International Aspects of U.S. Monetary and Fiscal Policy

Since 1980 U.S. rr~acroeconomic policy has diverged from that of other major industrial countries. While most countries responded to the inflationary impact of the 1979 oil shock by tightening their fiscal policies, the influence of supply-side doctrine has led the United States into a dramatic fiscal loosening. After 1979 all major countries moved towards tighter monetary policies; but until mid-1982 the United States was more determined in this respect than most others. Indeed, despite the fiscal stimulus the United States managed to have a deeper recession than the rest of the industrial world. The impacts of this divergence in policies on the world economy in general and on U.S. trade in particular have been dramatic. But there is a good deal of disagreement about just what these impacts are, and about the appropriate response. The purpose of this paper is to lay out a framework for thinking about the effects of this kind of policy divergence, and to suggest some tentative conclusions about the current situation. Readers should be forewarned that this is a "low-tech" paper. It neither sets out an econometric model nor develops a theoretical approach based on careful analysis of microfoundations. Instead, the empirical content, such as it is, consists of rough exploratory data analysis, while the theoretical analysis is in the Mundell-Fleming tradition of small-scale, ad hoc modeling. The justification for this crudity is of course that it has the compensating advantage of flexibility. We are now in an international macroeconomic situation which is quite different from anything previously experienced. In time the theory and econometric work necessary for a detailed and rigorous treatment of this situation will be done (although by that time the situation will have shifted again--generals are not alone in their tendency to be ready to fight the lost war). In the meantime, however, there is a place for ad-hockery and first-cut analysis. The paper is in four parts. The first part is background: an account of the divergent trends in fiscal and monetary policy and of the macroeconomic and financial developments which have accompanied these trends. The second part lays out a framework for analysis. It suggests that a slightly modified version of the Mundell-Fleming or "IS-LM-BP" model is a useful way to think about recent developments. The third part of the paper addresses the problem of the strong dollar from a U.S. point of view: should the United States do something to drive the dollar down to where it belongs?