Economic Policy in the Open Economy: Flexible Exchange Rates

1
Chapter 26

• Economic Policy in the Open Economy Flexible
  Exchange Rates

2
Why flexible exchange rate?

• In the previous chapter, we saw that, under a
  fixed exchange rate, a country relinquishes
  monetary control
• That is, adjustments in the money supply are the
  means by which the balance of payments are kept
  in balance.
• With flexible exchange rates, monetary policy can
  be used for internal targets

3
Why flexible exchange rate?

• Sometimes monetary crises occur because an
  exchange rate is fixed, and its rate becomes out
  of line with the economic realities of the
  country.
• (However, sometimes a monetary crisis occurs
  because structural features of the economy cannot
  be maintained under current conditions, and the
  exchange rate is irrelevant.)

4
Flexible exchange rate

• In this chapter we will examine
• fiscal policy
• monetary policy
• policy coordination
• market adjustments to shocks under flexible
  exchange rates.
• For each policy, we again pay attention to the
  degree of capital mobility.

5
Exchange rate and the BP Curve

• As in Chapter 25, the slope of the BP curve will
  be affected by capital flows.
• A change in the exchange rate will shift the BP
  curve right or left.
• An appreciation shifts the curve left because for
  a fixed level of interest, there are fewer
  exports and more imports.
• A depreciation shifts the BP curve right. A
  higher level of income can be maintained at any
  given interest rate with a lower-valued currency

6
The BP curve

• Other factors can also shift the BP curve
• Increase in
• foreign income or foreign price shifts the BP
  curve right
• domestic price shifts the BP curve left
• increase in the expected profit rate for foreign
  companies shift BP left
• for home companies shift right
• increase in foreign interest rate shifts BP left
  (up)
• increase in expected home currency appreciation
  shifts the BP curve right (down)

7
Exchange rate and Balance of Payments

• If the exchange rate is floating freely, then
  there is never an imbalance in the BoP.
• If current account and capital account
  transactions would cause a deficit (incipient
  deficit) then the currency depreciates.
• the deficit does not occur.
• If international transactions would result in a
  surplus (incipient surplus), the currency
  appreciates.
• No surplus occurs

8
Fiscal policy

• Given these two points
• exchange rate change shifts the BoP curve
• deficits and surpluses lead directly to changes
  in the value of the exchange rate
• We can now examine the effect of fiscal policy.

9
Fiscal policy

• Lets use the case of expansionary fiscal policy
  in which taxes are lowered or government spending
  increased.
• The effect of expansionary fiscal policy will be
  to increase injections into the economy (or
  decrease leakages)
• This will increase spending and income
• This will increase imports
• And depreciate or appreciate the currency.

10
Fiscal policy

• Expansionary policy will not only increase
  imports, however.
• It will also put pressure on the demand for money
  and therefore increase the interest rate.
• The stronger of the two effects will determine
  whether policy depreciates or appreciates the
  currency.

11
Fiscal policy

• Expansionary policy will increase imports
• which would, by itself, cause the currency to
  depreciate
• Expansionary policy will increase the interest
  rate
• which would, by itself cause the currency to
  appreciate
• Which effect is stronger depends on the degree of
  capital mobility.

12
Fiscal policy

• Note both the IS curve and the BP curve shift.
• The IS curve shifts because of the effect of
  policy on injections leakages
• The BP curve shifts because of the depreciation
  or appreciation of the currency.
• The change in the value of the currency will
  cause another change in injections leakages,
  shifting the IS curve again.
• The final effect depends on the mobility of
  capital.

13
Fiscal policy

• If capital is either perfectly or very immobile,
• then the import effect dominates
• the currency depreciates
• the IS curve shifts right again.
• fiscal policy is very effective
• If capital is either perfectly or very mobile
• then the interest rate effect dominates
• the currency appreciates
• the IS curve shifts left.
• fiscal policy is less effective (or ineffective)

14
Fiscal policy graphical analysis

• In the next slide, the four cases of fiscal
  policy effects are summarized.
• With immobile capital, the depreciation results
  in higher income and interest rate
• With mobile capital, the appreciation results in
  a smaller change in income and a mitigation of
  the increase in the interest rate.

15
Fiscal policy graphical analysis
BP
BP
BP
LM
BP
LM
i
i
i2
i2
i0
IS
i0
IS
IS
IS
IS
IS
Y
Y2
Y0
Y
Y0
Y2
LM
i
LM
i
BP
i2
BP
i0
BP
i0
IS
IS
IS
IS IS
IS
Y
Y
Y2
Y0
Y0
16
You do

• Increase in Taxes
• capital is very immobile
• capital is very mobile

17
Fiscal policy Canadas perspective

• In Canada in the late 1980s, early 1990s, there
  was growing pressure due to high government
  deficits.
• Government cut spending significantly.
• The effect on income was minimal.
• A contractionary fiscal policy was ineffective
  (in terms of lowering income) because our
  interest rates are tied closely to world interest
  rates, in particular those in the U.S.
• it did free up cash and create budget surpluses.

18
Monetary Policy

• One of the reasons many economists support
  flexible exchange rates is because monetary
  policy can be used to help reach internal
  targets.
• Therefore, we should not be surprised to find
  that monetary policy is effective under flexible
  rates.

19
Monetary Policy

• Monetary expansion has a number of effects on the
  market. It
• causes an increase in investment, raises income
• lowers the interest rate (price of domestic
  money)
• causes a depreciation.
• Whether the depreciation results from import
  demand or the interest rate depends on the level
  of capital mobility.
• However, in all four cases, monetary policy is
  effective.

20
Monetary Policy

• And, the mechanism is very similar in all four
  cases.
• Monetary policy (expansionary) shifts the LM
  curve right, lowering the interest rate and
  causing an incipient deficit as the interest rate
  is pushed down and imports rise.
• This causes a depreciation of the currency.
• The depreciation increases the effect of monetary
  policy on income, compared to the closed economy
  case.

21
Monetary Policy

• If capital is very or completely immobile
  internationally, the depreciation is mainly or
  only caused by the increase in imports.
• In this case the depreciation is only enough to
  offset the increase in imports.
• The depreciation leads to expenditure switching,
  with more exports and fewer imports than would be
  the case without the depreciation.

22
Monetary Policy

• If capital is mobile internationally, the
  downward pressure on interest rates also
  contribute to the depreciation.
• Therefore there is a bigger depreciation with
  mobile capital.
• The depreciation leads to expenditure switching,
  which causes the IS to shift further right.
• The next slide shows the graphical analysis of
  monetary policy.
• With flexible exchange rates the monetary
  authority is important in determining growth.

23
Monetary policy graphical analysis
BP
BP
BP
LM
BP
i
LM
i
LM
LM
i2
i2
IS
IS
IS
IS
Y
Y2
Y0
Y2
Y
Y0
LM
LM
i
LM
i
LM
BP
BP
i2
i0
BP
IS
IS
IS
IS
Y2
Y
Y
Y0
Y0
Y2
24
You do

• Contraction in money supply
• Capital is perfectly immobile
• capital is perfectly mobile

25
Fiscal and monetary policy coordination

• Monetary policy is effective under flexible
  exchange rates
• Fiscal policy is ineffective if capital is
  perfectly mobile, and less effective than
  monetary policy.
• Expenditure switching complements monetary policy
  but somewhat offsets fiscal policy.

26
Fiscal and monetary policy coordination

• However, in all cases but perfectly mobile
  capital, policy makers can use both monetary and
  fiscal policy to achieve more than one target
  (income and inflation, income and exchange rate,
  income and interest rate).
• We will look at simplest case, income and
  interest rate.
• We will use case where policymakers wish to
  increase income quite a bit and the interest rate
  slightly

27
Fiscal and monetary policy coordination

• If policymakers use only fiscal policy, the IS
  and BP curves will shift right, but, the
  increased spending raises the interest rate a
  lot.
• with mobile capital, the currency will
  appreciate, lowering the increase in income, and
  somewhat offsetting the increase in the interest
  rate.
• It may not be possible to reach both targets.

28
Fiscal policy only
LM
i
BPFP
BP
iFP
i
i0
ISFP
ISFP
IS
Y0
YFP
Y
Y
29
Fiscal and monetary policy coordination

• If policymakers use only monetary policy, the LM,
  curve will shift right, but,
• with mobile capital, the currency will
  depreciate, lowering the interest rate, and
  making it difficult to reach both targets.
• It would not be possible to reach both targets
  using only monetary policy.

30
Monetary policy only
LM
i
LMMP
BP
BPMP
i
i0
iMP
ISMP
IS
Y0
YMP
Y
Y
31
Fiscal and monetary policy coordination

• By combining fiscal and monetary policy,
  policymakers can use fiscal expansion to increase
  income, then use monetary expansion to offset the
  increase in interest rates and appreciation to
  the extent desired.

32
You do What combination of fiscal and monetary
policy will reach (Y,i)
LM
i
BP
i0
i
IS
Y0
Y
Y
33
You do What combination of fiscal and monetary
policy will reach (Y,i)
LM
i
i
BP
i0
IS
Y0
Y
Y
34
Exogenous shocks

• First foreign price shock
• If foreign prices rise
• our exports rise, imports fall
• the IS curve shifts right
• the BP curve shifts right.
• there is an appreciation of our currency
• the IS curve shifts left
• the BP curve shifts left
• NO effect on the economy

35
Foreign price shock
LM
i
BP
BP
i0
IS
IS
Y0
Y
36
Foreign price shock

• Two things to notice
• One, the currency acts as a shock absorber for
  foreign price changes,
• Two, remember, when trying to determine the final
  equilibrium in flexible rates, the IS and BP
  curves move to equilibrium along the LM curve.
• LM curve is the curve that does NOT move in
  response to changes in exchange rate.

37
Foreign price shock

• Think about.
• Would the foreign price shock have no effect on
  the economy if the BP curve is vertical?

38
Domestic price shock

• If domestic prices rise, they will affect our
  economy.
• Monetary equilibrium
• price increase raises the demand for money at
  each income level.
• therefore a higher interest rate is needed at
  each income level for monetary equilibrium to
  hold
• LM curve shifts up

39
Domestic price shock

• IS and BP curves
• The increase in prices makes the economy less
  competitive
• export demand falls
• import demand rises
• In the IS curve, this is an increase in leakages
  and a reduction in injections (IS shifts left)
• In the BP curve, this leads to a need for higher
  interest rates to maintain balance (BP curve
  shifts left)

40
Domestic price shock

• IS and BP curves
• The increase in prices makes the economy less
  competitive
• export demand falls
• import demand rises
• In the IS curve, this is an increase in leakages
  and a reduction in injections (IS shifts left)
• In the BP curve, this leads to a need for higher
  interest rates to maintain balance (BP curve
  shifts left)

41
Domestic price shock

• NOTE In this case, we might think that the
  currency will depreciate and the BP curve would
  shift right.
• However, the BP curve is moving because of a
  shift in exports and imports not because of a
  depreciation.
• If the currency depreciates, this will make the
  leftward shift smaller, but the BP curve will not
  shift right.

42
Domestic price shock
LM
LM
i
BP
BP
i0
IS
IS
Y0
Y
43
You do

• Domestic price increase when the BP curve is
  steeper than the LM curve.

44
Foreign interest rate shock

• An increase in the foreign interest rate will
  affect the balance of payments curve directly.
• The higher foreign interest rate attracts funds
  away from the country, and so the interest rate
  that would maintain balance of payments
  equilibrium is higher than before the increase in
  the foreign interest rate.
• (BP shifts UP)

45
Foreign interest rate shock

• The new BP curve is now out of sync with the
  internal equilibrium (ISLM)
• Since the internal equilibrium shows the true
  interest rate, a depreciation is needed because
  the interest rate is too low.
• Simultaneously with the increase in interest
  rates, the currency depreciates
• This causes exports to increase and imports to
  fall (IS right, BP right)

46
Foreign interest rate shock
LM
i
BP
BP
BP
i0
IS
IS
Y0
Y
47
Foreign interest rate shock--more

• A further adjustment is possible, examining
  portfolio balances.
• If home residents demand foreign bonds instead of
  home bonds, they reduce the demand for money at
  home at the original interest rate.
• This is a rightward shift of the LM.
• The portfolio adjustment causes the depreciation
  to be bigger than above.
• Income rises more.

48
Foreign interest rate shock
LM
LM
i
BP
BP
BP
i0
IS
IS
Y0
Y
49
You do

• Decrease in foreign interest rate when capital is
  perfectly mobile.

50
Shock to expected exchange rate

• If the foreign currency is expected to rise in
  value, then
• id if lt xa or
• id lt if xa
• In this case the adjustments in the IS/LM/BP
  diagram, and the economic forces underlying them
  are the same as for a foreign interest rate
  shock.
• The analysis is the same, because, whether the
  rise is in the foreign interest rate, or the
  expected value of the foreign currency, the cause
  is greater returns abroad.

51
International Policy Coordination

• Even though flexible exchange rates should shield
  the domestic economy from foreign price shocks,
  the following is always true
• the more interdependent countries are, the more
  policies in one country will affect the economies
  of other countries.
• This is especially true of policies that affect
  interest rates and exchange rates.

52
International Policy Coordination

• Therefore, policy coordination among countries is
  important in an interdependent world.
• The US interest rate affects not only the US but
  also the world economy.
• However, despite a few times when policies have
  been coordination, in the main more is likely
  needed.

53
International Policy Coordination

• Read boxes 3 and 4 of the text.
• Five areas of concern for policy coordination are
  (Bergsten and Henning, 1996)
• world growth and stability
• exchange rates
• current account imbalances
• the stance of G-7 members toward other countries
• the design of international financial economic
  system

54
International Policy Coordination

• The alignment of exchange rates seems to be at
  the top of the agenda.
• Karl Otto Pohl noted, that the US. dollar
  depreciated 36 on a trade weighted basis against
  the Euro from Feb. 2002 to May 2003. (10 in
  nominal terms)
• Bergsten and Rogoff have argued for and against
  the need for coordination.
• Bergsten would like to coordinated target zones,
• Rogoff thinks there is little to be gained from
  more than occasional coordination
• G-7 (G-8) leaders and central bankers meet
  regularly to coordinate policies, to the extent
  possible without compromising domestic priorities

55
Summary

• In the last two chapters, we have examined fiscal
  and monetary policy under fixed and flexible
  exchange rates.
• We saw that monetary policy is ineffective under
  fixed exchange rates (where the rules are
  followed for surpluses as well as deficits) but
  very effective under flexible exchange rates with
  mobile capital.