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Sem 5 Prep
← 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 3 of 29
The real wordsTheory

The three shifts a depreciation sets off

The low interest rate at U sends capital out, and with a flexible rate the currency depreciates. Three curves move.

  1. BP shifts right (equivalently down): the trade balance improves at every income.
  2. IS shifts right: the improved trade balance is extra demand for domestic output.
  3. LM' shifts left: domestic prices rise, so transaction demand for money rises and the real money supply falls.

IS' and LM'' meet on the new BP' at a fresh equilibrium E'. It may take repeated doses of easy money, and expansionary fiscal policy can be used to finish reaching YF.

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