Three issues have been central to recent discussions of international economic interdependence and macroeconomic policy coordination: (1) How should monetary and fiscal policy in the rest of the industrial world and monetary policy in the United States respond to a tightening of US fiscal policy? (2) What should be the monetary and fiscal policy response in the United States and elsewhere to a collapse of the US dollar? (3) How should macroeconomic policy in the United States and other countries respond to disappointing rates of real growth? In Discussion Paper No. 92, Research Fellow Willem Buiter analyses these policy issues using a theoretical model of the world economy. His analysis demonstrates the importance of determining the causes of dollar collapse or slow growth: the correct policy responses are very sensitive to the exact cause of the difficulty.

Buiter's model is one of two regions, the United States and the Rest of the Industrial World (ROW), and is based on work by Mundell, Dornbusch and Miller. He conducts most of the argument on the assumption that the economic structures of the two regions are identical, permitting a simpler analysis and a clear graphical description of the adjustment processes. The model resembles other open economy models and incorporates a floating exchange rate, perfect international capital mobility, rational expectations in the foreign exchange market and sluggish short- run adjustment of domestic prices. The long-run properties of the model are classical, however: output will be equal to its exogenously determined 'capacity level', the inflation rate will equal the rate of growth of the money stock and real competitiveness is independent of monetary policy. Expansionary fiscal policy at home and contractionary fiscal policy abroad cause an appreciation of the real exchange rate over the long run. Such an appreciation can also be caused by adverse shocks to domestic capacity output or favourable shocks to foreign capacity output. Expansionary fiscal policy or negative shocks to capacity output in either region will raise the real interest rate equally in both regions.

Buiter shows that a unilateral US fiscal contraction in this model would cause a temporary slowdown of world economic activity as well as a sudden drop in the nominal and real value of the dollar. Suppose governments intervened in the foreign exchange market to prevent this. Non-sterilized intervention will neither reduce the magnitude of the global recession nor alter the real long-run responses to the fiscal contraction. Such intervention would merely redistribute the unchanged global burden of unemployment and excess capacity towards the United States and away from the ROW. If the United States (but not the ROW) sterilized its foreign exchange losses when fixing the nominal exchange rate, the effect on global and regional economic activity is ambiguous in Buiter's model. The sterilization means that there are now two policy changes, contractionary US fiscal policy and expansionary US monetary policy, working in opposite directions. The long-run effects of these policy changes are independent of monetary policy and the exchange rate regime: a US fiscal contraction lowers real interest rates at home and abroad and improves US competitiveness.

But suppose there were a fiscal expansion in the ROW designed to compensate for the US fiscal contraction. Buiter finds that this would allow US competitiveness to improve without a global slump, but it would not permit a reduction in the world real interest rate. A simultaneous movement toward expansionary monetary policy in both regions can, however, achieve the desired improvement in US competitiveness and a reduction in the world real interest rate at full employment. These monetary stimuli could, but need not, involve permanent increases in the rate of money growth.

What if a sudden drop in the dollar reflects the bursting of a speculative bubble rather than a US fiscal contraction? Such a dollar collapse does not call for any obvious monetary and fiscal policy responses, Buiter argues. But collapses which reflect perceived changes in fundamentals do call for changes in policy. 'Direct currency substitution', i.e. a shift in liquidity preference out of the dollar, calls for open-market sales in the United States and open-market purchases in the ROW. If a real risk premium emerges on the return from foreign investment in the United States, it can be neutralized by appropriate monetary and fiscal responses, such as raising the rate of US taxation on interest earned abroad.

Buiter also considers the appropriate policy response to a slowdown in world growth rates. If such a slowdown reflects an adverse global supply shock, then both the United States and the ROW should reduce aggregate demand to avoid 'stagflation'. If, on the other hand, the slowdown is the result of deficient aggregate demand in the private sector, appropriate fiscal and/or monetary stimuli are called for.

Finally, Buiter discusses whether the activist policy conclusions suggested by his theoretical analysis need to be qualified in any way. It has often been argued that correctly anticipated monetary and fiscal policy will be ineffective. This is not convincing, according to Buiter: ineffectiveness arises only in a very restricted and implausible set of models. Buiter concedes that uncertainty about the true structure of the economy greatly complicates optimal policy design, but it does not affect the superiority, in principle, of 'contingent' policy rules, which take into account 'feedback' from the economy. Activist policies also face credibility problems. These can arise because of the reversibility of temporary fiscal expansions, or the monetary authority's ability to use inflationary surprises to stimulate output or to amortize the real value of non-index-linked government debt. Buiter concludes that these obstacles to activist policies are potentially serious, but can be resolved by political and institutional means.


Macroeconomic Policy Design in an Interdependent World Economy: An Analysis of Three Contingencies
Willem H Buiter

Discussion Paper No. 92, January 1986 (IM)