dvhchapte12

8/7/2019 DVHCHAPTE12

1/18

1

R

y

R2

R1

y1

A

B

y2

BP1

BP2

C

IS(y1

)*

IS(y2)*

R*

y*

A

B

C

R1*

R2*

BP1*

BP2*

LM*

y1* y

2*

IS*(g1, y

1)* IS*(g

2, y

2)*

IS*(g2, y

1)*

LMM1

P1

( )( )LM

M2

P1

The Effects of a Foreign Fiscal Expansion i.e. how doesforeign fiscal policy affect the domestic economy?

Foreign Economy: An increase in foreign government spending shifts the foreign IS curve

rightward (point Bappreciation of foreign currency), causing an increase in the foreigninterest rate and inducing a flow of financial resources from the domestic nation to the

foreign nation (BP shifts up to BP2 ). The rise in foreign income raises imports (IS shifts

back to Point C from B)

Domestic Economy: To keep the domestic currency from depreciating (with CO), thedomestic Central Bank must sell foreign exchange reserves (FER). If the interventions are

unsterilized, they cause the domestic money stock to decline and the LM schedule to shiftleftward (point B). If the rise in domestic exports caused by the rise in foreign real income(

since EX =f (y*)) (point B to point C) is insufficient to offset the decline in domesticinvestment caused by the higher domestic interest rate, then domestic real income falls.

IDEA: This is an example of a beggar-thy-neighbor effect (the foreign economysgrowth hurts the domestic economy)

Domestic Economy Foreign Economy


2/18

2

R

y

R2

R1

y1

A A

B

BP

IS

R*

y*

R1*

y1*

BP*

IS*

LMM1

P1

( )( )LM M2P1

LM *

The Effects of a Domestic Monetary Expansion i.e. howdoes domestic monetary policy affect the foreign economy?

Domestic Economy: An increase in the domestic money stock causes the LM schedule to

shift rightward (point B), which pushes down the domestic interest rate and induces a flowof financial resources from the domestic nation to the foreign nation (BP curve shifts down

to maintain UIP). To keep the domestic currency from depreciating, the domestic CentralBank must sell foreign exchange reserves (FER). If the interventions are unsterilized, they

cause the domestic money stock to decline and the LM schedule to eventually shift leftward

to its original position (from Point B back to C).

IDEA: This implies that the domestic Central Banks policy of a fixed exchange rate

insulates the foreign economy from the effects of domestic policy actions.

Domestic EconomyForeign Economy

Ms

FER


3/18

3

R

y

R2

R1

y1

A

B

y2

BP1

BP2

C

IS(g1,y1)*

IS(g2,y1)*

IS(g2,y2)*

R*

y*

R1*

R2*

y1* y

2*

A

C

LM*

IS*(y2)

IS*(y1)

BP1*

BP2*

LM

M1P1( ) ( )LM M

2

P1

The Effects of a Domestic Fiscal Expansion i.e. how does domesticfiscal policy affect the foreign economy?

Domestic Economy:An increase in domestic government spending shifts the

domestic IS curve rightward (B), causing an increase in the domestic interest rate and

inducing a flow of financial resources from the foreign nation to the domestic nation

(the BP shifts up to maintain UIP). To keep the domestic currency from appreciating,

the domestic Central Bank must purchase foreign exchange reserves (FER). If theinterventions are unsterilized, they cause the domestic money stock to increase and theLM schedule to shift rightward (Point C). The rise in foreign real income cause an

additional rightward shift of the domestic IS curve (from B to C).Foreign Economy: The increase in foreign exports due to the rise in domestic real

income causes the foreign IS curve to shift rightward (Point C).

IDEA: Domestic income growth due to domestic fiscal expansion complementsforeign economic growth:Note the interdependence of economies via export growth

g or t

FER ex* = f(yto y2)ex=f(y*toy2


4/18

4

Chapter 12Economic Policy with Floating Exchange Rates

The Effects of Exchange Rate VariationBP=f{ RH, S (+), YF(+), PF (+),PH(-), ProfitF (-), ProfitH(+), RF (-), xa (-)}:xa

home currency depreciation. Note: RH is a non-shift variable in thisexpression. Note: the accompanying signs relate to the direction of the shiftin the BP curve; + fora rightward shift/- for leftward shift

1. Before we consider the impact of monetary and fiscal policyactions, we must consider how changes in the exchange rate(S) affect the IS-LM-BP framework.

2. A depreciation (S) stimulates a rise in the expenditures on thenations aggregate autonomous expenditures and the IS curve

shifts to the right.3. A depreciation (S) causes the BP schedule to shift to the right

or down in case of perfect capital mobility.


5/18

5

Floating Exchange Rates

4. When policymakers decide to peg the exchange rate (fixedrate as in Chapter 11), the Central Bank shoulders twoburdens. (1)First, it must be willing to intervene in theforeign exchange mark by buying or selling foreign exchangereserves. (2) Second, it must decide if it will sterilize (sell

DC if FER increased or buy DC if FER decreased).5. By permitting the exchange rate to float, a Central Bank

relieves itself from these burdens.

6. The are, however, consequences for the potency (effectiveness) ofmonetaryand fiscal policyactions.


6/18

6

The Effects of a Currency Depreciation on the IS

Schedule

R

y1

A

y

BR1

y2

IS(S1)

IS(S2

)

A decline in the value

(depreciation) of a nations

currency from S1 to S2 makesimports more expensive for anations residents and, at the

same time, the nations export

goods become less expensive for

foreign residents. Together, these

effects cause an increase in thenations aggregate autonomousexpenditures (increase in AD) at

any given nominal interest rate,

the real income level consistent

with an incomeexpenditure

equilibrium increases from y1 atpoint A to y2 at point B.Consequently, the ISschedule

shifts rightward.

Depreciation

Depreciation shifts the IS curve


7/18

7

The Effects of a Currency Depreciation on the BPSchedule

R

y

AR1

BP(S1)BP(S

2)

B

y1

y2

1. At a given real income

interest rate combination,

such as at point A, anincrease in the exchange rate

from S1 to S2 (depreciation)

results in an improvement inthe trade balance.

2. Re-attainment of balance-of-

payments equilibrium requiresan increase in the nations real

income to a level such as y2,

which generates a sufficientincrease in import

expenditures to return thetrade balance to its previous

level.

4. Hence, point B lies on the

scheduled denoted BP(S2),which implies that a currency

depreciationcauses the BP schedule

to shift to the right.

depreciation, S

S1 : $1.9795/;

S2 : $2.00/

Contrast:1. In Chapter 11, a disequilibrium inBOP lead to (a) changes in MS and (b) shifts in the

LM curve.

2.In diagrams that follow a disequilibrium in the FX

market leads to (a) changes in S (cause

changes in EX and IM assuming M-L

conditions are met) and (b) shifts of the BPcurve


8/18

8

The Effects of an Increase in the Money Stockwith a Floating

Exchange Rate

R

y

R

y1

A

y

B

R2

R1

y2

IS(S1)

BP(S1) BP(S

2)

IS(S2)

BP(S1)

C

y3

R3

R2

R1R3

y1

A

B

y2

IS(S1)

IS(S2)

C

y3

BP(S2)

LMM1

P1

( )( )LM M2P1

LM

M1

P1( )( )LM M2P

1

An increase in the money stock causes the LMschedule to shift rightward to

point B. Because point B lies below and to the right of the BP(S1) schedule,there is a balance-of payments deficit at point B in both panels. The (i)

rise in import spending and (ii) acquisition of foreign financial assets by the

nations residents (CO) and (iii) the reduction in export spending andacquisition of domestic financial assets by foreign citizens causes the home

currency to depreciate, so the exchange rate rises from S1 to S2. As a result, the

IS (sinceEX, IM) and BPschedules shift rightward. At the final equilibriumpoint C, balance-of-payments equilibrium is re-attained in both panels.

Idea:With flexible rates, monetary policy is effective regardless of capital

mobility.

Assume M-L conditions

are met


9/18

9

The Effects of an Increase in Government Spendingwith a Floating Exchange

Rate

C

B

R

y

R

y1

A

y

R2

R1

y2

LM

IS1(g

1,S

1) IS

1(g

1,S

1)

IS2(g

2,S

2)

IS1(g

2,S

1)

BP(S1)BP(S

2)

BP(S1)

BP(S2)

IS1(g

2,S

1)

C

y3

R3

y1

R2

R1

y2y3

R3

IS2(g

2,S

2)

A

B

LM

In both panels, an increase in government expenditures causes an initial rightward shift

in the ISschedule, which leads to an increase in the equilibrium nominal interest rateand an increase in equilibrium real income (Point B).

In panel (a), in which the relatively steep slope of the BPschedule implies low capital

mobility, greater import spending more than offsets a small capital inflow in causing a

balance-of-payments deficit to arise at point B. This induces a currencydepreciation (S) that shifts both the ISand BPschedules to the right, leading to a

final equilibrium with a balance-of-payments equilibrium at point C.In panel (b), in which the relatively shallow slope of the BPschedule implies high

capital mobility, significant capital inflows more than offset greater import expendituresin causing a balance-of-payments surplus to occur at point B. This induces a currency

appreciation (S) that shifts both the ISand BPschedules leftward, leading to a finalbalance-of-payments equilibrium at point C.


10/18

10

The Effects of an Increase in the Money Stockwith a Floating Exchange Rateand Perfect Capital Mobility

R

y1

A

y

BR2

R1

y2

IS(S1)

IS(S2)

BP

C

y3

LMM1

P1

( )( )LMM2

P1

1. If there is perfect capital

mobility under a floatingexchange rate, an increase in the

amount of money in circulationcauses a rightward shift of the

LMschedule along the IS

schedule, from point A to point

B, which induces a decline in thenominal interest rate that leads,

in turn, to large capital outflows(CO)

2. The resulting balance-of-

payments deficit causes the

nations currency to depreciate(S).

3. This results in higher exportspending (by foreigners) and

lower import expenditures (by

domestic residents), so the IS

schedule shifts rightward to afinal equilibrium at point C.


11/18

11

The Effects of an Increase in Government Spendingwith a Floating ExchangeRate and Perfect Capital Mobility

LM

R

y

R2

R1

y1

A

B

y2

IS(g1,S

1) =IS(g

2,S

IS(g2,S

1)

BP

1. If there is perfect capital

mobility under a floating

exchange rate, an increase ingovernment expenditures shifts

the ISschedule rightward along

the LMschedule, from point Ato point B.

2. The resulting rise in the

nominal interest rate inducescapital inflows (CI)that lead to

a balance-of-payments

surplus that causes a currency

appreciation(S)

3. Consequently, export spending

declines (by foreigners) andimports expenditures increase

(by domestic residents), causing

the ISschedule to return to itsoriginal position at point A.

Idea: Fiscal Policy is ineffective under floating rates and perfect capital mobility

(contrast:fiscal policy was effective with fixed rates and perfect capital mobility inCha ter 11

Initial G

S


12/18

12

The Effects of a Domestic Monetary Expansion in the Two-

Country Model with a Floating Exchange Rate

R

y

R2

R

R1

y1

A

B

y2

y

BP1

BP2

C

IS(S1,y

1)*

IS(S2,y

1)*

IS(S2

,y2

)*IS*(S

1,y

1)

IS*(S2,y2)IS*(S

2,y

1)

R*

y*

R1*

R2*

y1*y

2*

A

C

LM*

BP1*

BP2*

LMM1P1( )( )LMM2

P1

Domestic: An increase in the domestic money stock shifts the domestic LMschedule

rightward in panel (a). The resulting decline in the domestic interest rate causes financial

resources to flow from the domestic country to the foreign country, thereby causing the

domestic currency to depreciate. The rise in the equilibrium exchange rate from S1 to S2induces a rise in net expenditures on domestic output (Point C) and a decline in net

spending by foreigners on H output (fall from C to C), so on net the domestic ISschedule shifts rightward in panel (a). At C, domestic income is higher.

Foreign: The foreign ISschedule shifts leftward in panel (b). At the final equilibrium

points labeled points C, foreign real income is lower. Thus, the domestic monetary

expansion has a beggar-thy-neighbor effect on the foreign country.

Domestic Economy

Foreign economyS reduces FsExports (Hsimports) to H

S

raises

Hs

exports

(but

IM) toF

EX (y* falls

to y2* )IM(y rises to

y2)

Rise in Fs EX

as H grows toy2

CS


13/18

13

The Effects of a Domestic Fiscal Expansion in the Two-Country Model with a

Floating Exchange RateR

y

R2

R

R1

y1

A

B

y2y

BP1

BP2

C

LM

IS*(S2,y

2)

IS*(S1,y

1)

R*

y*

R1*

R2*

y2*y

1*

A

C

LM*

BP1*

BP2*

IS(g1,S

1,y

1)*

IS(g2,S

2,y

2)*

IS(g2,S

1,y

1)*

Domestic:An increase in domestic government expenditures causes the domestic IS

schedule to shift rightward in panel (a). The resulting increase in the domestic interestrate induces an inflow of financial resources from the foreign country that causes an

appreciation of the domestic currency (S). The fall in the equilibrium exchange rate

from S1 to S2 induces a reduction in net expenditures on domestic goods and servicesplus (EX, IM) , which causes the domestic ISschedule to shift leftward in panel (a)but

Foreign: S (EX*, IM*)causes an increase in net spending on foreign goods andservices, which causes the foreign ISschedule to shift rightward in panel (b). At points

C, the equilibrium levels of real income in the two nations are higher than their initial

values, so the domestic fiscal expansion has a locomotive effect on the foreign country.

S

G

SEX*=IM,

IM*=EX


14/18

14

Exchange rate Volatility under Floating

Exchange Rates

DollarValueIndex

140

1979

1981

1983

1985

1987

1989

1991

1993

1995

120

100

80

60

1997

1999

2001

2003

2005

2007

Since the last years of theBretton Woods system of fixed

exchange rates, the dollarsvalue has exhibited several

periods of variability. Thevariability was most

pronounced during the 1980.


15/18

15

The Effects of a Decline in Aggregate AutonomousExpenditures in ROWon the Domestic Economy.

R

y

R2

R1

y1

B

y2

A

LM

IS(y2)*

IS(y1)*

A decline in real income in the rest of theworld, from y*1 to y*2, causes foreignresidents to reduce their expenditures on

domestic exports, resulting in a fall indomestic aggregate autonomous

expenditures and a leftward shift in the IS

schedule. Consequently, equilibriumdomestic real income declines from y1 atpoint A to y2 at point B, which indicates

that volatility in real income in the rest ofthe world results in domestic real income

instability.

Idea: Increasing interdependence (globalization)

implies that our well-being (in terms of income

& employment) is partly linked to events in the

ROW!

Note: Without foreign effects,

domestic income falls.


16/18

16

Domestic Real-Income Stabilityin the Face of a Decline in AggregateAutonomous Expenditures in ROWwith Perfect Capital Mobility

R

y

R2

R1= R*

y1

A

B

y2

BP

C

y

IS(y2)*

IS(y1)*

R

y

R2

R1=R*

y1

A

BBP

y

LM

IS(y2,S1)*

IS(y1,S

1) = IS(y

2,S

2)* *

LMM1

P1

( )( )LMM2

P1

Panel (a) shows that a fall in foreign real income with a fixed exchange rate causes the

domestic ISschedule to shift leftward. The resulting domestic balance-of-payments

deficit at B places downward pressure on the value of the nations currency. To keep

the exchange rate fixed, the central bank must reduce the money stock (sell FER) andshift the LMschedule leftward. This yields a final equilibrium at point Cin panel (a) and

reinforces the real income effect of the fall in foreign real income. Panel (b) indicatesthat under a floating exchange rate, the fall in foreign real income (point B) causes the

equilibrium exchange rate to rise from S1 to S2 (depreciation) , which induces a rise in

(EX but IM and hence improvement in CA) net export spending and a rightward

shift in the ISschedule. Hence, real income is more stable under a floating exchangerate as compared with a fixed exchange rate.

Fixed Rates ala Chapter 11 Flexible Rates ala Chapter 12

AAE

FER

AAE

S


17/18

17

The Effects of a Rise in the Demand for Real MoneyBalances

R

R1

R2

M1

P1

M

P1

R

y

A

IS

C

LM1M1

P1

( )

y1

y2

A

B

C

B

( )LM2

M1

P1

S

1

m (y2)

d

2

m (y1)

d

2

m (y2)d

1

R1

R2

m MP

RR

A rise in the demand for money caused by any factor other than an increasein real income causes an increase in the equilibrium nominal interest rate,

from R1 in panel (a) to R. At the initial level of real income, new realincomeinterest rate combination that maintains money market equilibrium,

given by point B in panel (b), lies above the initial combination given bypoint A. Thus, an increase in the demand for real money balances not

stemming from a rise in real income generates an upward and leftward shiftin the LMschedule. Thiscauses equilibrium real income to decline to y2 in panel (b),which inducesa leftward shift in the money demand schedule in panel (a). The net effect

is a rise in the equilibrium interest rate and a decline in equilibrium realincome. Recall: Md =f [R(-),R*(-), P (+), W(+)]

Md

Excess MsAs y falls

from y1 toy2,M

d falls

too.

Note:Md Ms


18/18

18

Real-Income Stability in the Face of a Rise in the Demand for Real MoneyBalances

R

R1= R*

R2

R

y

LM1M1

P1( )

y1

y3

y2

y1

y

A

B

( )LM2M1

P1

LM1

M1

P1( )= LM

2

M2

P1( )

( )LM2M1

P1

y

IS

BP R1 = R*

R2

A

C

B

IS(S1)

BP

IS(S2)

In panel (a), a rise in the demand for real money balances under a fixed exchange rate

causes the LMschedule to shift leftward. The resulting rise in the domestic interestrate causes a capital inflow (CI). To keep the exchange rate fixed, the domestic central

bank must purchase foreign assets (FER), which leads to a rise in the domestic

money stock and causes the LMschedule to shift back to the right. In panel (b), themovement to point B (incipient BOP surplus) caused by a rise in the demand for real

money balances with a floating exchange rate leads to a decline in the equilibrium

exchange rate from S1 to S2 (S). As a result, there is decline in net export

expenditures that causes the ISschedule to shift leftward to the final equilibrium

point C. At this point, real income is below the initial equilibrium income level, so real

income is less stable in the face of money demand variations undera floating exchange rate.

Fixed Rates ala Chap. 11 Floating Rates- ala Chap. 12

Initial Ms or

Md

S

S

Initial Ms or Md

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