ec202a macroeconomics handout 2 laura povoledo the university of reading

EC202A Macroeconomics

Handout 2

Laura Povoledo

The University of Reading

2002-2004 University of Wisconsin


The IS-LM-BP model

Reading material that you may find useful: Abel, Bernanke and McNabb, Chapters 5 and 14. Abel, Bernanke, 5th ed, Chapters 5 and 13. Dornbusch, Fisher and Startz, 9th ed, Chapter 12.Begg, Fischer an Dornbusch, 7th ed, Chapters 28 and 29.


Outline:

The Goods Market Equilibrium in an Open Economy ;The open-economy IS curve ;The Balance of Payments and Capital Flows ;The BP curve ;The Mundell-Fleming model .


The Goods Market Equilibrium in an Open EconomyEconomies are linked internationally through two main channels: trade in goods and services; international financial markets.

First, lets consider the effects of trade with the rest of the world on the goods market equilibrium and then well understand how to modify the IS curve.


The Goods Market Equilibrium in an Open EconomyPreviously, we have seen that the goods market equilibrium condition can be expressed in two ways:

1) National saving equals investment:S = I (1) Closed economy Equation2) Aggregate supply equals aggregate demand:Y = C + I + G (2) Closed economy Eq.


The Goods Market Equilibrium in an Open EconomyWhat changes in an open economy? National saving now has two uses:increase the nations capital stock by domestic investment;increase the stock of net foreign assets by lending to foreigners.

We capture this by re-writing the equilibrium condition (1) in the following way:S = I + CA = I + NX + NFP(1) Open economy Eq.Change no. 1


The Goods Market Equilibrium in an Open Economy

Eq. (1) shows the uses of savings in an open economy. Investment I is accrued to the domestic capital stock. The current account balance CA indicates the amount of funds that the country has available for net foreign lending.

Hence, Eq. (1) states that in goods market equilibrium in an open economy, the amount of national saving S must equal the amount of domestic investment I plus the amount lent abroad CA.


The Goods Market Equilibrium in an Open EconomyThe closed economy equilibrium condition (1) is a special case of the open economy equilibrium condition (1), with CA =0.Change no. 2What else changes in an open economy? Domestic spending on goods and services is no longer equal to domestic output. This happens because:Part of domestic output is sold to foreigners (exports);Part of spending by domestic residents purchases foreign goods (imports).


The Goods Market Equilibrium in an Open EconomyWe can also re-write the equilibrium condition (2) - aggregate supply equals aggregate demand for an open economy.

The main change is that domestic spending no longer determines domestic output. Instead, spending on domestic goods determines domestic output.

Define: A = spending by domestic residentsThen:A = C + I + G


The Goods Market Equilibrium in an Open EconomySpending on domestic goods is total spending by domestic residents less their spending on imports plus foreign demand or exports.

Therefore:

Where:

X = exports; Q = imports.

Spending on domestic goods = A + NX = = C + I + G + X Q = Domestic outputNote:A is also called absorption.


The Goods Market Equilibrium in an Open EconomyIn order to obtain an equilibrium condition, we write:

Y = C + I + G + NX (2) Open economy EquationEq. (2) states that in goods market equilibrium in an open economy, the supply of domestic goods Y is equal to spending on domestic goods, A + NX.


The Goods Market Equilibrium in an Open EconomyWhat affects net exports NX?

Foreign output YF (higher foreign output increases X and NX)

Domestic output Y (higher domestic output increases Q and decreases NX)

The real exchange rate (higher means more exports and less imports)


The open-economy IS curveThe IS curve shows the possible combinations of the interest rate r and domestic output Y, for which the goods market is in equilibrium.

In the closed economy, the IS curve can be written as:

Meaning: the goods market is in equilibrium when aggregate supply is equal to aggregate demand for goods. Consumption depends on Y, investment depends on r. We draw the IS line (goods market equilibrium condition) in the (r, Y) plane.Y = C (Y) + I(r) + GAS = AD


The open-economy IS curveIn the open economy, the goods market equilibrium condition becomes:

Or simply:

AS = ADY = C (Y) + I(r) + G + NX(YF , Y, ) Y = C (Y) + I(r) + G + NX(Y) IS(r, Y)Output, YrThe slope of the IS depends on size of multiplier and the elasticity of investment to domestic interest rate (which is negative, hence the negative slope of the IS).


The open-economy IS curveThe IS curve is shifted by changes in G, YF and the real exchange rate (we are assuming that prices are fixed). If then If then If there is a real appreciation then rYISYF XADG NX


The open-economy IS curve If then If then If there is a real depreciation then rYISYF XADG NXNote: above the IS line AS > AD (aggregate supply > aggregate demand).Below, AS < AD.


LM - Money market equilibrium in the open economyLMYrMD > MSMD < MSLM slope depends on elasticity of money demand with respect to interest rates: if the latter is low then LM is steep.LM is upward sloping because if income increases money demand increases and the interest rate must increase as well.The money supply is affected by changes in eNOM under fixed exchange rates, hence the LM shifts if eNOM is different from the target level eNOM*. Under floating exchange rates, the LM is not affected by eNOM.


The Balance of Payments and Capital FlowsThe Balance of Payments (from now on, BP) is the record of transactions between one country and the rest of the world.

The two main accounts in the BP are the current account and the capital account:

The current account records trade in goods, services, and transfer payments.The capital account records the trade in assets.

Balance of PaymentsCurrent AccountCapital Account


The Balance of Payments and Capital FlowsBalance of payments accounts = The record of a countrys international transactions.

Any transaction that involves a flow of money into the UK is a credit item (enters with a plus sign).

Any transaction involving a flow of money out of the UK is a debit item (enters with a minus sign).


The Balance of Payments and Capital FlowsThe overall BP surplus or deficit is the sum of the current and capital account surpluses or deficits:

Since residents of a country must pay for what they buy abroad, any current account deficit must be necessarily financed by an offsetting capital flow:

BP = CA + KABP = CA + KA = 0Balance of Payments equilibrium


The Balance of Payments and Capital FlowsBut what are the economic forces that affect the BP? To answer this question we must look at each separate component of the BP.

For convenience we divide the current account into 3 components:

Investment income from abroadNXNTNFPNet exports of goods and servicesNet unilateral transfersCANote: NFP (Net factor payments) is almost (but not always) equal to Investment income from abroad. Why?


The Balance of Payments and Capital FlowsIn general, NFP and NT are not much affected by current macroeconomic developments. From now on, we assume them to be equal to 0 for simplicity.

We write: CA = X(YF, ) - Q(Y, ) Net exports depend on: real exchange rate the level of domestic income Y the level of foreign income YFWhat determines CA = NX ?


The Balance of Payments and Capital Flows A rise in foreign income increases exports: A real depreciation improves net exports: A rise in domestic income increases imports:So the CA is a function of 3 variables:

The real exchange rate measures a country's competitiveness in foreign trade. If prices stay fixed then eR and eNOM (real and nominal exchange rate respectively) always move in the same direction.YF CA Y CA CA CA(YF , Y, )


The Balance of Payments and Capital Flows

Again, we look first at the separate components.

It is often useful to split the capital account into two separate components: (1) the transactions of the countrys private sector and (2) official reserve transactions, which correspond to the central bank activities:What about the KA ?KANet private capital inflowsOfficial reserve transactionsNPKIORT


The Balance of Payments and Capital FlowsPrivate residents selling off assets abroad or borrowing abroad.Example: a current account deficit (CA < 0) can be financed in two ways:The central bank sells foreign currency and buys home currency.Exercise: what are the implications of the two options above for the capital account KA?


The Balance of Payments and Capital FlowsNPKI depends on: the interest rates differential: (r rF) the expected depreciation of the currency: E eNOM/eNOMBut what affects KA?ORT depends on the choice of exchange rate regime: fixed and floating exchange rate system.Since the role of ORT is better understood in relation to the adjustment process, we write KA as a function of (r rF) and E eNOM/eNOM:

KA(r rF, E eNOM/eNOM)Answer:


The Balance of Payments and Capital FlowsThe sensitivity of KA to changes in interest rate differentials is a crucial issue, since it depends on the degree of capital mobility.

Three cases are possible (partial derivatives):

No capital mobilityImperfect capital mobilityPerfect capital mobility


The Balance of Payments and Capital FlowsExplanation: If capital is assumed to be perfectly mobile, investors in one country can trade assets with investors in any other country without restrictions, that is, at low transaction costs and in unlimited amounts, in search of the highest yield or the lowest borrowing costs.

As a result, under perfect capital mobility interest rates in one country cannot differ from the interest rates in other countries without infinite capital flows taking place.In practice, capital controls and transaction costs dampen the sensitivity of KA to changes in interest rate differentials.But as the world economies become more and more integrated, perfect capital mobility becomes increasingly the reality.


The BP curveWe are now ready to write the BP equation:

This equation shows the BP equilibrium condition as a function of 6 macroeconomic variables.

The next task is to obtain a diagram on the (r, Y) plane that represents all the possible combinations of the domestic real interest rate r and domestic output Y, for which the above equation BP = CA + KA = 0. We call this line the BP curve/line.BP = CA(YF , Y, )+ KA(r rF , E eNOM/eNOM) = 0


The BP curveIn the (r, Y) plane the balance of payments becomes a function of the domestic real interest rate r and domestic output Y only:

The slope of the BP line depends on the degree of capital mobility.BP(r, Y)Output, YrChanges in YF , rF, and E eNOM/eNOM shift the BP curve.


The BP curveThe level of r does not affect the BP since KA = 0 always (only private KA). As a result, there is only one level of Y such that CA = 0 and the BP is in equilibrium.Case 1: No capital mobilityrYBPNote: in the case of no capital mobility, the BP line corresponds in practice to the condition that the Current Account is in balance.To the left of the BP line, BP > 0 .To the right , BP < 0 .


The BP curveBP is upward sloping because if Y rises, there will be an increase in imports leading to a deficit in the CA, and (to balance this with a surplus in the KA) r must raise to attract more capital.Case 2: Imperfect capital mobilityrYBPNote: in the case of imperfect capital mobility, the BP line corresponds to the condition that the Current Account surplus/deficit is exactly offset by Net Private Capital Inflows.Above the BP line BP > 0 .Below, BP < 0 .


The BP curveIf capital can instantaneously move, the only level of r that ensures the equilibrium in the KA is rF . Y can be at any level because the KA dominates over the CA . Case 3: Perfect capital mobilityrYBPrFAbove the BP line BP > 0 . Below, BP < 0 .The different ways in which a BP imbalance is corrected depend on the choice of exchange rate regime, fixed or floating.Note: in the case of perfect capital mobility, the BP line corresponds to the condition that Net Private Capital Inflows (or outflows) not be infinite.


The BP curve If then If then If there is an expected nominal depreciation then Shifts in the BP curverYBPChanges in YF , rF, and E eNOM/eNOM shift the BP curve.YF XrF KAKANote 1: changes in YF do not affect the BP curve under perfect capital mobility. (Why?)


The BP curve If then If then If there is an expected nominal appreciation then Shifts in the BP curverYBPChanges in YF , rF, and E eNOM/eNOM shift the BP curve.YF XrF KAKANote 2: changes in rF, and E eNOM/eNOM do not affect the BP curve if there is no capital mobility. (Why?)


The Mundell-Fleming modelBPYrISLMThe graphical analysis that extends the IS-LM model to the open economy under the assumption of perfect capital mobility is called the Mundell-Fleming model.This model is used to explore the effects of fiscal and monetary policies under both fixed and flexible exchange rate systemsIt can also be extended to cases other than perfect capital mobility.



Monetary Policy in the IS-LM-BP model

Reading material that you may find useful: Dornbusch, Fisher and Startz, Chapter 12 (9th ed). Begg, Fischer an Dornbusch, Chapter 29 (7th ed).


Objective of the lectures

While the IS-LM-BP model still works under the assumption that the price level is given, it nevertheless clearly establishes the key linkages among open economies: trade, the exchange rate and capital flows.

In this lecture, we want to understand how monetary policy operates in the open economy, under fixed or floating exchange rates.


Outline:

Exchange rates and the equilibrium in the Balance of Payments ;The IS-LM-BP model (revision) ;Monetary Policy under imperfect capital mobility ;Monetary Policy under perfect capital mobility ;Monetary Policy without capital mobility .


Exchange rates and the equilibrium in the Balance of PaymentsChoice of exchange rate regime:Fixed: Monetary authority has to intervene in foreign currency markets to maintain fixed nominal exchange rate eNOM ;Managed flexibility: free float but interventions to prevent excessive fluctuations ;Floating: no intervention in foreign exchange market. Can be joint floating: a group of currencies are pegged to each other, but fluctuate with respect to all the other currencies.ERM (before Euro) was joint float with adjustably pegged exchange rate band.


Exchange rates and the equilibrium in the Balance of PaymentsThe way in which the equilibrium in the balance of payments is achieved depends on the choice of the exchange rate regime and on the degree of capital mobility.Lets consider 3 cases:Fixed exchange rates, no capital mobility ;Fixed exchange rates, perfect capital mobility ;Floating exchange rates .


Exchange rates and the equilibrium in the Balance of Payments1. Fixed exchange rates Suppose initially that there are no private sector capital flows, perhaps because of capital controls.Without capital mobility, a current account deficit (CA < 0) can only be financed by the Central Bank.The Central Bank sells foreign exchange and buys domestic currency. As a result, domestic money in circulation falls, as pounds disappear back into the Bank of England. This is called unsterilized intervention. Forex reserves fall to restore the equilibrium in the BP.


Exchange rates and the equilibrium in the Balance of PaymentsAnother possibility is sterilized intervention. This happens when the Central Bank (to offset the fall in domestic money supply) buys domestic bonds thereby restoring the domestic money supply.Both sterilized and unsterilized interventions restore the BP equilibrium under fixed exchange rates.However, with no long term remedial action to resolve the original reason for the CA deficit, eventually the Central Bank will run out of foreign reserves, and will be forced to adjust exchange rates.


Exchange rates and the equilibrium in the Balance of Payments2. Fixed exchange rates In the modern world, with capital mobility, international investors have more money at their disposal than Central banks, thus making the defence of exchange rates in the manner just explained futile.The Central Bank no longer defends the exchange rate by buying and selling foreign reserves. Instead, it sets domestic interest rates to provide the correct incentive for speculators.


Exchange rates and the equilibrium in the Balance of PaymentsThe Central Bank must set the correct interest rate, to eliminate one-way capital flows. This is the only option open to the Central Bank if it wishes to keep exchange rates fixed, yet faces perfect capital mobility.This interest rate, coupled with the level of income, determines money demand. Sterilisation options in this case do not work (as international capital flows will nullify them). Thus perfect capital mobility undermines monetary sovereignty.


Exchange rates and the equilibrium in the Balance of Payments3. Floating exchange rates Anything that tends to create a CA surplus (resource discovery, increase in exports,), induces an appreciation in the exchange rate. Competi-tiveness decreases and net exports fall, until the external balance (BP equilibrium) is restored.Anything that tends to create a CA deficit induces a depreciation in the exchange rate. Competitiveness increases and net exports rise, until the external balance (BP equilibrium) is restored.


Exchange rates and the equilibrium in the Balance of PaymentsWhen exchange rates float freely, there is no official intervention in the forex market and no net monetary transfers between countries since the CA and the KA (and therefore the BP) are always zero.Thus under floating exchange rates monetary sovereignty is restored.


The IS-LM-BP model (revision)Assumptions:There is one general level of prices (P), and it is fixed ;Aggregate demand (AD) is: Positively related to the level of government expenditure (G) ; Positively related to overseas output (YF), which is exogenous ; Positively related to the exchange rate (eNOM) ; Negatively related to the domestic interest rate (r) .


The IS-LM-BP model (revision)Assumptions:

Money demand (MD) is: Positively related to domestic income level (Y); Negatively related to domestic interest rate (r).Money supply (MS) is under the control of the Central Bank .Capital account is affected by the differential between domestic and foreign interest rates (r rF) and expected depreciation E eNOM/eNOM .


The IS-LM-BP model (revision)Assumptions:

Trade (or current) account (i.e. balance of goods and services) is determined by the relationship between domestic income (Y) and foreign income (YF), and by the real exchange rate


The IS-LM-BP model (revision) goods market equilibrium

Or simply:

AS = ADdY = C (Y) + I(r) + G + NX(YF , Y, ) Y = C (Y) + I(r) + G + NX(Y) IS(r, Y)Output, YrShifts occur with exogenous changes in aggregate demand, that is G, Taxes, YF, and net exports NX (which are positively influenced by eNOM and YF) IS:AS < ADdAS > ADd


The IS-LM-BP model (revision)LM(r, Y)YrMD > MSMD < MSLMMoney market equilibrium:MD(Y, r) = MSShifts occur with exogenous changes in MS MD = MS


The IS-LM-BP model (revision)BPExternal equilibrium:Shifts occur with exogenous changes in YF, eNOM and rF . BP(r, Y)YrBP = CA(YF , Y, )+ KA(r rF , E eNOM/eNOM) = 0Or simply:BP (r, Y) = 0 BP < 0BP > 0


The IS-LM-BP model (revision)Overall model diagramBPISLMMD < MSAS < ADdBP < 0MD < MSAS < ADdBP > 0

MD < MSAS > ADdBP > 0MD > MSAS < ADdBP < 0MD > MSAS > ADdBP > 0MD > MSAS > ADdBP < 0rYPoint E in the diagram represents internal and external balance, and the six regions around it are characterised by different kinds of disequilibria .E


Monetary Policy under imperfect capital mobilityUnder imperfect capital mobility, the BP is upward sloping.Alternatively, we can justify the positive slope of the BP by saying that this country is a large open economy.Large open economy = an economy large enough to affect the world interest rate.A good example of a large open economy is the US.rYBP


Monetary Policy under imperfect capital mobilityFixed exchange ratesBPISLM0rYOverall money supply is completely ineffective in stimulating output in a fixed exchange rate regime. The initial equilibrium E0 cannot be changed by changes in MS.E0LM1E1M S


Monetary Policy under imperfect capital mobilityExplanation: E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase and as interest rates fall capital outflows increase, so BP is in deficit at E1.E1 back to E0 : as the BP is in deficit, there is excess supply of the domestic currency in the international markets, and pressure to devalue, but exchange rate is fixed, so monetary authority has to intervene buying the excess (i.e. losing foreign currency reserves), and money supply MS contracts back to the original level.


Monetary Policy under imperfect capital mobilityFloating exchange ratesBP0IS0LM0rYOverall money supply is very effective in stimulating output in a floating exchange rate regime. E0LM1E1M S BP1IS1E2


Monetary Policy under imperfect capital mobilityExplanation: E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase, and as interest rates fall capital outflows increase, so BP0 is in deficit at E1.E1 to E2 : as the BP is in deficit, there is excess supply of the domestic currency in the international markets, so exchange rate depreciates, which stimulates exports and increases output: BP0 shifts to BP1 , and IS0 shifts to IS1


Monetary Policy under perfect capital mobilityCapital controls (regulations which prevent private sector capital flows) were commonplace between 1945 and 1973 but are very rare now. Under perfect capital mobility, the BP is horizontal as the domestic interest rate r must be equal to the foreign rate rF.Alternatively:Small open economy = an economy that is too small to affect the world interest rate.rYBPrF


Monetary Policy under perfect capital mobilityrYBPrFExample: assume that the world consists of only European countries (simplifying assumption, but European countries are much more integrated financially and in trade with each other than with the rest of the world).During the 1990s:France fixed exchange rateAfter introduction of the :UK = floating exchange rate /


Monetary Policy under perfect capital mobilityFixed exchange rates (France) BPISLM0rYAny attempt to change the money supply, and hence interest rates, causes an immediate capital inflow or outflow until the money supply and interest rate are restored back to the original level.E0LM1M S rF


Monetary Policy under perfect capital mobilityThus money supply is ineffective under a fixed exchange rate regime (both under imperfect and perfect capital mobility).But: graphs are not enough, it is important also to explain IN WORDS the effects of monetary policy under perfect capital mobility and fixed exchange rates.Explanation: see next page. Moreover, suppose you are Jean-Claude Trichet (Governor of the Banque de France from 1993 to 2003). A famous columnist is blaming the Banque de France for keeping interest rates too high in spite of a severe recession. What is your answer to this?


Monetary Policy under perfect capital mobilityExplanation: Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). However, any fall in interest rates will generate a massive capital outflow. The central bank must reduce the domestic money supply, to prevent a change in interest rates. As a result, the economy stays at E0.Reply to the columnist: under fixed exchange rates and perfect capital mobility, any attempt to lower the interest rate below rF is ineffective, it only depletes the foreign reserves of the central bank.


Monetary Policy under perfect capital mobilityFloating exchange rates (UK)BPIS0LM0rYUnder floating exchange rates, monetary policy is highly effective in changing output. E0LM1E1M S IS1E2rF


Monetary Policy under perfect capital mobilityExplanation: E0 to E2 : An increase in money supply shifts the LM curve to the right, so the interest rate falls while the level of output demanded increases (E1). At E1, the goods and money market are in equilibrium (at the initial exchange rate), but r has fallen below rF . The lower domestic interest rate causes an outflow of capital, which causes a currency depreciation. Because of the depreciation, competitiveness increases and the IS shifts to the right. At point E2, there is no further tendency for exchange rate to change.


Monetary Policy under perfect capital mobilityWe have shown that, under floating exchange rates, a monetary expansion in the home country leads to exchange rate depreciation, increased exports and a higher level of domestic output. But our depreciation shifts demand from foreign goods to home goods.Such a policy is known as a beggar-thy-neighbour policy, since an increase in domestic employment has been created at the expense of other countries, which now might experience higher levels of unemployment.


Monetary Policy without capital mobilityOutlawing capital flows is a measure unlikely to be taken these days.

How can we explain the effects of monetary policy under no capital mobility (fixed versus floating exchange rates)?rYBP


Monetary Policy without capital mobilityFixed exchange ratesBPISLM0rYThe expansion of MS causes the movement from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the Central Bank has to buy the domestic currency to avert the depreciation, hence MS contracts back to the original level. E0LM1M S E1


Monetary Policy without capital mobilityFloating exchange ratesBP0IS0LM0rYThe expansion of MS causes the movement from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the domestic currency depreciates. Because of the depreciation, competitiveness increases and both the IS and the BP shift to the right. E0LM1M S E1IS1BP1E2



Fiscal Policy in the IS-LM-BP model

Reading material that you may find useful: Dornbusch, Fisher and Startz, Chapter 12 (9th ed).Begg, Fischer an Dornbusch, Chapter 29 (7th ed).


Objective of the lecture

To understand how fiscal policy operates in the open economy, under fixed or floating exchange rates.

The IS-LM-BP model is our method of analysis.


Outline:

The adjustment out of equilibrium ;Fiscal Policy under imperfect capital mobility;Fiscal Policy under perfect capital mobility ;Fiscal Policy without capital mobility ;Stabilization policy .


The adjustment out of equilibrium In lecture 2, we said that the way in which the equilibrium in the balance of payments is achieved depends on the choice of the exchange rate regime and on the degree of capital mobility.In fact, the balance of payments is always in equilibrium, because in practice the capital account KA finances the current account CA imbalance:BP = CA + KA = 0

but the way in which a current account imbalance is financed depends on the choice of the exchange rate regime and on the degree of capital mobility!We now look at what this means for the adjustment out of equilibrium.


The adjustment out of equilibriumYrAssume that initially the economy is in E0 Because of a sudden fall in foreign output, the IS and the BP shift and the economy moves to E1. Because of the fall in exports, CA : how is this financed?ISLME1E0BP


The adjustment out of equilibrium Because of the fixed exchange rate regime, the Central Bank is committed to buy any excess supply of domestic currency.1. Fixed exchange rates & no capital mobilityBPYISLMrSince CA is in deficit, there is excess supply of domestic currency and excess demand for foreign currency.Foreign exchange reserves fall, generating a positive number in the KA (see Abel et al. page 156). The LM shifts to the left.Y0


The adjustment out of equilibrium 2. Fixed exchange rates & perfect capital mobility BPYISLMY0rSince the interest rate is below the world level rF , private capital flows out of the country.Private residents buy assets abroad, so the KA is in deficit too.The Central Bank must set the correct interest rate, to eliminate one-way capital flows. Contractionary monetary policy, the LM shifts to the left.rF


The adjustment out of equilibrium Because of the depreciation, competitiveness increases and both the IS and the BP shift to the right.3. Floating exchange ratesBPYISLMY0rAssume again that the CA is in deficit. Because the interest rate has fallen, the KA is in deficit too. There is excess supply of domestic currency and excess demand for foreign currency. As a result, the exchange rate depreciates.The BP goes back to 0.


Fiscal policy (foreword)The actor of monetary policy is the Central Bank.The actor of fiscal policy is the government.The tools of fiscal policy are: Government spending G ; Taxation T .In the remainder of this lecture, G indicates an expansionary fiscal policy (an increase in government spending or a fall in taxes), while G indicates a contractionary fiscal policy (a fall in government spending or an increase in taxes).


Fiscal policy (foreword)We want to determine whether a policy to stimulate output through an expansionary fiscal policy will be successful and how it will work. An expansionary fiscal policy has the effect of increasing domestic aggregate demand. The amount of the increase is determined by the multiplier (which tells us how much of this injection will be leaked out of the system in the form of savings, taxation and demand for foreign goods i.e. imports).As money demand increases with income, the increase in aggregate demand (i.e. income) will also increase money demand, and equilibrium in the money market (LM) will be restored at a higher level of domestic interest rate.What are the implications for the external (BP) equilibrium?


Fiscal Policy under imperfect capital mobilityFixed exchange ratesBPIS0LM0rYFiscal policy in a fixed exchange rate regime with imperfect capital mobility is effective in expanding domestic output, with some rise in the interest rate r.E0LM1E1G IS1E2


Fiscal Policy under imperfect capital mobilityExplanation: E0 to E1 : due to the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen. E1 to E2 : as the BP is in surplus, there is excess demand of the domestic currency in the international markets, and pressure to revalue, but exchange rate is fixed, so the central bank has to intervene (i.e. buying foreign currency reserves). As a result, the money supply increases and the LM shifts until the BP equilibrium is restored.


Fiscal Policy under imperfect capital mobilityFloating exchange ratesBP0IS0LMrYSo fiscal policy in a floating exchange rate regime with imperfect capital mobility is less effective in expanding Y , and rises interest rates r and exchange rates.E0E1G IS2IS1BP1E2


Fiscal Policy under imperfect capital mobilityExplanation: E0 to E1 : after the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen. E1 to E2 : Surplus in BP means excess demand for domestic currency and the nominal exchange rate e appreciates shift of BP0 to BP1. If prices dont change, the nominal appreciation is also a real appreciation, and exports will decrease (as they become more expensive) reducing demand the IS shifts to the left .


Fiscal Policy under perfect capital mobilityrYBPrFExample: assume that the world consists of only European countries (simplifying assumption).During the 1990s:France fixed exchange rateAfter introduction of the :UK = floating exchange rate /


Fiscal Policy under perfect capital mobilityFixed exchange rates (France) BPIS0LM0rYFiscal policy is strengthened by capital mobility because, unlike in a closed economy , the money supply must expand to keep the interest rate constant at rF. E0LM1G IS1E1rF


Fiscal Policy under perfect capital mobilityInsightFiscal policy affects the level of aggregate demand, thus causing interest rates to change. This causes a flow of capital across borders, which affects exchange rates. Therefore the central bank has to implement monetary policy to keep interest rates constant. This policy action by the central bank will reinforce the effects of the fiscal policy on output.


Fiscal Policy under perfect capital mobilityFloating exchange rates (UK)BPIS0LMrYFiscal policy is completely ineffective in stimulating output in a floating exchange rate regime. E0G IS1rF


Fiscal Policy under perfect capital mobilityExplanation: After the expansionary fiscal policy, the IS shifts to the right and the domestic interest rate rises above the level of the world interest rate rF. A capital inflow occurs, leading to an appreciation of the domestic currency. The appreciation makes foreign goods cheaper for domestic citizens, and exported goods become relatively more expensive for foreigners. Therefore, net exports decrease and the IS shifts back to its original location.In the end, the level of output Y does not change, although its composition does (less exports and more imports).


Fiscal Policy without capital mobilityFixed exchange ratesBPIS0LM1rYAs the IS shifts to the right, the economy moves from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the Central Bank has to buy the domestic currency to avert the depreciation, hence MS contracts and output falls. E0LM0E1G IS1E2


Fiscal Policy without capital mobilityFloating exchange ratesBP0IS0LMrYAs the IS shifts to the right, the economy moves from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the domestic currency depreciates. Because of the depreciation, competitiveness increases and both the IS and the BP shift to the right. E0E2IS2BP1E1G IS1


The effectiveness of monetary/fiscal policies on output depends on the exchange rate regime and on the degree of capital mobility (summary table):


FIXED EXCHANGE RATE REGIME

No capital mobility

Imperfect capital mobility

Perfect capital mobility

Monetary policy

No effect

No effect

No effect

Fiscal Policy

No effect

Effectiveness increases with capital mobility

Maximum effect

FLOATING EXCHANGE RATE REGIME

No capital mobility

Imperfect capital mobility

Perfect capital mobility

Monetary Policy

Effective

(effect depends on slopes of IS and LM)

Effectiveness increases with capital mobility

Maximum effect

Fiscal Policy

Effective (depending on the slope of LM)

Effectiveness decreases with capital mobility

No effect

Stabilization policyBPYrISLMIn the IS-LM-BP model, exogenous changes in other variables not under the direct control of the monetary authority or the government are called shocks.For example, changes in YF , rF , and E eNOM/eNOM shift the BP.Changes in YF shift the IS.Changes in preferences for money demand shift the LM.


Stabilization policyBPYrISLMFor example, consider an economy initially at full employment YF and external balance. Assume that foreign output falls (war, restrictive policies abroad, ). Both the IS and the BP shift: output falls below full potential and the BP goes in disequilibrium.YFY0Notation:YF = domestic full employment outputYF = foreign output


Stabilization policyStabilization policy = the use of fiscal/monetary policy to restore internal/external balance.Internal balance exists when the economy is at the full-employment level of output.External balance exists when the Balance of Payments is equal to 0.Problem: how to achieve 2 objectives (internal & external balance) simultaneously. Policy dilemma caused by potential conflicts between the goals of external and internal balance.


Stabilization policyExample 1: Fixed exchange ratesThe economy is below full employment: Y0 < YF. Cannot use monetary policy (fixed exchange rates).In order to restore internal balance, need expansionary fiscal policy.In order to restore external balance, need contractionary fiscal policy. BPYrISLMYFY0In general, a combination of policies is needed to establish internal and external balance simultaneously.


Stabilization policyExample 2: Automatic adjustment of the BPUnder fixed exchange rates, the economy would move to Y1. To restore internal balance, need for an expansionary fiscal policy that shifts the IS to the right. A depreciation or an import tariff would also shift the IS to the right.Under floating exchange rates, the economy would move to Y2: need for a contractionary monetary policy.BPYrISLMYFY1Y2Policy measures are monetary and fiscal policy, and also tariffs or devaluations.



Exchange Rate Policy in the IS-LM-BP model

Recommended reading: Begg, Fischer an Dornbusch, Chapter 29 Abel, Bernanke and McNabb, Chapter 14


Objective of the lecture

To understand exchange rate policy , as one of the tools available to policymakers to influence the level of economic activity in their country.

Monetary and fiscal policy are not the only available tools.

In this lecture we will see how exchange rate policy works.


Outline:

Exchange rate policy in the Mundell-Fleming model ;Are devaluations effective in the long run? ;How to fix the exchange rate ;Fixed versus floating exchange rates ;Exchange rates & monetary policy.


Exchange rate policy in the Mundell-Fleming model Previously, we saw that monetary policy is ineffective under fixed exchange rates. However, monetary policy does have many attractions over fiscal policy. Are there any other tools available for stabilization?BPYrISLMYFY0The economy is below full employment: Y0 < YF, and the BP is in deficit (internal and external imbalances). In general, a combination of policies is needed to establish internal and external balance simultaneously.


Exchange rate policy in the Mundell-Fleming model Terminology:Under a system of floating exchange rates a currency depreciates (appreciates) when it becomes less (more) expensive in relation to foreign currencies. This is caused by market forces or, in some instances, by the intervention of central banks. However, under a system of fixed exchange rates, currency devaluation (revaluation) takes place when the price at which foreign currencies can be bought is increased (decreased) by official government action.In other words, a devaluation or revaluation is a change in the par value (the exchange rate that the central bank agrees to defend).


Exchange rate policy in the Mundell-Fleming model In order to represent the effects of a devaluation in the Mundell-Fleming model, we must go back to its building blocks:

since the nominal exchange rate only enters the IS and the BP lines, devaluation does not affect the LM.ISY = C (Y) + I(r) + G + NX(YF , Y, ) LMMD(Y, r) = MSBPBP = CA(YF , Y, )+ KA(r rF ) = 0


Exchange rate policy in the Mundell-Fleming model In order to make precise statements about the effects of a devaluation in the IS-LM-BP model, we must clarify first: The effect of changes in eNOM on the real exchange rate eR ; The effect of changes in eR on net exports (NX CA) .If a devaluation increases NX then both the IS and the BP shift to the right, and output increases.But only if.


Exchange rate policy in the Mundell-Fleming model Devaluation (pursued by a country in fixed exchange rate regime) is effective in expanding output if:Relative prices do not change, so that a decrease in nominal exchange rate will also mean a decrease in real exchange rate. This means that exports become cheaper in foreign currency and imports become more expensive in domestic currency ;Net exports NX increase in value.


Exchange rate policy in the Mundell-Fleming model Condition 2 requires that the value of exports increases more than value of imports. This depends on the price elasticities of demand for exports and imports, and is summarised in the Marshall-Lerner condition (sum of price elasticities of demand for exports and imports exceeds 1).In the rest of the analysis, we assume that the Marshall-Lerner condition holds and relative prices are fixed, so if there is a devaluation then NX and both the IS and the BP shift to the right. Condition 1 is not satisfied in the long run, but it may be quite realistic in the short run.


Exchange rate policy in the Mundell-Fleming model A devaluation of the domestic currency improves competitiveness and increases output in the short run.BP0IS0LM0YE0LM1E1IS1E2rBP1Devaluation under fixed exchange ratesYF


Exchange rate policy in the Mundell-Fleming model Explanation: E0 to E1 : Devaluation means that the balance of payments equilibrium changes - shift from BP0 to BP1 -. Net exports increase shift of IS0 to IS1 -. As output expands interest rates rise, so there will be a capital inflow. This will result in a balance of payments surplus (point E1), and excess demand of domestic currency.E1 to E2 : under fixed exchange rates, money supply expands to accommodate the excess demand of domestic currency. This will give a further impulse to aggregate demand and the final equilibrium will be for a higher level of output.


Are devaluations effective in the long run? Q: In the long run can changes in a nominal variable (the nominal exchange rate) ever have any effect on real variables (output, competitiveness)?

A: No, unless there is real change in the economy at the same time. In the absence of this, the eventual effect of devaluation is a rise in all other nominal wages and prices in line with the higher import prices, leaving all real variables unchanged. If there is a devaluation of the home currency, the import price of raw materials increases. Domestic firms want to pass on these costs increases in higher prices. Workers realise that that consumer prices are higher, and demand higher wages.


Are devaluations effective in the long run?Eventually, devaluation has no real effects. Most empirical evidence suggests that the effect of devaluation is completely offset by a rise in domestic wages and prices after 4-5 years. Devaluation leads to a temporary, not a permanent, increase in competitiveness.

In the long run, competitiveness is determined by real factors, and it goes back to its long-run equilibrium level.

However, devaluation is the simplest way to change competitiveness quickly. It may thus be an appropriate response to a real shock which needs a quick change in the equilibrium real exchange rate.


Are devaluations effective in the long run?BPYrISLMFor example, consider an economy initially at full employment YF and external balance. Assume that there is a permanent fall in export demand: both the IS and the BP shift to the left. At the original exchange rate, this generates a slump that reduces wages and prices, until the resulting increase in competitiveness restores the original equilibrium.YFTBA: the full employment level of output YF is not the foreign level of output YF !


Are devaluations effective in the long run?Devaluation can deliver an overnight improvement in competitiveness, shifting both the IS and the BP back to their original positions. Devaluation speeds up adjustment .Devaluation may therefore be an appropriate response to a real shock that requires a change in the equilibrium real exchange rate. Conversely, where no real change is required, devaluation eventually generates rises in prices and nominal wages.


Fixed exchange rates and macroeconomic policy We are now getting close to the question of how to choose the nominal exchange rate in a fixed exchange rate regimes. The above discussion has taught us that governments cannot realistically expect to fix the level of competitiveness or real exchange rate (not in the long/medium run), but what about the nominal exchange rate eNOM?Thus, we have learned that the Mundell-Fleming model is useful to analyse the effects of a devaluation in the short run. However, since it was not designed to explain how the exchange rates are determined in the long run, it cannot be used for this purpose.


Fixed exchange rates and macroeconomic policy Fixed-exchange-rate systems are important historically and are still used by many countries.

In this subsection, we will be talking about fixed exchange rate systems only.There are two key questions wed like to answer:How should the official nominal exchange rate be fixed?

Which is the better system, flexible or fixed exchange rates?


How to fix the exchange rate In a fixed exchange rate system, the government sets the nominal exchange rate, in an agreement with other countries.However, a potential problem with fixed exchange rate systems is that the official rate may not what the market wants: the currency may be overvalued or undervalued, according to whether the official rate is above or below the market value.Example:Assume the par value is 0.5 = 1 But the market value is 0.6 = 1 the euro is undervalued the pound is overvalued


How to fix the exchange rateHow can a country deal with a situation in which its official exchange rate is overvalued?The country could devalue the currency, thus officially changing the par value;The country could restrict international transactions to reduce the supply of its currency to the foreign exchange market (if a country prohibits people from trading the currency at all, the currency is said to be inconvertible).The central bank can buy its own currency, using its official reserves (the decline in official reserve assets is equal to a countrys current account deficit). Thus the market value changes.


How to fix the exchange rate A country cant maintain an overvalued currency forever, as it will run out of official reserve assets.

Moreover, a speculative run (or speculative attack) may end the attempt to support an overvalued currency.If investors think a currency may soon be devalued, they may sell assets denominated in the overvalued currency, increasing the supply of that currency on the foreign exchange market.This causes even bigger losses of official reserves from the central bank and speeds up the likelihood of devaluation, as occurred in Mexico in 1994 and Asia in 19971998.


How to fix the exchange rate Thus an overvalued currency cant be maintained for very long.

Similarly, in the case of an undervalued currency, the official rate is below the fundamental value.

In this case, a central bank trying to maintain the official rate will acquire official reserve assets.

If the domestic central bank is gaining official reserve assets, foreign central banks must be losing them, so again the undervalued currency cant be maintained for long.


How to fix the exchange rate The best way for a country to make the official nominal exchange rate equal to the long run market value is through the use of monetary policy.In fact,

Then:calling: eR , the real exchange rate, which is given in the long run P, the level of domestic prices PF , the level of foreign prices eNOM = eR * P / PF


How to fix the exchange rate So, provided eNOM = eR * P / PF is also used by the currency traders as an anchor value in the short run, given that eR and PF are beside the control of the government, the central bank must manage the money supply so that this equation is satisfied (i.e. ensuring equality between the par value and the market value). This is because the money supply has an effect on the domestic price level P.

For example, if the currency is overvalued a monetary contraction is needed.

If the currency is undervalued a monetary expansion is needed.


How to fix the exchange rate This implies that countries cant both maintain the fixed exchange rate and use monetary policy to affect output (as seen previously).

Using expansionary monetary policy to fight a recession would lead to an overvalued currency.

So under fixed exchange rates, monetary policy cant be used for macroeconomic stabilization.

However, a group of countries may be able to coordinate their use of monetary policy.


Fixed versus floating exchange rates Flexible-exchange-rate systems also have problems, because the volatility of exchange rates introduces uncertainty into international transactions.

There are two major benefits of fixed exchange rates:Stable exchange rates make international trades easier and less costly: certainty for exporters / importers/ investors ;Fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy; the result may be lower inflation in the long run.


Fixed versus floating exchange rates

But there are also some disadvantages to fixed exchange rates:They take away a countrys ability to use expansionary monetary policy to combat recessions ;Sudden real shocks that require a change in the equilibrium real exchange rate cannot be absorbed by nominal exchange rate adjustment, a new par value must be negotiated, via a lengthy political process ;Disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system ;Speculators can cause financial & political crises .


Fixed versus floating exchange rates Benefits of floating exchange rates are:Government ignores exchange rate, no intervention needed ;No need to worry about the balance of payments ;Sudden real shocks that require a change in the equilibrium real exchange rate immediately absorbed by nominal exchange rate adjustment, the economy is thus insulated from shocks ;Government can concentrate on internal policy objectives (inflation, unemployment, income distribution) .


Fixed versus floating exchange rates Disadvantages of floating exchange rates are:Exchange rate can be volatile in the short run, causing uncertainty (harmful to investment & trade) ;Loss of external, balance of payments constraint on macro-policy may lead to inflationary bias. Large capital flows may get out of control, causing the nominal exchange rate to get out of line with its underlying (fundamental) value .


Fixed versus floating exchange rates

If large benefits can be gained from increased trade and integration, and when countries can coordinate their monetary policies closely, then fixed exchange rates may be desirable.

Countries that value having independent monetary policies, either because they face different macroeconomic shocks or hold different views about the costs of unemployment and inflation than other countries, should have a floating exchange rate.Which system is better may thus depend on the circumstances:


Exchange rates & monetary policy

In conclusion, exchange rate policy and monetary policy are not independent. The increased trade & financial integration will undoubtedly have an effect on how monetary policy is conducted around the world.Example. The Bank of England core purposes:Monetary Stability ;Financial Stability .You can read them online: http://www.bankofengland.co.uk/about/corepurposes/index.htm


Exchange rates & monetary policy

Among other things, Monetary Stability means, according to the Bank of England: stable prices and confidence in the currency.And, under Price stability and monetary policy, we can read:The first objective of any central bank is to safeguard the value of the currency in terms of what it will purchase at home and in terms of other currencies. Monetary policy is directed to achieving this objective and to providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money, in other words the interest rate.


What is an equilibrium condition, and what is an identity?Why the signs?The U.S. current account has been consistently in deficit over the last two decades, and in each of these years, the U.S. experienced a net inflow of capital. Why buy/sell? What happens to reserves?

Examples of the 3 cases?Under fixed exchange rates, if CA+NPKI=0, Official Reserve Transactions are 0 and the LM does not move. There cannot be an equilibrium such as CA+NPKI+ORT=0 with ORT different from 0.Under floating exchange rates (so assume ORT=0), CA+NPKI=0 always since the depreciation/appreciation in the foreign exchange market is immediate.Also note: the US is on the BP curve, since up to now the CA deficit has been matched by sufficient NPKI. However, a protracted CA

ec202a macroeconomics handout 2 laura povoledo the university of reading

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