contractionary
fiscal policy
Value of
domestic
currency
i
P
Imports
Y
Competitiveness
Value of
domestic
currency
?
Value of
domestic
currency
L-R effect
© 2003 McGraw-Hill Ryerson Limited.
17 - 71
Fiscal Policy’s Effect on the
Trade Deficit

Fiscal policy works on the trade deficit
through its effects on income and
prices.
© 2003 McGraw-Hill Ryerson Limited.
17 - 72
The Effect on the Trade
Deficit via Income
Expansionary fiscal policy increases
income.
 Imports go up, as does the trade deficit.

© 2003 McGraw-Hill Ryerson Limited.
17 - 73
The Effect on the Trade
Deficit 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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 74
The Effect on the Trade
Deficit 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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 75
The Effect on the Trade
Deficit 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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 76
The Net Effect of Fiscal
Policy on the Trade Deficit
Expansionary fiscal policy increases a
trade deficit.
 Contractionary fiscal policy decreases a
trade deficit.

© 2003 McGraw-Hill Ryerson Limited.
17 - 77
The Net Effect of Fiscal
Policy on the Trade Deficit
Y
Imports
Trade
deficit
Expansionary
fiscal policy
P
Competitiveness
© 2003 McGraw-Hill Ryerson Limited.
17 - 78
The Net Effect of Fiscal
Policy on the Trade Deficit
Contractionary
fiscal policy
Y
Imports
Trade
deficit
P
Competitiveness
© 2003 McGraw-Hill Ryerson Limited.
17 - 79
Monetary and Fiscal Policy’s
Effect on International Goals
Trade
deficit
Value of
domestic
currency
Expansionary
monetary policy
UP
DOWN
Expansionary
fiscal policy
UP
AMBIGUOUS
© 2003 McGraw-Hill Ryerson Limited.
17 - 80
International Phenomena
and Domestic 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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 81
International Monetary and
Fiscal Coordination

Governments try to coordinate their
monetary and fiscal policies because
their economies are interdependent.
© 2003 McGraw-Hill Ryerson Limited.
17 - 82
International Monetary and
Fiscal Coordination

Because of this interdependence, many
economists argue that all countries
must work together to coordinate their
monetary and fiscal policies.
© 2003 McGraw-Hill Ryerson Limited.
17 - 83
International Monetary and
Fiscal Coordination

Because of the fear of retaliatory
measures, nations take their trading
partners’ desires into account when
making their monetary and fiscal
policies.
© 2003 McGraw-Hill Ryerson Limited.
17 - 84
Coordination Is a Two-Way
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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 85
Coordination Is a Two-Way
Street

Each country will likely do what is best
for the world economy as long as it is
also best for itself.
© 2003 McGraw-Hill Ryerson Limited.
17 - 86
Crowding Out and
International Considerations
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.

© 2003 McGraw-Hill Ryerson Limited.
17 - 87
Crowding Out and
International Considerations

Internationalizing a country’s debt may
help in the short run.
© 2003 McGraw-Hill Ryerson Limited.
17 - 88
Crowding Out and
International Considerations

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.
© 2003 McGraw-Hill Ryerson Limited.
17 - 89
Selecting Policies to Achieve
Goals,Table17-1, p 429
International Goal Policy Alternatives
Low value for domestic Contractionary foreign
currency
monetary policy
Expansionary domestic
monetary policy
© 2003 McGraw-Hill Ryerson Limited.
17 - 90
Selecting Policies to Achieve
Goals, Table17-1, 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 Dimensions
of Monetary and Fiscal
Policy
End of Chapter 17
© 2003 McGraw-Hill Ryerson Limited.