3.3 Conclusions

3.3 Conclusions

In this chapter we have illustrated some important aspects concerning the conduct of economic policy in an open economy.While fiscal and/or monetary policy may be useful in achieving full employment, they will also have important implications for the balance of payments and exchange rate which will in turn have feedback effects on the domestic economy.Compared to a simple closed economy, an open economy has to take into account many important additional considerations in economic policy formulation.

Among the most important lessons for economic policy-makers is that they generally need as many independent policy instruments as they have targets.This is important because the idea that authorities can use a single policy instrument such as monetary policy alone to achieve all the targets of economic policy is highly questionable.Nevertheless, policy-makers still have a major policy problem in deciding which instrument to assign to which target.Since the structures of economies differ, no general rules exist to solve this problem.Theory warns that an incorrect assignment may provoke rather than limit instability in the economy.

In reality, to achieve internal and external balance will be far more difficult than what our theoretical analysis has suggested.Policy-makers face uncertainty over instrument-target relationships; there are time lag problems; the authorities are in the possession of only limited information about the position of an economy, and economies are continually being subject to new shocks as well as adjusting to previous shocks.In practice, getting close to targets is likely to be the name of the game rather than actually achieving them.

We have seen that the relative effectiveness of fiscal and monetary policy is very much dependent upon the choice of exchange-rate regime.In particular, with perfect capital mobility monetary policy is more effective under a floating exchange-rate regime, while fiscal policy is more effective under a fixed exchange rate.One of the crucial parameters determining the effectiveness of both fiscal and monetary policy in an open economy is the degree of financial integration of the economy with the rest of the world, as reflected by the mobility of capital internationally.

Although the Mundell-Fleming model has many limitations it none the less focuses attention on the difficulties and dilemmas facing policy-makers in an open economy.Perhaps its most significant contribution to international economics is that it focuses on the important role that international capital flows can play in determining the effectiveness of macroeconomic policies under alternative exchange rate regimes.

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1.A major lesson of the Swan diagram model is that the use of one instrument, be it a fiscal expansion or devaluation to achieve two targets—internal and external balance, is most unlikely to be successful.

2.The Mundell-Fleming model’s major contribution was to incorporate international capital movements into formal macroeconomic models based on the Keynesian IS-LM framework.Their papers led to some dramatic implications concerning the effectiveness of fiscal and monetary policy for the attainment of internal and external balance.

3.The problem for economic policy-makers to determine which instruments to assign to which targets, is termed the “assignment problem”.Mundell suggested that under fixed exchange rates, monetary policy should be assigned to external balance and fiscal policy to internal balance.

4.The Mundell-Fleming model also has limitations: the Marshall-Lerner condition; interaction of stocks and flow; neglect of long-run constraints; wealth effects; neglect of supply-side factors; treatment of capital flows; exchange-rate expectations; flexibility of policy instruments.