© 2003 McGraw-Hill Ryerson Limited.
International International Dimensions of Dimensions of
Monetary and Fiscal Monetary and Fiscal PolicyPolicy
Chapter 17Chapter 17
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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy Macroeconomics’ international goals
are less straightforward than its domestic goals.
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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy There is great debate about how
Canada should maintain its position in the world economy.
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Ambiguous Ambiguous International Goals of International Goals of Macroeconomic PolicyMacroeconomic Policy Do we want a high or a low value for our
currency? Do we want a balance of trade surplus
or a trade deficit? Should we even pay attention to the
balance of trade?
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The Exchange Rate The Exchange Rate GoalGoal A high value for a currency has
advantages and disadvantages. Depending on the state of the economy,
there are arguments both for high and low exchange rates.
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Advantages of a High Advantages of a High Value for the DollarValue for the Dollar It makes foreign currencies cheaper. It lowers the price of imports.
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Advantages of a High Advantages of a High Value for the DollarValue for the Dollar Lower import prices puts competitive
pressure on domestic firms and helps to keep down inflation.
Canadian residents’ living standards are enhanced.
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Advantages of a High Advantages of a High Exchange RateExchange Rate A low value for the dollar has the
opposite effect.
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Disadvantages of a Disadvantages of a High Value for the High Value for the DollarDollar A high value for a currency encourages
imports and discourages exports. It can cause a trade deficit that can
have a contractionary effect of the economy by decreasing aggregate demand for domestic output.
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Disadvantages of a Disadvantages of a High Value for the High Value for the DollarDollar A low exchange rate has the opposite
effect.
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The Exchange Rate The Exchange Rate GoalGoal Because of the divergent views, some
economists argue that government should simply accept whatever exchange rate exists and not consider it in its conduct of monetary and fiscal policies.
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The Trade Balance GoalThe Trade Balance Goal
A deficit in the trade balance means that, as a country, we are consuming more than we are producing. Trade balance – the difference
between imports and exports.
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The Trade Balance GoalThe Trade Balance Goal
There is a debate about whether we should worry about a trade deficit or not.
A trade deficit is not without costs. We pay for a trade deficit by selling off
Canadian assets to foreigners.
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The Trade Balance GoalThe Trade Balance Goal
All the future interest and profits on those assets will flow to foreigners, not Canadian citizens.
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The Trade Balance GoalThe Trade Balance Goal
Eventually, we will have to produce more than we consume so that we can pay them their profit and interest on their assets.
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The Trade Balance GoalThe Trade Balance Goal
In the short-run a trade deficit allows more current consumption, in the long run it presents problems.
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International versus International versus Domestic GoalsDomestic Goals Domestic goals generally dominate
international goals. International goals are ambiguous.
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International versus International versus Domestic GoalsDomestic Goals International goals affect a country’s
population indirectly. In politics, indirect effects take a back
seat.
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International versus International versus Domestic GoalsDomestic Goals When a nation is forced to face certain
economic facts (threats by other countries that they must limit their imports), international goals can become its primary goals.
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International versus International versus Domestic GoalsDomestic Goals As countries become more
economically integrated, these pressures from other countries become more important.
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Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates An economy with fixed exchange rates
is much more restricted in its monetary and fiscal policies than one with flexible exchange rates.
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Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates The reason is that the amount of
currency stabilization that can be achieved with direct intervention is quite small, since a country's foreign reserves are limited.
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Monetary and Fiscal Monetary and Fiscal Policy with Fixed Policy with Fixed Exchange RatesExchange Rates If foreign reserves are limited, a country
must adjust its economy to maintain the value of its currency.
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Raising the Value of Raising the Value of the Euro Using the Euro Using Monetary and Fiscal Monetary and Fiscal PolicyPolicy There are three options for raising the
value of the euro: Increase the private demand for euros
via contractionary monetary policy. Decrease the private supply of euros via
contractionary monetary and fiscal policy.
Use some combination of both.
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© 2003 McGraw-Hill Ryerson Limited.
Increase the Private Increase the Private Demand for EurosDemand for Euros The primary way to increase the
demand for euros in the short run is through contractionary monetary policy.
The interest rate will increase which increases the demand for the countries’ interest-bearing assets.
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Increase the Private Increase the Private Demand for EurosDemand for Euros The problem? The area can achieve an interest rate
target or an exchange rate target, but not both at the same time.
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Decrease the Private Decrease the Private Supply of EurosSupply of Euros The private supply of euros can be
decreased via contractionary monetary and fiscal policy.
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Decrease the Private Decrease the Private Supply of EurosSupply of Euros Contractionary monetary and fiscal
policy will create a recession. The demand for imports will decrease,
thereby decreasing the private supply of euros.
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Decrease the Private Decrease the Private Supply of EurosSupply of Euros The problem? A purposely induced recession for political
reasons is not a very popular decision.
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S0
D0
Price of euros (in dollars)
$0.30
0.20
Quantity of euros
D1
S1
Targeting an Exchange Targeting an Exchange Rate with Monetary and Rate with Monetary and Fiscal Policy, Fiscal Policy, Fig. 17-1, p 419Fig. 17-1, p 419
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Monetary and Fiscal Monetary and Fiscal Policy with Flexible or Policy with Flexible or Partially Flexible Partially Flexible Exchange RatesExchange Rates Many countries choose flexible or
partially flexible exchange rate regimes to avoid the constraints that a fixed exchange rate regime places on domestic monetary and fiscal policy.
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Monetary Policy’s Monetary Policy’s Effect on Exchange Effect on Exchange RatesRates Monetary policy's effect on exchange
rates is felt in three ways: Through its effect on the interest rate. Through its effect on income. Through its effect on price levels and
inflation.
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The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates An expansionary monetary policy
pushes down the Canadian interest rate.
Lower interest rates decrease foreign capital inflow into Canada.
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The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Less foreign capital inflow decreases
the demand for dollars. Lower demand for Canadian dollars
decreases the exchange.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates A contractionary monetary policy does
the opposite. It raises Canadian interest rate, bringing
in the capital from abroad, increasing the demand for dollars and increasing the value of the dollar.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Monetary policy affects income in a
country. As money supply rises, income
expands. When money supply falls, income
contracts.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Rising Canada’s income increases the
demand for imported goods. To buy imported goods, Canadian
citizens need foreign currency that they must buy with dollars.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income The supply of dollars in the foreign
exchange market increases as Canadian citizens sell dollars to buy foreign currencies to pay for the imports.
The increase in the supply of dollars causes its value to decrease.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Expansionary monetary policy pushes
up the Canadian price level. As the prices rise relative to foreign
prices, Canadian exports become more expensive and goods Canadian imports become cheaper.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels The demand for foreign currencies
increases and the demand for dollars decreases, pushing the value of the dollar down.
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The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Contractionary monetary policy puts
downward pressure on Canadian price level and slows down any existing inflation.
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The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels As a result, contractionary monetary
policy pushes the value of the dollar up via the price path.
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The Net Effect of The Net Effect of Monetary Policy on Monetary Policy on Exchange RatesExchange Rates Expansionary monetary policy lowers
exchange rates. It decreases the relative value of a
currency.
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The Net Effect of The Net Effect of Monetary Policy on Monetary Policy on Exchange RatesExchange Rates Contractionary monetary policy
increases exchange rates. It increases the relative value of a
country's currency.
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© 2003 McGraw-Hill Ryerson Limited.
M
Competi-tivenessExpansionary
monetary policy
i
P
Y
Net Effect of Monetary Net Effect of Monetary Policy on Exchange Policy on Exchange RatesRates
Value of domestic currency
Value of domestic currency
Value of domestic currency L-R effect
Value of domestic currencyImports
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M
Competi-tiveness
Imports
Contractionary monetary
policy i
P
Y
Net Effect of Monetary Net Effect of Monetary Policy on Exchange Policy on Exchange RatesRates
Value of domestic currency
Value of domestic currency
Value of domestic currency L-R effect
Value of domestic currency
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© 2003 McGraw-Hill Ryerson Limited.
Monetary Policy’s Monetary Policy’s Effect on the Trade Effect on the Trade BalanceBalance Monetary policy affects the trade
balance in three ways. Through income. Through price levels. Through the exchange rate.
17 - 48
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The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income Expansionary monetary policy
increases income. When incomes rise, imports rise;
exports are unaffected.
17 - 49
© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income As imports rise, the trade balance shifts
in the direction of deficit. As a result, the trade balance shifts
toward a deficit.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via IncomeBalance via Income Contractionary monetary policy works in
the opposite direction. As a result, the trade balance shifts
toward a surplus.
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The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Expansionary monetary policy pushes a
country’s price level up. This decreases it competitiveness. Trade deficits go up as residents
substitute imported for domestic goods.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Contractionary monetary policy works in
the opposite direction. As a result, contractionary monetary
policy decreases a trade deficit.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via Price Balance via Price LevelsLevels Monetary policy’s effect on the price
level is a long-run effect.
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The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Expansionary monetary policy
decreases the interest rate. This tends to push the dollar exchange
rate down. This increases Canadian
competitiveness which decreases a trade deficit.
17 - 55
© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Contractionary monetary policy works in
the opposite direction. As a result, contractionary monetary
policy increases a trade deficit.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Balance via Exchange Balance via Exchange RatesRates Like the price level effect, the effect of
the exchange rate on the trade deficit is a long-term effect.
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The Net Effect of The Net Effect of Monetary Policy on the Monetary Policy on the Trade BalanceTrade Balance Expansionary monetary policy makes a
trade deficit larger. Contractionary monetary policy makes
a trade deficit smaller.
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© 2003 McGraw-Hill Ryerson Limited.
M
Value of domestic currency
Expansionary monetary
policy
Net Effect of Monetary Net Effect of Monetary Policy on the Trade Policy on the Trade DeficitDeficit
Imports
Tradedeficit
Y
P
i
Competi-tiveness
Competi-tiveness
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M
Contractionary monetary
policy
Net Effect of Monetary Net Effect of Monetary Policy on the Trade Policy on the Trade DeficitDeficit
Imports
Competi-tiveness
Tradedeficit
Y
i
Competi-tiveness
P
Value of domestic currency
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© 2003 McGraw-Hill Ryerson Limited.
Fiscal Policy’s Effect on Fiscal Policy’s Effect on Exchange RatesExchange Rates Fiscal policy affects exchange rates in
three ways. Through income. Through price. Through interest rates.
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The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Expansionary fiscal policy increases
income. When incomes rise, imports rise;
exports are unaffected. As imports rise, the trade deficit
increases and the currency value drops.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via IncomeRates via Income Contractionary fiscal policy works in the
opposite direction. Imports decrease and the currency
value increases.
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The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Expansionary fiscal policy increases
aggregate demand. The prices of a country’s exports
increases. The competitiveness of a country’s
exports decreases and the currency value drops.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Price LevelsRates via Price Levels Contractionary fiscal policy works in the
opposite direction. The price path is a long-run effect.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Expansionary fiscal policy increases
interest rates because the government sells bonds to finance the deficit.
Higher Canadian interest rates cause foreign capital to flow into Canada.
The dollar value goes up.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on Exchange The Effect on Exchange Rates via Interest Rates via Interest RatesRates Contractionary fiscal policy works in the
opposite direction. Interest rates decrease, capital flows out of
Canada and the value of the dollar decreases.
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The Net Effect of Fiscal The Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates The interest rate effect and the income
effect are both short-term effects. The two work in opposite directions, so
the net effect of fiscal policy is ambiguous.
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The Net Effect of Fiscal The Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates It is unclear what the effect of
expansionary or contractionary fiscal policy will be on exchange rates.
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© 2003 McGraw-Hill Ryerson Limited.
Net Effect of Fiscal Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates
Competi-tivenessExpansionary
fiscal policy
i
P
Y
Value of domestic currency
Value of domestic currency
Value of domestic currency L-R effect
Imports ?
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Net Effect of Fiscal Net Effect of Fiscal Policy on Exchange Policy on Exchange RatesRates
Competi-tiveness
Imports
Contractionary fiscal policy i
P
Y
Value of domestic currency
Value of domestic currency
Value of domestic currencyL-R effect
?
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© 2003 McGraw-Hill Ryerson Limited.
Fiscal Policy’s Effect on Fiscal Policy’s Effect on the Trade Deficitthe Trade Deficit Fiscal policy works on the trade deficit
through its effects on income and prices.
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The Effect on the Trade The Effect on the Trade Deficit via IncomeDeficit via Income Expansionary fiscal policy increases
income. Imports go up, as does the trade deficit.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Deficit via IncomeDeficit via Income Contractionary fiscal policy works in the
opposite direction. It decreases the size of the trade deficit. These are the same effects as those of
monetary policy.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Deficit via PricesDeficit via Prices Expansionary fiscal policy increases the
price level. This increases the price of a country’s
exports and decreases it competitiveness.
This increases the trade deficit.
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© 2003 McGraw-Hill Ryerson Limited.
The Effect on the Trade The Effect on the Trade Deficit via PricesDeficit via Prices Contractionary fiscal policy works in the
opposite direction. It decreases the size of the trade deficit. These are the same effects as those of
monetary policy.
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The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit Expansionary fiscal policy increases a
trade deficit. Contractionary fiscal policy decreases a
trade deficit.
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Expansionary fiscal policy
The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit
Imports
Tradedeficit
Y
PCompeti-tiveness
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Contractionary fiscal policy
The Net Effect of Fiscal The Net Effect of Fiscal Policy on the Trade Policy on the Trade DeficitDeficit
Imports
Competi-tiveness
Tradedeficit
Y
P
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Monetary and Fiscal Monetary and Fiscal Policy’s Effect on Policy’s Effect on International GoalsInternational Goals Trade
deficit Value of domestic currency
Expansionary monetary policy
UP DOWN
Expansionary fiscal policy
UP AMBIGUOUS
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© 2003 McGraw-Hill Ryerson Limited.
International International Phenomena and Phenomena and Domestic GoalsDomestic Goals Monetary and fiscal policy can work the
other way around. The monetary and fiscal policies of
other countries can have significant effects on Canadian domestic economy.
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International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Governments try to coordinate their
monetary and fiscal policies because their economies are interdependent.
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International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Because of this interdependence, many
economists argue that all countries must work together to coordinate their monetary and fiscal policies.
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International Monetary International Monetary and Fiscal Coordinationand Fiscal Coordination Because of the fear of retaliatory
measures, nations take their trading partners’ desires into account when making their monetary and fiscal policies.
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Coordination Is a Two-Coordination Is a Two-Way StreetWay Street If other nations are to take the needs of
Canadian economy into account, Canada must take the needs of other countries into account in determining its goals.
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Coordination Is a Two-Coordination Is a Two-Way StreetWay Street Each country will likely do what is best
for the world economy as long as it is also best for itself.
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Crowding Out and Crowding Out and International International ConsiderationsConsiderations There is another way to avoid crowding
out that results from financing the debt. Foreigners could buy the debt at the
existing interest rate. This is called internationalizing the debt.
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Crowding Out and Crowding Out and International International ConsiderationsConsiderations Internationalizing a country’s debt may
help in the short run.
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Crowding Out and Crowding Out and International International ConsiderationsConsiderations In the long run it presents potential
problems since foreign ownership of a country’s debts means the country must pay interest to those foreign countries and that debt may come due.
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Selecting Policies to Selecting Policies to Achieve Goals,Achieve Goals,Table17-1, p 429Table17-1, p 429
International Goal Policy Alternatives
Low value for domestic currency
Contractionary foreign monetary policy
Expansionary domestic monetary policy
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Selecting Policies to Selecting Policies to Achieve Goals, Achieve Goals, Table17-1, p 429Table17-1, p 429
International Goal Policy Alternatives Lower trade deficit Contractionary domestic
fiscal policy Expansionary foreign
fiscal policy Contractionary domestic
monetary policy Expansionary foreign
monetary policy
© 2003 McGraw-Hill Ryerson Limited.
International International Dimensions of Dimensions of
Monetary and Fiscal Monetary and Fiscal PolicyPolicy
End of Chapter 17End of Chapter 17