CHAPTER 2
OPEN ECONOMY
GLOBALIZATION
Globalization essentially means the increase in economic integration among nations. Increasing integration is seen today in the dramatic growth in the flows of goods, services, and capital across national borders.
The tremendous increase in the share of national output devoted to imports and exports is one of the major parts of globalization. As a consequence of continuous drop in transportation and communication costs, along with declining tariffs and other barriers to trade the share of trade in the national output of many countries has more than doubled over the last few decades. Domestic industries and producers are now forced to compete with producers from around the world in their prices and other competitive issues.
This increase in share of trade has been accompanied by increased specialization in the production process has lead to various tasks being outsourced to different countries. India has become the home of business process outsourcing. There has been evidence which shows that most major goods producing industries resort to some or the other kind of slicing up of their work.
The second part of globalization is the increased integration of financial markets. Financial integration is seen in the accelerated pace of lending and borrowing among nations as well as in the convergence of interest rates among different countries. The major causes of financial market integration have been the dismantling of restrictions on capital flows among nations, cost reductions, and innovations in financial markets, particularly the use of new kinds of financial instruments. Financial integration among countries has undoubtedly led to gains from trade as nations with productive uses for capital can borrow from countries with excess saving. In the last two decades, Japan has served as the world’s major lending company.
We also need to note that integration of goods and financial markets has produced impressive gains from trade in the form of lower prices, increased innovation, and more rapid economic growth but at the cost of some very harmful and painful side effects. One serious consequence of economic integration is the unemployment and lost profits that occur when low cost foreign producers displace domestic production. The unemployed textile and other mill workers, the bankrupt tobacco farmers and others hit equally seriously cannot obviously be satisfied by the fact that consumers are enjoying lower prices for food and clothing. Those who loose due to this increased international trade have become tireless advocates of protectionism in the form of tariffs and quotas on international trade. Another major problem arises from the integration of financial markets arises in the form of international financial crisis. Many instances of this have already occurred which makes many nations only reluctant participants in globalization.
BASICS OF AN OPEN ECONOMY
A policy of openness is one which keeps trade barriers as low as possible, relying primarily on tariffs rather than quotas and other non tariff barriers. It minimizes the interference with financial flows and allows supply and demand to operate in financial markets. It avoids a state monopoly on exports and imports it keeps government regulation to minimum necessary for an orderly market economy. Above all, it relies primarily on a private market system of profits and losses to guide production, rather than depending on public ownership and control of the commands of a government planning system.
MACROECONOMIC GOALS IN OPEN ECONOMY
In open economy the basic goals which drive policy makers are the goals of internal and external balance. To put these in plain terms internal balance requires full employment of a country’s resources and domestic price level stability. External balance on the other hand is attained when a country’s current account is neither so deeply in deficit that it may be unable to repay its foreign debts in the future nor is so strongly in surplus that foreigners are put in that position.
However it is not correct to claim that the definitions provided above give us the potential concern about policy. For example along with full employment and stability of the overall prices the policy makers might also consider a particular domestic distribution of income as an additional internal target. Policy makers may also have to worry about swings in balance of payments accounts other than the current account. The line between external and internal goals can be very thin and almost invisible at times.
However the simple definitions of internal and external goals given above capture the goals that most policymakers share regard less of the economic environment. Thus these can be considered as the basic macroeconomic goals in an open economy. We shall now discuss these goals in more detail.
Internal Balance
A country is in internal balance when its price level is stable and its productive resources are fully employed. We know the problems caused when the resources are under employed. However a scenario can exist where the economy is said to be overheated, that is the resources are over employed. Even in this situation waste of a different kind occurs. This waste is considered to be less harmful by many economists. An example for this can be workers who work overtime might prefer to be working less and enjoying leisure even while their contracts require them to put in longer hours during periods of high demand. Machines that are being made to work more intensely than usual will suffer from break downs and will depreciate more quickly.
Under and over employment also lead to general price level movements that reduce that economy’s efficiency by making the real value of the money less certain and thus a less useful standard for economic decisions. It also should be noted that domestic wages and prices rise when demand for labor and output exceed maximum employment level increase and that they decrease when the opposite take place. Thus it becomes the duty of the policy makers to prevent substantial movements in aggregate demand relative to its full employment level to maintain a stable price level.
One very disruptive effect of an unstable price level is its effect on the real value of loan contracts. Because loans tend to be denominated in the monetary unit, unexpected price level changes cause income to be redistributed between creditors and debtors. A sudden increase in the U.S. price level, for example makes those with dollar debts better off since the money they owe to lenders is now worth less in terms of goods and services. At the same time the price level increase makes creditors worse off. This is a very important reason why governments intend to maintain price stability.
This leads to conclude that in theory a perfectly predictable trend of rising or falling prices would not be too costly, since everyone would be able to calculate easily the real value of money at any point in the future. But practically there appears to be no such thing as a predictable inflation rate. Indeed, experience shows that the unpredictability of the general price level is magnified tremendously in periods of rapid price level change. The costs of inflation have been most apparent in the post war period in many countries where they were astronomical and this practically stopped the functioning of economy.
To avoid price level instability therefore the government must prevent large fluctuations in output, which are also undesirable in themselves. In addition it must avoid ongoing inflation and deflation by ensuring that the domestic money supply does not grow too quickly or too slowly.
External Balance
The concept of external balance is more difficult to define than internal balance because there are no natural benchmarks like full employment or stable prices to apply to an economy’s external transactions. Whether an economy’s trade with the outside world poses macroeconomic problems depends on several factors, including the economy’s particular circumstances, conditions in the outside world and the institutional arrangements governing its economic relations with foreign countries. A country that is committed to fix its exchange rate against a foreign currency for example may well adopt a different definition of external balance than one whose currency floats.
Most economists often identify external balance with balance in a country’s current account. While this definition is appropriate in some circumstances it is not helpful as an general benchmark. For example a country’s opportunities for investing the borrowed resources may be attractive relative to the opportunities for investing the borrowed resources may be attractive relative to the opportunities available in the rest of the world. In this case paying back loans from foreigners poses no problem because a profitable investment will generate a return high enough to cover the interest and principal on those loans. Similarly a current account surplus may pose no problem if domestic savings being invested more profitably abroad than they would at home. In more general terms we may think of current accounting imbalances as providing another example of how countries gain from trade. The trade involved is what we have called intertemporal trade that is the trade of consumption over time. Just as countries with differing abilities to produce goods at a single point in time gain from concentrating the worlds investment in those economies best able to turn current output into future output. Countries with weak investment opportunities should invest little at home and channel their saving s into more productive investment activity abroad. It put it in more simpler way, countries where investment is relatively unproductive should be net exporters of currently available output, while countries where investment is relatively productive should be net importers of current output. To pay off their foreign debts when the investments mature, the latter countries export output to the former countries and therby complete the exchange of present output for future output.
Other considerations may also justify this. A country where output drops temporarily my wish to borrow from foreigners to avoid the sharp temporary fall in its consumption that would otherwise occur. In the absence of this borrowing the price of present output in terms of future output would be higher in the low output country than abroad, so the inter temporal trade that eliminates this price difference leads to mutual gains.
Insisting that all countries be in current account equilibrium makes no allowance for these important gains from trade over time. Thus no realistic policymaker would want to adopt a balanced current account as policy target appropriate in all circumstances.
At a given point, however policy makers generally adopt some current account target as an objective, and this target defines their external balance goal. While the target level of the current account is generally not zero, governments usually try to avoid extremely large external surpluses or deficits unless they have clear evidence that large imbalances are justified by potential intertemporal trade gains. Governments are cautious because the exact current account balance that maximizes the gains from intertemporal trade is difficult if not impossible to figure out . in addition this optimal current balance can change unpredictably over time as conditions in the economy change. Current account balances that are very wide of the mark can, however cause serious problems.
CHAPTER 3
MONETARY POLICY IN AN OPEN ECONOMY
The Central Banking System
The central bank as mentioned earlier has a very important role in any economy. Before going into monetary policy further we should note that the major functions of monetary policy are
1. Conducting the nations monetary policy
2. Supervising and regulating banking institutions
3. Maintaining the stability of the financial system
4. Providing certain financial services to the government and the public.
It is easy to understand the exact reasoning that led to a particular monetary policy we have to keep in mind that the central band whether it is the RBI of India or the FED of U.S. they mainly concerned with preserving the integrity of our financial institutions, combating inflation, defending the exchange rate of the dollar and preventing excessive unemployment.
The three major instruments of monetary policy are
- Open market operations-buying or selling of government securities in the open market to influence the level of reserves.
- Discount rate policy-setting the interest rate, called the discount rate, at which commercial banks and other depository institutions can borrow reserves from a regional reserve bank.
- Reserve requirements policy- setting and changing the legal reserve ratio requirements on deposits with banks and other financial institutions.
Monetary policy in an open economy.
Central banks are particularly important in open economies where they manage reserve flows and the exchange rate and monitor international financial developments.
Reserve flows
Before going into reserve flows one should clearly understand that an open economy is subject to various international disturbances which affects it on domestic grounds. This is because integration of financial markets is an important feature of and open economy. A close economy on the other hand is immune to these international disturbances as it has not been a part of the financial markets integration.
The central banks control of the nation’s money is modified by international disturbances to bank reserves. But the central bank has the power to offset any change in reserves coming from abroad. It affects this by engaging in what is called sterilization. Sterilization refers to actions by a central bank that insulates the domestic money supply from international reserve flows. Sterilization usually is accomplished when the central bank implements an open market operation that reverses the international reserve movement. In practice the central bank routinely sterilizes international disturbances to reserves. This essentially means that the central banks control over bank reserves is subject to disturbances from abroad. These disturbances can however be offset if the central bank sterilizes the international flows.
The American Fed can be used as an illustration to explain this. The dollar is widely used today as a store of value and also as a medium of international trade and finance. Foreigners own hundreds of billions of dollars. Foreigners do hold narrow money in U.S. dollar checking accounts because they need to buy and sell goods and assets. This is in addition to their holding interest bearing assets like bonds and stocks. This is an important issue because now the Fed can use the deposits by foreigners the same way as it uses the deposits of domestic residents. Thus changes in the foreigner’s dollar money holdings can set off a chain of expansion or contraction of the U.S. money supply.
The Role of Exchange Rate System.
One important element in a country’s financial market is its exchange rate system. International trade and finance involve the use of different national currencies, which are linked by relative prices called foreign exchange rates.
A very important exchange rate system is floating exchange rates, in which a country’s foreign exchange rate determined by market forces of supply and demand. The untied states, Europe and Japan today operate floating exchange rate systems. These three regions can pursue their monetary policy independently form other countries. Some other economies like honking and Argentina and many countries in earlier periods had maintained fixed exchange rates and peg their currencies to one or more external currencies. When a country has a fixed exchange rate, it must align its monetary policy with the country to which its currency is pegged. We can now study fixed and flexible exchange rates.
Fixed exchange rates.
The key feature of countries with fixed exchange rates and high capital mobility is that their interest rates must be very closely aligned. Any interest rate divergence between two such countries will attract speculators who will sell one currency and buy the other until the interest rates are equalized. For example argentina pegs its peso to the us dollar. Because the small country’s interest rates are determined by the monetary policy of the large country, the small country no longer has an independent monetary policy. The small country’s policy must be devoted to ensuring that its interest rates are aligned with its partners.
Macroeconomic policy in such a situation is therefore exactly the case described in our multiplier model above. From the small country’s point of view investment is exogenous because it is determined by world interest rates.
Flexible exchange rates.
One important insight in this area is that macroeconomic policy with flexible exchange rates operates in quite a different way from the fixed exchange case. Monetary policy becomes highly effective with a flexible exchange rate.
We can illustrate it with the example of United States. The monetary transmission mechanism in the u.s. has changed significantly over the last two decades as result of increased openness and an evolving exchange rate system after the introduction of flexible exchange rate. In the presence of increasingly linked financial markets international trade and finance have come to play a new central role in US macroeconomic policy.
Foreign trade actually opens up another link in the monetary transmission mechanism when a country has flexible exchange rates. Monetary policy operates through exchange rates to affect net exports as well as domestic investment. The interest rate impact on net exports reinforces the impact on domestic investment.
Evolution of monetary systems in Europe
An ideal exchange rate system is one that allows high levels of predictability of relative prices while ensuring smooth adjustment to economic shocks. In a well functioning system, people can trade and invest in other countries without worrying that exchange rates will suddenly change and make their ventures unprofitable. This ideal seemed to be attained during most of the Bretton Woods era, when exchange rate changes were infrequent yet output and trade grew rapidly. In the last decade however fixed exchange rate systems have more often been sources of instability than stability. Fixed exchange rate systems were the subject of intense speculative attack that reached global proportions on three occasions during the 1990s. We shall now see the pitfalls of fixed exchange rate systems and chart the evolution of the European monetary union from a fixed rate system to a common currency.
The Crisis due to fixed exchange rates
The loss of control over monetary policy would not be fatal during normal times. But in times of crisis the actual and desired monetary policies may diverge too much. This divergence almost led to the destruction of the European monetary system and eventually led to monetary union.
Faced with rising German interest rates, other nations in the European monetary system after the reunification of Germany, they had to raise their interest rate to prevent their currencies from depreciation against the German mark and moving outside the prescribed range. Many countries found themselves with over valued exchange rates. These interest rate increases along with a worldwide recession and a sharp decline in output from the collapsing communist bloc pushed Europe into even deeper recession.
Speculative attack
A fixed exchange rate system is prone to devastating speculative attack if financial capital flows freely among countries. The reason is that a fixed but adjustable exchange rate is susceptible to attack whenever speculators believe that changes in the exchange rate are imminent. If a currency is likely to be devalued speculators will quickly start selling that currency. The supply of the currency increases while demand drops. At this point central banks step in to defend the currency. But given the private resources available for speculative attacks the defender of a weak currency quickly runs out of reserves. Unless hard currency countries are willing to provide unlimited lines of credit, the defending to provide unlimited lines of credit, the defending central bank will sooner or later give up and either devalue or allow currency to float.
The Euro
Many Europeans believe that complete market integration requires monetary union through a common currency. This general belief was reinforced by the breakdown of the European monetary system in the 1990s. Many countries recognized that due to fundamental contradiction of fixed exchange rates, markets would become increasingly unstable with the growing integration of European financial market.
Eleven European countries joined the European countries joined the European monetary union. The monetary structure under a European monetary union resembles that of the United States.
Pros and Cons of Monetary Union
Under a common currency exchange rate volatility within Europe was reduced to zero. Therefore trade and finance will no longer have to contend with the uncertainties about prices induced by changing exchange rates. The primarily result will be a reduction in transactions costs among countries. To the extent that national financial markets are segmented moving to a common currency may allow a more efficient allocation of capital across countries. Some believe that firm macroeconomic discipline will be preserved by having an independent European central bank committed to strict inflation targets. Perhaps the most important benefit may be political integration and stability of western European.
However there are certain concerns also about this monetary union. Many economists skeptical and point out that the individual countries will lose the use of both monetary policy and exchange rate as tools of macroeconomic adjustment. There has also been a worry that Western Europe is not an optimal currency area because of the rigidity of its wage structures and the low degree of labor mobility among the different countries. Monetary union may therefore condemn unfortunate regions persistent low growth and high unemployment. Nevertheless European monetary union is one of the greatest experiments in the history of monetary policy.
CONCLUSION
One must conclude saying that the monetary policy of North American and western European countries more or less has been quite successful. However the international monetary system continues to be a source of turmoil, with frequent crises as many countries encounter balance of payments and currency crisis. However the major changes have been taking place in the monetary policies of Europe, America and Japan which conduct independent monetary policy with flexible exchange rates while smaller countries either float or have fixed rates tied to one of the major blocks.
One can say that the major test for the next few years will how strong the new European union remains. The operation of monetary policy has new implications in an open economy. An important example involves the operation of monetary policy in a small open economy that has a high degree of capital mobility. Such countries which operate on a fixed exchange rate essentially lose monetary policy as an independent instrument of macroeconomic policy.as its interest rates are aligned with those countries with whom it pegs its interest rates. Therefore one can say that fiscal policy by contrast becomes a powerful instrument because fiscal stimulus is not offset by changes in interst rates
It can therefore be said that the monetary policy of many nations will evolve further in the new millennium but in which direction this change will take place depends on the failure or success of the existing policy.
BIBLIOGRAPHY
Articles
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A.Weerapana, “The Performance of Simple Monetary Policy Rules in Large Open Economy.”, http://www.nber.org (September 1st 2004)
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R.H.Clarida, “Monetary Policy in Open versus Closed Economy”, http://www.nber.org (September 1st 2004)
Books
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C.R.McConnell, Economics (10th edn.,Singapore:McGraw-Hill Book Co,1987)
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P.R.Krugman et al., International Economics (6th edn.,Singapore: Pearson Education, 2004)
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P.Samuelson et al, Economics (17th edn., New Delhi: Tata McGraw-Hill Ltd, 2002
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R.A.Arnold, Macroeconomics (6th edn., Ohio:South-Western,2004)
Websites
- http://www.google.com
- http://www.imf.com
- http://www.jstor.com
- http://www.nber.org
P.Samuelson et al, Economics (17th edn., New Delhi: Tata McGraw-Hill Ltd, 2002) at 420.
P.R.Krugman et al., International Economics (6th edn.,Singapore: Pearson Education, 2004) at 283.
C.R.McConnell, Economics (10th edn.,Singapore:McGraw-Hill Book Co,1987)at 881 C.R.McConnell, Economics (10th edn.,Singapore:McGraw-Hill Book Co,1987)
