Chapter 26

Economic Policy in the Open Economy: Flexible Exchange

Rates

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

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.)

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.

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

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)

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

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.

Fiscal policy

• Let’s 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.

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.

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.

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.

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)

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.

Fiscal policy: graphical analysis

IS

IS’

IS’

IS = IS”

IS’

IS

IS’

IS

BP

LMLM

LM LMi

BP

BP

BP

Y

ii

i

Y

Y

Y

BP’

BP’

BP’

Y0Y2

Y0Y0

Y0

i2

Y2 Y2

IS’’

i2

i0

i0

IS’’

IS’’

i2

i0i0

You do:

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

Fiscal policy: Canada’s 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.

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.

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.

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.

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.

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.

Monetary policy: graphical analysis

IS

IS’

IS’IS

IS’

IS

IS’

IS

BP

LM’

LM’ LMLM

LM

LM’LM

LM’

i

BP

BP

BP

Y

ii

i

Y

Y

Y

BP’

BP’BP’

Y0 Y2

Y0Y0

Y0

i2

Y2 Y2

Y2

i0i2

i2

You do:

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

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.

Fiscal and monetary policy coordination

• However, in all cases but perfectly mobil 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

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.

Fiscal policy only

Y0 YFP Y*

i0

Y

iFPi*

IS

BP

IS’FP

ISFP

BPFP

LMi

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.

Monetary policy only

Y0 YMP Y*

i0

Y

iMP

i*

IS

BP

IS’MP

BP’MP

LMLMMP

i

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.

You do: What combination of fiscal and monetary policy will reach

(Y*,i*)

Y0 Y*

i0

Y

i*

IS

BP

LMi

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

Foreign price shock

Y0

i0

Y

IS

BP

IS

LM

BP

i

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.

Foreign price shock

• Think about….

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

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

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)

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)

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.

Domestic price shock

Y0

i0

Y

IS

BP’

IS’

LM

BP

LM’

i

You do:

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

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)

Foreign interest rate shock

• The new BP curve is now out of sync with the internal equilibrium (IS=LM)

• 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)

Foreign interest rate shock

Y0

i0

Y

IS

BP’’

IS’

LM

BP

BP’i

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.

Foreign interest rate shock

Y0

i0

Y

IS

BP’’

IS’

LM

BP

BP’i

LM’

You do:

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

Shock to expected exchange rate• If the foreign currency is expected to rise in

value, thenid – if < xa or

id < 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.

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.

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.

International Policy Coordination

• Read boxes 3 and 4 of the text.• Five areas of concern for policy coordination

are (Bergsten and Henning, 1996):

1. world growth and stability

2. exchange rates

3. current account imbalances

4. the stance of G-7 members toward other countries

5. the design of international financial economic system

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

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.