Effectiveness of macroeconomic policies in the contextof closed and open economies

Abstract

IntroductionMonetary and fiscal policies have long been the important instruments for policy makers to achieve their macroeconomic goals like economic growth with price stability and exchange rate stability and economic development. Monetary policy is the policy used by the central bank to control the liquidity in the market which involves controlling inflation, exchange rate oscillations through various monetary instruments like CRR, SLR various interest rates and open market operations. Likewise finance ministry uses fiscal policy to achieve its objectives like economic growth and development through various fiscal tools like public revenue, public expenditure and public borrowings.According to traditional macroeconomic theories, fiscal policy is more effective in the case of fixed exchange rate system and monetary policy is more effective under flexible exchange rate system. Economists usually compare the effect of both these policies on different economies under different exchange rate regimes and different economic systems. The reason behind is both the policies are equally important to achieve major and common macroeconomic goals like economic growth (growth rate of GDP) and economic development directly or indirectly through GDP. In case of economic growth and development, fiscal policy can be applied directly and results can be obtained immediately, but monetary can be applied directly for economic growth through decreasing rates and it is difficult to apply monetary policy directly to achieve development goals. It is possible only through decreasing interest rate and its impact on investment, employment and income. Also it will take some time to achieve the development goals. That's why it is always necessary and important to test the effectiveness of fiscal and monetary policy in the economy. In order to analyses the effectiveness of macroeconomic policies on the economy; this study uses Money Supply (M1), Interest rate (R), Government expenditure (G), Taxation (T) and Exchange rates (E) for analysis.In the last few centuries countries across the world have been increasingly engaging with one another in terms of trade. The advent of mass production techniques and discovery of new technology and hence greater demand have opened up several fronts in global trade. Countries which earlier were self-sufficient became reliant on others. Much of the work in economics had an underlying assumption that the nation was a closed economy.Several new models were proposed by various eminent economists like Mundell-Fleming, Trevor Swan and other models widely followed in international macroeconomics. Globalization has only accelerated the process of higher trade between nations. The western world was the first to embrace the concept of open economy. Many Asian countries like South Korea and Singapore adopted the open economy in early 1960s. Asians giants India and China have been relatively late in adopting the open economy model. India freed the control of government over key sectors in the 1990s reforms that had restricted the interaction of India with foreign nations.Opening up of the economy brings in several benefits. However, due to limited governmental control over the functioning of the economy now it becomes difficult for the policy makers to strike a balance between governmental interference and market forces. Due to various factors, the effectiveness of a policy may or may not produce the desired effects. It becomes more important to consider the implications and the behavior of such policy actions. Analyzing the effect of macroeconomic policies under different exchange rate regimes may provide clue towards taking appropriate measures.The impacts of these decisions seem to have profound effect on several key economic parameters and hence their analysis assumes considerable significance. The present paper is structured as follows: Introduction and significance of the study are given in Section 1. …