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Chapter 26 Economic Policy in the Open Economy Under Flexible Exchange Rates McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 26-1 Learning Objectives • Analyze the impact of fiscal policy on income, trade, and exchange rates under flexible exchange rates. • Analyze the impact of monetary policy on income, trade, and exchange rates under flexible exchange rates. • Show how external economic shocks affect the domestic economy under flexible exchange rates. 26-2 Introduction • The effectiveness of monetary and fiscal policies at influencing national income differ dramatically under fixed and flexible exchange rate systems. • Do flexible exchange rate systems make countries more vulnerable to external shocks such as the recent global recession? 26-3 The Effects of Fiscal and Monetary Policy Under Flexible Exchange Rates • Under a flexible exchange rate system, combinations of income and interest rates not on the BP curve will cause disequilibrium in foreign exchange markets, and force an adjustment in the exchange rate. • This will cause the BP curve to shift. 26-4 The Effects of a Currency Depreciation on the BP Curve i BP0 BP1 A depreciation expands exports and contracts imports. For any given level of Y, a lower i is required to balance the BOP. Y 26-5 The Effects of a Currency Appreciation on the BP Curve i BP1 BP0 An appreciation contracts exports and expands imports. For any given level of Y, a higher i is required to balance the BOP. Y 26-6 Fiscal Policy Under Flexible Exchange Rates – With perfect capital immobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP deficit, causing a depreciation and a rightward shift of the BP curve. – The depreciation increases exports, decreases imports, and shifts IS even farther rightwards. – This continues until IS, LM, and BP intersect at a common point. 26-7 Fiscal Policy Under Flexible Exchange Rates i BP0 BP1 LM Perfect capital immobility i3 i0 IS '' IS Y0 Y2 IS' income 26-8 Fiscal Policy Under Flexible Exchange Rates – With perfect capital mobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP surplus, causing an appreciation of the currency. – The appreciation decreases exports, increases imports, and shifts IS back to the left. 26-9 Fiscal Policy Under Flexible Exchange Rates LM i Perfect capital mobility iE BP IS Y0 IS' income 26-10 Fiscal Policy Under Flexible Exchange Rates – The bottom line: • When capital is relatively immobile, fiscal policy is more effective at increasing national income. • When capital is relatively mobile, fiscal policy is less effective at increasing national income. • Between these two extremes, the effect on the exchange rate depends on the relative slopes of LM and BP. – BP steeper than LM: depreciation – LM steeper than BP: appreciation 26-11 Monetary Policy Under Flexible Exchange Rates – With perfect capital immobility, a monetary stimulus increases Y, and the increase in imports causes an incipient BOP deficit to emerge. – As currency depreciates, BP shifts rightward. – Depreciation also shifts IS rightwards. 26-12 Monetary Policy Under Flexible Exchange Rates i BP' LM LM' BP Perfect capital immobility i2 i0 E IS Y0 Y2 IS' income 26-13 Monetary Policy Under Flexible Exchange Rates – With perfect capital mobility, any monetary stimulus increases Y. – This generates a large capital outflow and a depreciation of the home currency. – The depreciation causes IS to shift outwards. 26-14 Monetary Policy Under Flexible Exchange Rates LM i LM' Perfect capital mobility iE BP IS' IS Y0 Y2 income 26-15 Monetary Policy Under Flexible Exchange Rates – The bottom line: • When capital is relatively immobile, monetary policy is effective at increasing national income. • When capital is relatively mobile, monetary policy is particularly effective at increasing national income. 26-16 Policy Coordination Under Flexible Exchange Rates – Coordination of fiscal and monetary policy may make the attainment of other targets besides income possible. – Examples of alternative targets include interest rates and exchange rates. – Consider an income and interest rate target of Y* and i*as an example. 26-17 Policy Coordination Under Flexible Exchange Rates – If fiscal policy alone is used to reach Y*, it is likely that the interest rate will overshoot the target of i*. – In addition, the fiscal policy creates an incipient BOP surplus, appreciating the currency, and shifting BP back to the left. – The depreciation also shifts IS part of the way back to the left. – In the end, neither target is reached. 26-18 Policy Coordination: Fiscal Policy Alone LM BPFP iFP BP0 iY* i* i0 IS ISFP IS'FP Y0YFP Y* 26-19 Policy Coordination Under Flexible Exchange Rates – If monetary policy alone is used to reach Y*, the increase in Ms will cause a currency depreciation, and a rightward shift in BP. – In addition, the monetary policy shifts IS rightwards. – In the end, neither target is reached. 26-20 Policy Coordination: Monetary Policy Alone i LM LM' BP BP' i* i0 i' IS IS' Y0 Y' Y* Y 26-21 Policy Coordination Under Flexible Exchange Rates – If monetary and fiscal policies are used, both i* and Y* can be attained. – Expansionary fiscal policy allows Y to increase without the expenditure switching effects. 26-22 Policy Coordination: Monetary Policy Alone i LM LM' BP i* i0 IS IS' Y0 Y* Y 26-23 Effects of Shocks in the IS/LM/BP Model (Imperfect K-Mobility) – So far, we’ve examined the effects of fiscal and monetary policy holding a number of factors constant, including • domestic and foreign prices, • foreign interest rate, and • expected exchange rate changes. – How are changes in such variables (“shocks”) transmitted through the economy? 26-24 Effects of Shocks: A Foreign Price Shock – If the foreign price level were to increase, the home economy would expand due to increases in exports and decreases in imports (IS shifts right). – The BP also shifts right due to expenditure switching effects of higher foreign prices. – Both effects cause i to rise, and the currency to appreciate. – These shift IS and BP back to where they started. 26-25 Foreign Price Shock i LM BP BP' i0 IS IS' Y0 Y 26-26 Foreign Price Shock i LM BP BP' i0 IS IS' Y0 Y 26-27 Foreign Price Shock i LM BP i0 IS Y0 Y 26-28 Effects of Shocks: A Domestic Price Shock – If the domestic price level were to increase, the real money supply would fall, shifting LM leftwards. – Exports will fall and imports rise, so IS shifts leftwards. – The BP curve will also shift left in order to bring the BOP back into equilibrium. 26-29 Domestic Price Shock LM' LM i BP' BP i1 i0 IS' Y1 Y0 IS Y 26-30 Effects of Shocks: A Foreign Interest Rate Shock – If the foreign interest rate were to increase, the home country should experience an outflow of short-term capita; BP shifts leftwards. – The home currency depreciates. – This shifts • the IS curve rightward, and • the BP curve back toward the right. 26-31 Foreign Interest Rate Shock i LM BP' BP i0 IS Y0 IS' Y 26-32 Foreign Interest Rate Shock i LM BP' BP'' BP i1 i0 IS Y0 Y1 IS' Y 26-33