Monetary Policies in Open Economies



The central bank and the government have tools to accelerate the monetary policies or contract the economy such as the interest rate, public spending, the amount of money in the economy among others. But when an economy is exposed to international trade some factors can have undesirable effects on the local economy. That is why when the authorities are going to intervene in the economy they not only think about local theoretical models, they also must think about how these measures will affect trade with other countries and how the trade balance of the country will turn out. Not only will the trade balance end up affected, but also the exchange rates with other currencies and therefore the purchasing power of people, so it is essential to analyze the effects in an open economy of economic intervention.

With globalization, economies face various challenges as seen in the article Globalization and its risks. One of the most important decisions faced by central banks and authorities is the determination of the exchange rate and the economic policy that each country will take depending on the objectives pursued by the government and the central bank. Economies that are exposed to international trade and thus to globalization are called open economies. Open economies can be affected by internal factors such as public spending or the level of consumption or external factors such as the depreciation of foreign currencies or consumption in other countries.


In the case of the global crisis of 2007, this relationship between open economies was evident, because when the domestic market of the United States was depressed, other countries such as China and European countries were affected because their exports decreased and therefore the income of its inhabitants. In the next part of the article, we will show how some variables affect open economies. The first will be to analyze how a variation in the demand for domestic production affects a free economy.

If at a given moment the government decides to increase public spending given the economic situation of the country this will boost domestic demand and the production of national goods. According to some analyzes carried out by economists, it has been observed that the increase in public spending has a multiplier effect on the rise in production and the level of consumption. But the unwanted result of the increase in public expenditure is the generation of a deficit in the trade balance.
The above is generated due to the increase in the consumption of imported goods, but exports are not affected by domestic consumption, which leads to a deficit. Unlike what would happen in a closed economy, public spending affects production to a lesser extent because, as mentioned above, people will consume more, but not necessarily from local production, so a government’s effort might result in a minimal boost to the economy. In summary, an increase in public spending in open economies will generate a trade deficit and a small effect on local production due to the rise in demand for foreign goods.

It is a fact that the more open an economy is, the lower the effect on production will be and the greater the negative effect on the trade balance since demand will increase more on the part of foreign goods. Given the above in open economies, it is unattractive monetary policies to get the economy out of a recession based on demand alone.

Now an increase in the production of foreign goods and its effect on local economies will be considered. This increase in the production of foreign goods could be due to a rise in the public expenditure of the foreign country or another positive shock for overseas production. If foreign production increases, this is also linked to a rise in foreign demand including foreign goods. Therefore, it increases the exports of the local country to respond to this increase in foreign demand, which increases local production and domestic demand. In some cases, imports may also increase due to the rise in local demand, but it will be less than the increase in exports and as a result, it will be a surplus in the trade balance.

So far, two necessary conclusions have been presented:
• An increase in domestic demand causes an increase in domestic production but affects negatively the trade balance. This effect applies to a rise in public spending, tax reduction, or a net increase in consumer spending.
• An increase in foreign demand causes an increase in local production and a better trade balance thanks to the incentive to exports.

The higher the commercial relations between the countries, the higher their interactions and they will be more exposed to the shocks that each economy has. These basic conclusions can be observed by what has happened in recent years in some countries. In most OECD countries, there was a strong expansion of the economy in the second half of the 1990s, followed by a sharp recession in the first years of the 21st century. An explanation for this similar behavior in the OECD steps was the commercial relations between these countries.

These commercial interactions make difficult the tasks of those responsible for the monetary and monetary policies of a country since not only must local variables be considered, they must also analyze how the main trading partners of the country will respond. No government likes to see a trade deficit with other countries since this means that new debt is accumulated with other nations through imports and if there is an increase in this deficit the debt will grow with their respective interests. But in some cases, it is better to incur a deficit in the trade balance. If on a recessive economy a government waits for other countries to take measures to overcome this crisis, and thus increase exports, it may occur in some cases that no country acts and the crisis might become worse for all the countries involved.

In order for governments not to wait for the responses of other states, in theory, they should coordinate their macroeconomic policies to increase their domestic demand simultaneously as well as production without entering larger trade deficits as imports increase at the same pace than exports. At this point, it is important to clarify that if they coordinate their monetary policies, the deficit of the balance between them does not increase, but it is likely that the deficit increases concerning other countries of the world. This coordination between economies is not rare to see. Many countries, especially the most powerful ones, meet periodically to analyze their economic situation and try to reach a better point together.

But like OPEC, full cooperation between member countries is difficult since some countries could benefit more than others and not work in the same way. In other cases, there will be countries that are not in recession, so they will not have incentives to cooperate because if they do this, they will see their increased deficit with countries outside the agreement. Besides, each state can have problems such as fiscal deficits, issues in the exchange rate among others, so to reach a common understanding on the solutions for each country will be complicated.

Another important variable in open economies is the nominal exchange rate. Some countries could benefit from depreciating their currency to be more competitive in their exports such as China, a country that many have accused of having an artificial rate that does not respond to market forces. This topic is analyzed in the article China and its economic predominance.
If the government or central bank of a country takes measures that lead to a depreciation of its currency in nominal terms, it will end up affecting the real economy since it will have effects on the trade balance and the production of the country in question. Depreciation will change the trade balance since exports will increase since with a depreciation they will receive more income in nominal terms and their costs will remain the same and this will be an incentive to produce more for external consumption. Another effect is the reduction in imports because they will be more expensive to acquire in the country which will transfer the consumption of external goods to local goods.

To make the trade balance better, after a depreciation, exports must increase enough, and imports must decrease enough to offset the rise in the price of imports. The effects of a real depreciation are very similar to the effects caused by an increase in the demand for goods in a foreign country. A depreciation causes an increase in net exports, which causes an increase in local production and a better trade balance. The problem of depreciation is that they affect the well-being of people due to the rise in the cost of foreign goods, so this type of policy is not well received by people as it increases the cost of their goods.

In the following part of the article, the different types of systems of change will be exposed. There are two main types of methods of change. The flexible exchange system allows the exchange rate to fluctuate according to market forces and is not controlled by the authorities. This kind of exchange system is useful for countries that need to achieve a real depreciation to either get out of a recession or clean up a trade deficit.

In a system of fixed exchange rates, a country cannot use its exchange rate to solve its problems since the exchange rate will be at a certain level. One drawback of the fixed rate is that the country to defend the exchange rate must renounce the management of its monetary policy concerning the interest rate since with this they manage to maintain parity when they equalize the local interest rate with the interest rate. of interest of the foreigner.

In the medium term, the authorities manage to adjust the real exchange rate by modifying the nominal exchange rate or by altering the level of prices in the country to equalize the price of goods abroad. In an open economy with fixed exchange rates, the price level will affect production through the effect they produce on the real exchange rate since prices cause a rise in the actual exchange rate. This genuine appreciation causes a decrease in the demand for local goods and, in turn, a reduction in domestic production.

In short, a price increase makes domestic goods lower thus reducing their demand. In the short term, a fixed nominal exchange rate implies a fixed real exchange rate. In the medium term, the real exchange rate can be adjusted, although the nominal rate is fixed since the adjustment is achieved through changes in the price level.

In a fixed exchange rate system, the economy can produce its potential in the medium term, but the adjustment to maintain that exchange rate can be complicated for the authorities. If a government wants to boost production to its natural level with a fixed-rate system, it can devalue its currency only once to avoid losing credibility. This devaluation causes a real depreciation and therefore an increase in production. But this devaluation must be in its correct proportion because if it exceeds undesired effects may appear.

Depreciation does not immediately affect production. Initially, depreciation may have a contractionary effect since consumers will pay more for imports without having generated the adjustment between imports for exports. Besides, it will directly affect the prices of goods in general, so that the consumption basket will increase its price, and this will lead workers to request a higher nominal increase in their salaries and force companies to raise their prices respectively. It will reach the point already studied that a devaluation can boost production, but this will take due to all transmission mechanisms.

When a country has fixed exchange rates and faces a high trade deficit or a broad recession there are incentives to leave the parity and devalue the currency to have tools to activate production. So, many economists prefer flexible exchange rates than fixed because in some parities the national currency may be overvalued, and this will affect in the medium term or until parity ends economic development as it will mainly affect exports.

There is evidence that shows that the lower the interest rate, the lower the exchange rate will be. So, a country that wanted to maintain a stable exchange rate had to keep the interest rate close to the foreign interest rate. This is because many investors are continually looking at the interest rate since many investments such as bonds depend on this interest rate. So, if a country like the United States increases its rates, it will make its bonds more attractive for profitability and low risk, and this will end up affecting other nations if they do not follow that interest rate increase.

Therefore, a country that would like to achieve a depreciation would only have to lower interest rates in the correct proportion. But the relationship between fees is not that simple. In many cases, the interest rate may fall, and the exchange rate may not. In addition, the magnitude of the correlation between both rates can vary. To predict the magnitude of the correlation, expectations about future rates should be introduced, and thus the ratio of the exchange rate to increase or reduction in the interest rate could be predicted.

Any factor that alters the current or future local or foreign interest rates will affect the current exchange rate. Therefore, to predict a current exchange rate it is not enough to analyze the local market and its relationship with other variables such as raw materials, foreign economies or interest rates, it is also important to examine the expectations of the investors of the future that will be determined at present.

To finish this article, we will clarify what the decision of the countries should be when they are choosing the type of their exchange system. Exchange rate systems can be crucial in economic development in the short term. In the short term, countries that have fixed exchange rates and perfect capital mobility relinquish control of their interest rate and exchange rate. That reduces their ability to respond to shocks and can also generate currency crises where they cannot maintain their parity even selling central bank reserves and after a while, they must leave their exchange rate free.

If a country has a fixed exchange rate and investors expect a large devaluation, they will ask for higher interest to reflect that risk, which will worsen the economic situation and put more pressure on the country to devalue. One problem with flexible exchange rates is that the exchange rate can fluctuate significantly and control over this is difficult. This will generate uncertainty among the agents in the economy and may affect some transactions. But with the flexible exchange rate, countries have more tools to deal with external shocks, which is why most economists prefer this type of system.

But the system of fixed exchange is preferable when there is not full confidence in the central bank with its management of the exchange rate parity. An extreme measure to not be aware of the rate of change is the adoption of a single currency among several countries such as the euro. With the adoption of a single currency, the fluctuations of the currency with the countries that are most traded are eliminated, but this, also, has problems since autonomy is lost in the monetary policy decisions and it is exposed to all the economic problems that may arise in the common area of that currency.