CHAPTER FOUR

4. MACROECONOMIC POLICY IN AN OPEN ECONOMY

4.1. What is Open – Economy Macroeconomics?
An open economy is a type of economy where not only the domestic factors but also entities in other
countries engage in trade of products (goods and services). Trade can take the form of managerial
exchange, technology transfers, and all other kinds of goods and services. An open economy is said to be
one that trades with other countries in commodities and services and often also in financial assets. Ethiopia,
for example, can utilize goods which are manufactured around the world and some of the goods from
Ethiopia are exported to other nations. A closed economy is one that does not interact with other economies
in the world. There are no exports, no imports, and no capital flows. An open economy is one that interacts
freely with other economies around the world. An open economy allows foreign investors to own domestic
companies and allows citizens to invest their money in foreign countries. Open economies are also known
as free economies. An open economy interacts with other countries in two ways. It either buys and sells
goods and services in world product markets or buys and sells capital assets in world financial markets.
The international flow of goods can either be Exports, Imports, and Net Exports. Exports are goods and
services that are produced domestically and sold abroad. Imports are goods and services that are produced
abroad and sold domestically. Net exports (NX) are the value of a nation’s exports minus the value of its
imports. Net exports are also called the trade balance. A trade deficit is a situation in which net exports
(NX) are negative. I.e. Imports > Exports. A trade surplus is a situation in which net exports (NX) are
positive. I.e. Exports > Imports. Balanced trade refers to when net exports are zero—exports and imports
are exactly equal. Today, with few if any exceptions, all countries are open.

4.2. Macroeconomic Policy Goals in an Open Economy

In broad terms, the goal of macroeconomic policy is to provide a stable economic environment that is
conducive to fostering strong and sustainable economic growth, on which the creation of jobs, wealth and
improved living standards depend. Economic growth, full employment (or low unemployment), and stable
prices (or low inflation). Economic growth ultimately determines the prevailing standard of living in a
country. There are two types of economic policy makers in an economy that manage economic fluctuations:
Monetary authorities and Fiscal authorities. Monetary authorities: - institutions or people that conduct
monetary policy. The monetary authority in Europe is the European Central Bank; in Ethiopia is Ethiopian
National Bank and in the U.S. is the Federal Reserve. Fiscal authorities;- institutions or people in charge of
conducting fiscal policy. Each individual country maintains control over its own fiscal policy. Those in
charge of fiscal policy in each country can range from the president, prime minister, finance minister,
and/or Parliament. For instance, the fiscal authority in the U.S is the executive and legislative branch of the
govt.
Economic stability and higher rate of economic growth are the major policy objectives of both the
monetary and fiscal authority. In open economies, macroeconomic policymakers are motivated by two
goals: internal and external balance.
a) Internal Balance: It requires the full employment of a country’s resources, little or no inflation, and
domestic price level stability. Full employment and price-level stability under- and over-employment
lead to price level movements that reduce the economy’s efficiency. Overworked machines more repair
and breakdown. Overworked workers reduce productivity; more leisure or waste of resources. To avoid

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 price-level instability, the government must: prevent substantial movements in aggregate demand
relative to its full-employment level: ensure that the domestic money supply does not grow too quickly
or too slowly: to avoid inflation or deflation. Eg: Any price level disruptions effects those who are
lending money and those who are borrowing money (loan contracts and interest rates)

b) External Balance: It is attained when a country’s current account is neither so deeply in deficit nor so
strongly in surplus. The optimal level of the current account and External balance has no natural
benchmarks like “full employment” or “stable prices” to apply to an economy’s external transactions.
An economy’s trade can cause macroeconomic problems depending on several factors. The institutional
arrangements governing its economic relations with foreign countries. Eg: CA surplus may pose no
problem if the domestic savings are being invested more profitably abroad than they would be at home.
Several factors might lead policymakers to prefer that domestic saving be devoted to higher levels of
domestic investment and lower levels of foreign investment. It may be easier to tax. It may reduce
domestic unemployment and can have beneficial technological spillover effects. Eg: highly-skilled
human capital turnover, breaking monopoly.

4.3. Stabilization Policies and Instruments

Stabilization policy is the modification of economic policies by governments to support economic growth
and development without substantial swings in joblessness. Because the economy fluctuates, governments
use stabilization policies to make sure that the economy is doing well. A stabilization policy is a solution
used by governments to mitigate unpredictable price fluctuations that harm an economy's GDP. It is
frequently employed as an economic and political tool to maintain the economy's well-being. When the
economy is weak, these policies' specific goals include putting money into the market, trying to make it
simpler for consumers to borrow and spend cash, and assisting markets. Without the stabilization initiatives
set out by the government, the economy would be forced to get back to normal on its own. The main
disadvantage is that market forces don't cater to the wellness of single economic actors. This means that
significant collateral damage can occur well before the economy is capable of correcting itself and getting
back to normal. These perilous situations illustrate the necessity of government involvement through
stabilization policies. If the economy gets into trouble, the government may convene to deliberate on
stabilization policies. Typically, stabilization policies are developed along with other government policies.
The business cycle is important when it comes to the stabilization of the economy. It pertains to the
economy's ongoing booms and slumps. It is the most important aspect in determining the government's
strategy for policy execution. Whenever the cycle reaches its apex, the government should potentially
contemplate enacting policies to slow the economy. Whenever the cycle is in a slump, the government may
consider actions to boost the economy.

In general, there are three basic approaches that a government may take to stabilize peaks and troughs in an
economy, whether during a recession or simply to improve on the economy's present stability.
Sit Back: One strategy is to do nothing at all and let the economy repair itself. This isn't generally done in
economic emergencies, but governments may contemplate it if the economy is only somewhat unstable.
Rather than meddling, it's frequently better to let the powers of the market economy regulate the system.
Fiscal Policy: Fiscal policy is seen as the next technique a government may employ to stabilize an
economy. Of all the options, this option is the most explicit kind of government intervention in the
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economy. It usually pertains to the utilization of taxes and government spending to control the overall
amount of economic activity. Tax and Government expenditure are considered as instruments of fiscal
policy. Therefore, if unemployment (for example) is deemed excessive, taxes may be adjusted to boost
aggregate spending.
Monetary Policy: Fiscal policy is strongly linked to the third technique, which is monetary policy.
Monetary policy is focused on adjusting the money supply and interest rates in order to stabilize the
economy at maximum employment or potential output by guiding aggregate demand. To specify, during a
recession, monetary policy entails the use of a few financial tools (Central Funds rate, required reserve
ratio, open market operations) to boost the supply of money and decrease interest rates in order to
encourage aggregate demand. Conversely, during an inflationary period, monetary policy strives to limit
spending by reducing the supply of money and increasing interest rates.
The government employs two forms of stabilization policy: expansionary and contractionary.
Expansionary fiscal policy is when the federal government moves to lower taxes or increase spending to
boost the economy. Contractionary fiscal policy is when the federal government increases taxes or
reduces spending to slow the economy and reduce inflation. Expansionary monetary policy is when the
Federal Reserve moves to lower interest rates to boost the economy. Contractionary monetary policy is
when the Federal Reserve increases interest rates to slow the economy and reduce inflation.

4.3.1. Fiscal and Monetary Policies under Fixed Exchange Rate Regime
In fixed exchange rate policy, monetary authorities gives up their ability to make changes through money
supply. Fiscal can be used to influence output and employment and lets suppose that the future exchange
rate fixed at Eo. Monetary Policy: in the figure below, the economy is at equilibrium at 1, Eo exchange rate
and Y1 output level. Suppose now so as to raise output, the central bank raises the money supply via
purchasing domestic assets. In floating rate, the rise in MS reduces the exchange rate.

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 Figure 4. Effects of change of Money supply on Short run Equilibrium under fixed exchange rate

The AA1 curve shifts leftwards to AA2 and to point 2. To prevent a fall in exchange rate, the central bank
sells exchange currency, pulls the MS back and ER restores. It is only after when the new money
circulated is pulled back that initial equilibrium and exchange rate restores. A change in money supply
under fixed exchange system leaves the economy at its initial state with fixed ER. Central bank monetary
policy tools are thus ineffective in influencing an economy under fixed exchange rate

Fiscal Policy: the economy is at equilibrium at point 1. A fiscal expansion raises aggregate demand to DD2
and if central bank refrains, output rises to y2 and ER falls. But central bank intervenes to keep exchange
rate fixed by buying foreign currency assets with domestic money. The rise in money supply takes the
exchange rate to its initial position and output rises with out affecting price. In fixed exchange rate regime,
fiscal policy maintains equilibrium by making domestic goods more expensive. The added expansionary
effect of more money supply by the central bank makes fiscal policy more potent.

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 Figure 5.8. Effects of change of Fiscal policy on Short run Equilibrium under fixed exchange rate

4.3.2. Fiscal and Monetary Policies under Flexible Exchange Rate Regime
Having determined the short run equilibrium, we see now effects of macroeconomic policies on
equilibrium. Macroeconomic policies are used to counteract changes causing imbalances in output,
inflation and employment. We will thus examine how macroeconomic policies can be used to main
full employment in open economies. We focus on monetary policies via money supply and fiscal
policies through government spending and tax.

Monetary policies: a temporary rise in money supply shifts the AA curve outward but does not
affect the DD. A shift in the AA schedule shifts short run equilibrium. A rise in money supply causes
currency depreciation and a rise in national output and expansion in employment. A rise in money
supply lowers interest rate that raises exchange rate and domestic price lower and AD higher. A
higher aggregate demand is followed by higher output.
Fiscal Policy: expansionary fiscal policy involves a rise in spending, a cut in tax or a combination of
the two. Expansionary fiscal policy thus raises aggregate demand.

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 Figure 5.9. Effects of change of Money supply under floating exchange rate
An expansionary fiscal policy that does not affect future expected exchange rate shifts the DD curve

rightwards. An expansionary fiscal policy increases output and raises exchange rate and tax cuts have
similar effects. The rise in output or real income raises the aggregate demand for money in turn raising
IR and reducing ER. Temporary monetary and fiscal expansion can be used to fight effect temporary
disturbances that lead to recession. Because both policies raise the national output and employment
levels, they can help ease disturbances. The effectiveness of monetary and fiscal policy in promoting
internal balance for an economy with a high degree of capital mobility
4.4. International Macroeconomic policy coordination
International macroeconomic policy coordination refers to the modifications of national
economic policies in response of international interdependence. International policy
coordination (or cooperation) is a form of cooperative relationship between the policy-makers
and regulating authorities of two or more countries. Coordination is the most rigorous form of
economic cooperation because it involves mutually agreed modifications in the participants'
national policies. In the macroeconomic domain, it involves an exchange of explicit, operational
commitments about the conduct of monetary and fiscal policies. The coordination could be in
the areas of: (i) exchange of information, (ii) acceptance of mutually consistent policies, and (iii)
joint actions.
4.4.1. Reasons for Macroeconomic Policy Coordination
Each country is afraid to undertake fiscal expansion on its own, for fear of worsening its trade
balance, but the world can do better if the major countries agree to act together as locomotives
pulling the global train out of recession. During recent decades, the world has become much
more integrated, and industrial countries have become increasingly interdependent. The
increased interdependence in the world economy today has sharply reduced the effectiveness of
national economic policies and increased their spillover effects on the rest of the world. With
increased interdependence, international macroeconomic policy coordination becomes more

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desirable and essential.
4.4.2. Obstacles
There are several obstacles to successful and effective international macroeconomic policy
coordination
 Uncertainty as to the correct initial position of the economy; uncertainty as to the correct
objective; and uncertainty as to the correct model linking policy actions to their effects in the
economy.
 The lack of consensus about the functioning of the international monetary system
 Another obstacle arises from the lack of agreement on the precise policy mix required
 There is the problem of how to distribute the gains from successful policy
coordinationamong the participants and how to spread the cost negotiating and policing
agreements.
The benefit of policy coordination is the improvement of welfare for the participating countries.
Meanwhile, the cost of policy coordination is the loss of flexibility for the central bank of the
participating country to conduct monetary policy in the presence of a shock.
4.4.3. Forms of international economic cooperation
The forms of international economic cooperation can be categorized into four based on the degree of
closeness of countries making the economic cooperation. These are cooperation for exchange of
information, international economic policy coordination, international policy harmonization, and
economic unification or integration.
a) Exchange of information
There has been some degree of international economic cooperation for hundreds of years. Often it was
in a very moderate form, namely the exchange of information on the state of the countries' own
economies and on their plans for future national economic policy. It was not until this century that
international economic cooperation became more or less permanent. At the end of the Second World
War it actually gained momentum.
Since the Second World War the exchange of information on national economic policy has been
incorporated in the work of the Organization for Economic Cooperation and Development (OECD),
which has its secretariat in Paris. Government representatives regularly meet there to exchange ideas
on the economic situation in their country and forthcoming economic policy. With the information
thus obtained, a country's government is in a better position, when preparing its policy, to take account
of the expected policy in other countries and the influence which that is likely to have on the economy
of the home country. For example, if it is apparent that Germany is preparing for an expansionary
policy, the governments of countries such as Belgium and the Netherlands can react by moderating
any plans which they have for expansion. They can expect that via the increased German demand for
imports, stronger growth in Germany will have an expansionary influence on their economies, which
traditionally send a substantial percentage of their exports to Germany.
b) International policy coordination
A closer form of international cooperation is policy coordination. All countries involved in the
coordination have their own preferences as regards the future values of their economic policy
objectives. They are aware of the mutual influence exerted by national economic policy. The ultimate
aim of policy coordination is that individual countries should adjust their policy instruments in the best

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interests of all the economic objectives of the countries concerned. In theoretical form: the
econometric model containing all the countries concerned includes all national economic objectives
and economic policy instruments; there is also an objective function comprising all countries and
containing all national objectives, each in relation to the target value for that objective, with a specific
weighting which expresses the importance of the objective concerned. The aim is to maximize the
objective function under the condition of the econometric model. This process yields the optimum
value of each of the national policy instruments, in the best interests of the group of countries
concerned - although it cannot be precluded that the result of this optimization is that some countries'
welfare declines.
Since the mid 1970s, international policy coordination has taken place mainly in the G-7. This is the
group of seven leading industrial countries: the US, Japan, Germany, United Kingdom (UK), France,
Italy and Canada. Since 1976 these G-7 members have held annual meetings of the heads of state or
government leaders of the participating countries. The agreements made at these meetings are general
in character, aiming, for instance, to reduce the American budget deficit, cut-taxes in Japan and
produce a more expansive government policy in Germany. There is no retrospective monitoring or
evaluation. The agreed policy often fails to be implemented because, according to the country
concerned, new developments during the year necessitated interim adjustments of their policy
intentions.
Various other groups of countries have developed in addition to the G- 7. These also aim at
coordination, but in regard to a specific aspect of economic policy. Thus, the G-I0 has been in
existence since 1962. It consists of the G- 7 countries plus the Netherlands, Belgium and Sweden, with
the addition of Switzerland in 1964 this group became involved in the IMF's liquidity position on the
initiative of the US; Since 1972 there has also been a G-24 comprising a large group of developing
countries. The number of members rapidly grew to far more than 24. This group discusses
international monetary issues and tries to arrive at common positions before the annual meeting of the
IMF, so that the developing countries can speak with one voice and thus have more say at that
meeting. There have been periods in which a G-5 looked likely to develop as a permanent consultation
agency. This group consisted of the G-7 without Italy and Canada. However, the G-5 now seems to
have had its day. Instead there is a tendency to establish a G-3 consisting of the US, Japan and
Germany, or a variant in which Germany is replaced by the European Union (EU). The G-7
coordination meetings could then become a matter for the G-3.
c) International policy harmonization
Another form of international economic cooperation is international policy harmonization. We
usually talk of harmonize at ion if the object of cooperation is to achieve a degree of convergence in
policy intervention in the various countries. Thus, harmonization does not so much concern macro-
economic policy but rather policy intervention which influences the international competitive
position of national enterprise, e.g. the setting of rates of tax - particularly indirect taxes such as VAT
rates - and government regulations aimed at protecting the safety and health of consumers. This has
been attempted in the EC, in particular, in recent years. As regards VAT, so much progress has been
made that all countries impose their indirect taxation on the basis of VAT and a minimum level has
been set for both the low and high rates of VAT. This system combats price advantages which are not
based on low production costs but on something else than comparative advantage such as favorable

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rates of tax.

d) Unification/integration of economic policy

The most radical form of international economic cooperation is total integration or unification of
economic policy in the countries concerned. Obviously, such an economic policy is supranational
in practice. This means the existence of economic control at a higher than national level, mapping out
and implementing economic policy for the countries involved in the unification. Another form of
supranational decision-making is majority decisions by participating countries. This form of
cooperation combines well with democratic decision-making, though this requires a supranational
parliament. The plans for an Economic and Monetary Union (EMU) in the EU clearly contain
supranational elements and thus' constitute an example.
The above four forms of international economic cooperation were put in ascending order of
closeness, these are: exchange of information as the least radical form, coordination,
harmonization and unification as undoubtedly the closest form of international economic
cooperation. For each of these a further distinction can be made according to the scope of the
cooperation, which ranges from strictly sectoral (e.g. international cooperation on trade policy for the
textile sector only, in the form of the Multi-Fibre Arrangement) to fully integrated economic policy.
There is also a geographical differentiation in scope: from small-scale, regional cooperation (e.g.
by Belgium, the Netherlands and Luxembourg in the Benelux) to truly global cooperation (as in the
IMF).
4.4.4. Advantages and Disadvantage of international economic cooperation
Advantages of international economic cooperation
As stated in previous section, the advantage of international economic cooperation is undeniably that
the effects on other countries' economies are taken into account in determining national policy.
Disadvantages of international economic cooperation
However, in economics there are no advantages without disadvantages; it remains a science based on
weighing up costs and benefits, and international economic cooperation is no exception to that. The
disadvantages of international cooperation can be divided into: the sacrifice of national autonomy in
policy-making; the complexity of implementation; the risk of cheating; and free riders. These four
disadvantages will now be explained in more detail.
a) Loss of national autonomy in policy making
Loss of national autonomy in the implementation of economic policy is often in itself a psychological
disadvantage for a national government. Independence and autonomy are usually regarded as positive
attributes. But optimum international economic cooperation ought to lead to maximum economic
welfare for the whole co-operating region. However, one cannot rule out the possibility that part of the
region, e.g. one of the co-operating countries, will nevertheless suffer a loss of welfare or gain hardly
anything at all. Much depends on the weightings given to that country's economic objectives in the
overall economic welfare function. Those weightings will be small if the country in question is of
minor importance in the overall co-operative framework. In economic terms, it is the largest countries
which have the power. They have very little interest in cooperation since their economy is relatively
little influenced by other countries. For small countries the exact opposite applies. As a result, the
large countries will be able to impose the most demands, and they will do so.

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 b) Complexity of implementation
International economic cooperation in the form of policy coordination is difficult to implement. It is in
fact even more difficult to implement than national economic policy. In formal terms, ascertaining the
outcome of optimum international policy coordination demands knowledge of a number of elements,
which are particularly difficult to quantify. One is the combined welfare function for the countries
taking part in the coordination. Another is the composition of national models considered to give a
good quantitative description of the participating economies. At national level this information is
already hard to come by, and people continue to disagree on the correct form. Where several countries
are concerned, the level of disagreement can clearly increase significantly. One complication here is
that simulation results of econometric models for policy coordination indicate that use of a model
which, on closer examination, proves to be incorrect or unsatisfactory as a reflection of the economy
involved, can easily more than negate the positive result of coordination.
c) The risk of cheating or behaving as free riders
The last issue in connection with policy coordination concerns the fact that (potential) participants
withdraw from the agreements or from the cooperation as a whole. In this case, the cooperation is
undermined by participants cheating or behaving as free riders. Once the form in which the
coordinated economic policy is to be implemented has been decided by mutual consultation, it can be
to the advantage of a participating country to fail to carry out its own part. The other countries' policy
will in itself make a positive contribution to the desired economic development of the country in
question. One reason for trying to avoid participating in the implementation of the policy may be that
the country's own intended contribution to the coordinated policy entails costs for that country: One
example is the implementation of an expansive fiscal policy which has to be financed on the capital
market by issuing government bonds. Failure to meet obligations, or cheating, cannot be avoided
altogether; at best the risk can be reduced. In this connection, retrospective legal action serves no
practical purpose, because there are no legal rules for this type of international agreement, although
failure to comply with agreements will be less attractive if such policy coordination is not an isolated
instance but continues from year to year. Cheating in anyone year then entails costs for the country
concerned, in that it is bound to be excluded from the policy coordination in subsequent years - and
hence also from the important phase of devising the common policy! The risk of cheating can be
further reduced if the policy for countries taking part in the cooperation is laid down in an agreement
and if an organization is set up to supervise compliance with the rules.
The free rider issue concerns the fact that a country can withdraw not only from implementing the
coordinated policy but also from devising it. In short, the country remains totally outside the
international economic cooperation. Such an attitude combined with the expectation that the country
will actually benefit from the common policy of the remaining group of countries - in the form of an
improvement in economic development - makes the country into a free rider. Nothing can be done
about this problem apart from bringing political pressure to be~ on the free rider. A single free rider
will not block international policy coordination. However, if a number of mainly larger countries thus
stay out of range, this can mean the end of the attempt at coordination.

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