MGE 13'1

1

• Session 13 A Global Economy - Monetary and
  Fiscal Policies in Open Economies
• Goal Understand the role of capital flows and
  exchange rates have on economic activity and
  policy
• Economic Activity and Exchange Rates
• Applications The Fall of the Yen and of the
  Dollar
• International Transmission of Business Cycles
• Monetary Policy with Flexible Exchange Rates
• Application Why does the US Dollar appreciate
  when Fed cuts rates?
• Fiscal Policy with Flexible Exchange Rates

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
But first Studying for the Final

• Homework old exams available on
  website(http//faculty.insead.edu/sadoulet)
• More technical approach? Mankiw(do not forget to
  read the book if you are having trouble
  understanding!)
• Review session (Session 16) QA evenings
• Friday 13th at 15h45
• Thursday 19th at 19h15

3
Strategy for FX market

• Always look at one thing at a time
• Foreigners demanding domestic currency on FX
  market
• Demand for our exports
• Demand for our assets (capital inflows)
• Domestic agents supply domestic currency to FX
  market
• Demand for imports
• Demand for foreign assets (capital outflows)

4
Strategy for FX market

Ex
EU
goods improve in quality

DEMAND EFFECT

o


Supply of domestic currency by
Exchange rate

domestic
agents



Imports





Capital outflows



e


Demand for domestic
currency by foreign agents




Exports




Capital inflows


Number of units of

domestic currency traded


5
Strategy for FX market

Ex EU goods improve in quality

SUPPLY EFFECT

o


Supply of domestic currency by
Exchange rate

domest
ic agents



Imports



Capital outflows

e

Demand for domestic
currency by foreign agents



Exports



Capital inflows

Number of units of
domestic currency traded

6
Strategy for FX market
Ex EU goods improve in quality

COMBINED EFFECT

o



Supply of domestic currency by
Exchange rate

domestic agents




Imports

e




Capital outflows



e


Demand for domestic
currency by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


7
What is the effect on Exports?
IF EXCHANGE RATE DID NOT MOVE

o



Supply of domestic currency by
Exchange rate

domestic agents




I
mports




Capital outflows



e


Demand for domestic

currency by foreign agents



Exports



Capital inflows



Number of units of

domestic currency traded


Change in v
alue of
exports

8
What is the effect on Exports?
BUT EXCHANGE RATE ADJUSTS

foreign goods become more competitive

o



Supply of domestic currency by

Exchange rate

domestic agents




Imports

e




Capital outflows



e


Demand for domestic

currency by foreign agents



Exports



Capital inflows



Number of units of

domestic currency traded

Change in value of

exports

9
What is the effect on Imports?
IF EXCHANGE RATE DID NOT MOVE
o



Supply of domestic currency by
Exchange rate

domesti
c agents




Imports




Capital outflows



e


Demand for domestic

currency by foreign agents



Exports



Capital inflows



Number of units of

domestic currency traded


Change in value of
imports

10
What is the effect on Imports?
foreign goods become more competitive

BUT EXCHANGE RATE ADJUSTS
o



Supply of domestic currency by
Exchange rate

domestic agents




Imports

e




Capital outflows



e


Demand for domestic

currency by foreign agents



Exports



Capital inflows



Number of units of

domestic currency traded

Change in value of

imports

11
Strategy for FX market

• So far, we have only talked about exports and
  imports
• What about effects on capital flows?
• (Due to interest rate effects)

12
Economic Activity and Exchange Rates

• (how does e react to a recession?)(adverse
  demand shock)

Ex Singapore goods improve in quality

DEMAND EFFECT



Supply of domestic currency by
Exchange rate

domestic
agents




Imports




Capital outflows



e


Demand for domestic
currency by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


13
Recession and International Trade
Less income therefore demand for imports drops
Ex Singapore goods improve in quality


Supply of domestic currency by
Exchange rate

domestic
agents




Imports




Capital outflows



e


Demand for domestic
currency by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


?Upwards pressure on exchange rate
14
Recession and International Capital Flows
Recession downwards pressure on domestic
interest rates

Supply of domestic currency by
Exchange rate

domestic
agents




Imports




Capital outflows



e


Demand for domestic
currency by foreign agents




Exports



Capital inflows



Number of units of

domestic currency traded


?Downwards pressure on exchange rate
15
Which way does Exchange Rate go?

• Response of capital flows tends to be much larger
  (and faster) than response of flows of goods and
  services (over 1 trillion in FX per day!)

Supply of domestic currency by
Exchange rate

domestic
agents




Imports




Capital outflows



e


e
Demand for domestic
currency by foreign agents




Exports



Capital inflows


Number of units of

domestic currency traded

Less imports and less

capital inflows

16
Capital Outflows?
Lower domestic interest rates should lead to
capital outflows
Ex Singapore goods improve in quality


Supply of domestic currency b
y
Exchange rate

domestic agents




Imports




Capital outflows



e


Demand for domestic
currency by foreign agents




Exports

e



Capital inflows



Number of units of

domestic currency traded


17
The Depreciation of the Yen
Capital Outflows 2001 10.3 trillion Yen (2 of
GDP)

18
Recent Evolution of Yen against the USD

It isnt the Yen appreciating, its the dollar
falling(although Jp is doing much better than
expected)
19
Recent fall of US Dollar

• Three factors
• Dollar was overvaluedTrade weighted
  index(measure of real exchange rate)
• Current-account deficit looks unsustainable
• Bush Administration has abandoned strong
  dollar policy(Snow strong means reliable)

Source Economist, 9/23/03
20
International Transmission of Business Cycles

• What is the effect of a recession for trading
  partners?
• Ex US 20 of Singapore exports
• Two Channels
• Decrease in demand
• Y C I G X IM
• Capital outflows from US gt Depreciation of US
  dollar and loss in competitiveness of
  Spore X

21
II. Monetary Policy with Flexible Exchange Rates

• In closed Economies

Real interest
LM0

rate

IS

LM1
r
0

r
1

(SR) Shift in LM curve


(increase in M/P supply)

Output

Y
Y
1

0

22
In Small Open Economies

• Interest rate is fixed (at international level
  adjustment for risk)
• Any upwards or downwards pressure on interest
  rates will lead to international capital flows
  (to re-equate the interest rates)
• Strategy to see total effect of policy
• Look at demand for domestic currency on FX market
• Look at supply of domestic currency on FX market

23
Expansionary monetary policy and Demand for
domestic currency (by foreigners)




Supply of domestic currency by

Exchange rate

domestic agents




Imports



Capital outflows


e


Demand for domestic
currency by foreign agents




Exports



Capital inflows




Fall in capital inflows (at every exchange rate
shift)


due to lo
wer domestic interest rates



Increase in exports (due to lower exchange rate
movement along the curve)


24
Expansionary monetary policy and Supply for
domestic currency (by domestic agents)



Supply of domestic currency by
Exch
ange rate

domestic agents



Imports



Capital outflows

e

Demand for domestic
currency by foreign agents



Exports



Capital inflows

Increase in capital outflows due to lower
r


increase in imports due to higher
Y

Reduction in imports (due to lower exchange rate)

25
Expansionary monetary policyin Small Open Economy

• Depreciation of exchange rate
• Increase in Net Capital Outflows
• Improvement in Trade Balance
• (Recall an increase in net capital outflows
  requires a improvement in the trade balance S
  I NX )

26
Monetary Policy is strengthened by flexible
exchange rates

• Ex expansionary policy

(3) reduction in AS due
AS


(lower
e
)
to
lower
e
(imports)

AS

P
2

(2) Increase in AD due
to lower
e
(exports)

P
1

AD

(lower
e
)
P
0

AD

(exp. Mon. policy)
AD

Y
Y
Y
Output

1

2

0

(1) Increase in AD due
to lower interest rates

27
2000-2002 Why did USD appreciate when Fed Funds
Rate was cut?
28
2000-2002 Why did USD appreciate when Fed Funds
Rate was cut?

• Greenspan Effect confidence in a US Soft
  landing
• Fall in interest rates interpreted as brighter
  future for US (capital inflows)
• Flight to quality
• Fear of US stock market crash contagion to
  other markets internationally
• Investors thus seek safer assets (safest asset
  US Tbills)

29
Reversal of Fortunes
Confidence matters
30
III. Fiscal Policy with Flexible Exchange Rates

• In closed Economies

IS1
Real interest
LM

rate

IS0

r
1

r
0

Output

Y
Y
0

1

31
Expansionary Fiscal Policy ? Interest rates
increase
Supply of domestic currency
by domestic agents

Exchange rate



Imports



Capital outflows

e

Demand for domestic currency
by foreign agents



Exports



Capital inflows

Number of units of
domestic currency traded

32
Expansionary Fiscal Policy ? Consumption increases
Supply of domestic currency
by domestic agents

Exchange rate



Imports



Capital outflows

e

Demand for domestic currency
by foreign agents



Exports



Capital inflows

Number of units of
domestic currency traded

33
Final Effect financial flows dominate
Supply of domestic currency
by domestic agents

Exchange rate



Imports



Capital outflows

e


new
e

Demand for domestic currency
by foreign agents



Exports



Capital inflows

Number of units of
domestic currency traded

34
Fiscal policy is weakened by flexible exchange
rates

• The extra government spending led to an increase
  in AD
• However, the higher resulting interest rates
  increase net capital inflows, which crowds out
  net exports
• NOTE
• Monetary policy domestic demand and net export
  effects worked in same direction
• Fiscal policy contradictory effects

35
Summary Session 13

• Recessions lead to large capital outflows, which
  leads to a depreciation of the exchange rate
  despite an improvement in the trade balance
• International capital flows increase the
  effectiveness of monetary policy and decrease the
  effectiveness of fiscal policy (because of their
  response to interest rates)
• International transmission of Business Cycles
• Trade effects through lower demand for domestic
  product
• Competitiveness effects through relative
  appreciation of currency
• US economy is a special case (confidence
  matters)
• Greenspan effect lower interest rates signal
  future strong growth
• Flight to quality US government bonds are the
  safest assets