Globalization and macroeconomic management:
Closer integration makes both a qualitative and quantitative change in economic decision-making. On the quantitative front, multipliers are smaller (because of the larger 'leakage' into imports) so that government needs to undertake larger policy actions either stimulate the economy or to slow it down.
But it also means that a country is more readily affected by developments abroad. So a government has not only to respond to domestic events, but also foreign events including policy actions by governments of major countries and partners.
Qualitatively, capital market liberalisation has significant effects on economic management. Capital flows can have substantial destabilising effects. Most governments need to supplement domestic savings to maintain a high rate of investments and achieve higher growth. Policy makers have to become cautious about the danger that outflow of foreign capital can generate. Consequently, most governments are striving to maintain adequate level of reserves. It is an open question whether it is good for poor country to hold such large reserves on which they earn a very low return. Building up of reserves means that either developing countries run a current account surplus, which means they are actually lending to the developed countries or build up reserves by borrowing for which they pay a higher interest rate. Therefore, in recent years, developing countries have been borrowing but most of this borrowing does not seem to have been used to boost the investment rate. Investment rates in Africa and Latin America are lower than they were in late 60s and 70s and this lowering of investment rates has contributed to reduced growth rates in these regions.
Capital flows require a hdamental change in policy-making. We discuss how globalisation affects the ability of monetary and fiscal policy to affect the level of income. To examine this, we use the conventional IS-LM framework. You should revise your
basic macroeconomics and the BOP concats from Units 7 and 8. Suppose the government adopts an expansionary fiscal policy, then the IS curve shifts rightward from IS to IS'. This leads to an increase in the income and the interest rate, as the equilibrium shifts from A to B (Figure 16.1). The increase in income leads to higher imports and so to a worsening of the current account.
If there are no capital flows, the. worsening of the current account is also worsening of the BOP. This, under a fixed exchange rate (ER) system, will lead to a fall in foreign assets, a decline in the money base and in the money supply. So the LM curve will shift leftward to LM' and the new equilibrium will be at C. Here the original level of income and the current account is restored. The higher interest rate implies that interest sensitive expenditures, most importantly investments, are lower, namely have been crowded out by the expansionary fiscal policy.
If capital flows are permitted then because of the higher interest rate, capital will flow in so that there is a capital account improvement and the worsening of the BOP will be less and equilibrium could be at a point such as D where the current account deficit is matched by a capital account surplus. The position of D depends on the extent of capital mobility. If capital mobility is relatively small, as at D, there will only be a small improvement in income. The greater is the capital mobility, the greater is the increase in income and the smaller is the rise in the interest rate. If there is perfect capital mobility, the country can borrow any amount from the rest of the world at the going interest rate, which will also determine the domestic interest rate, which must therefore be the same as before the expansionary fiscal policy was implemented. The large inflow of capital would imply a BOP surplus and an outward shift of the LM curve to LM'" so that equilibrium is at E.
Suppose instead of a fixed ER, the country has a flexible exchange rate. If there are no capital flows, the BOP deficit afterhe expansionary policy will lead to a depreciation of the ER. This will increase net exports if the Marshall-Lerner-Robinson condition is satisfied (as explained to you in Unit 8), so that the IS curve will shift further to the right, to IS", leading to an
equilibrium at F where income and the rate of interest are even higher.
If, however, there are capital flows, the inflow of capital will limit the depreciation, and so the rightward movement of the IS curve. With perfect capital mobility, there will be a BOP surplus and the ER will appreciate leading to a fall in net exports and hence a leftward shift of the IS curve. Ultimately, equilibrium will be restored at the initial level of income and the interest rate. In this case, the higher ER is crowding out exports to nullify the expansionary fiscal policy. Hence, the fiscal policy is more effective in the presence of capital flows when the ER is fixed, but is ineffective when the ER is flexible.
Let us now examine the operation of monetary policy. An expansionary monetary policy will shift the LM curve rightward leading to equilibrium at J in the first instance (see Figure 16.3). Here income is higher so that there is current account deficit, and if there are no capital flows, a BOP deficit. Therefore, the country loses foreign exchange reserves to finance the deficit and moneysupply shrinks until the original equilibrium is restored, so monetary policy has no lasting effect on income. If, however, capital is mobile, there will be a deficit on the capital account also as capital flows out due to downward pressure on the domestic interest rate, so the LM curve will shift leftward faster.
With perfect capital mobility, the LM curve will not shift at all, because any monetary expansion will lead to an equal outflow of foreign exchange. In this case, monetary policy is completely ineffective in changing the income level. This is often referred to as the impossible trinity - a country cannot simultaneously have a fixed ER, free capital mobility and an independent monetary policy.