Flexible rates, the policy mix and direct controls

← Open Economy MacroFlexible rates, the policy mix and direct controls

Formulas for this chapter

Policy effectiveness by exchange rate regime

Fixed rate: fiscal EFFECTIVE, monetary ineffective (powerless at perfect mobility) Flexible rate: monetary EFFECTIVE, fiscal ineffective (powerless at perfect mobility) Reason: the induced capital flow lands on reserves under a fixed rate and on the exchange rate under a flexible one

Any question naming a regime and asking which instrument to use. State the rule, then trace the capital flow to justify it.

fixed rate chain: rate gap, capital flow, reserves, money supply, LM shifts back: monetary policy cancelled
flexible rate chain: rate gap, capital flow, exchange rate, net exports, IS shifts back: fiscal policy cancelled

The four policy pairs

Inflation + surplus : contractionary fiscal + EASY money Recession + surplus : expansionary fiscal Inflation + deficit : contractionary fiscal Recession + deficit : expansionary fiscal + TIGHT money

Any question that states an internal and an external condition together. The two-instrument rows are the conflicting Swan zones II and IV.

assignment rule: Fiscal policy to the internal target, monetary policy to the external one
one-instrument rows: Zones I and III, where both problems want the same change in spending

Uniform tariff plus subsidy equals devaluation

Import: value x R x (1 + t) = value x R x (1 + d) when t = d Export: P x R x (1 + s) = cost gives the same P as P x R(1+d) = cost With partial coverage: effective devaluation = t x (share of trade covered)

Whenever a question compares a control package with an exchange rate change. Prove it on both sides, then apply the coverage weighting.

t, s, d: The tariff rate, the subsidy rate and the devaluation rate. Equivalence needs t = s = d and full coverage
coverage: The share of imports or exports the measure actually reaches. Each exemption is a hole in the equivalence

Tariff-equivalents of other controls

Advance deposit: equivalent tariff = deposit fraction x annual interest rate x fraction of a year Multiple exchange rates: implicit tax = (luxury rate - essential rate) / essential rate

Converting a non-tariff control into a comparable tariff rate, which is how the exam asks you to judge its severity.

deposit fraction: Share of import value that must be deposited, often 1.0
essential rate: The reference exchange rate, always the denominator

Step 2 of 29

The real wordsTheory

Flexible rates with imperfect capital mobility

Figure 18-8. Start at point E with unemployment and external balance, with full-employment income YF = 1,500.

The deck's prescription: expansionary fiscal policy plus easy monetary policy.

The notes trace the easy-money leg. LM shifts right to LM', taking income to 1,500 at point U with the interest rate down to 2.5 per cent. But the low rate has consequences, and the next screen follows them.

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