Download Exchange Rates and Business Cycles

Exchange Rates and
Business Cycles
Business Cycles

In the IS-LMP framework, there are two basic
ways that equilibrium output will change:
1.
A Shift in the IS Curve: The IS curve will shift
because of a change in autonomous demand
(including fiscal policy, autonomous consumption, investment, foreign
trade, foreign interest rates, etc.).
2.
A Shift in the LMP Curve: The LMP curve will shift
because of a change in the monetary policy
stance.
Equilibrium
LMP
i
i$ +(eLR/e)-1
i
i*
IS
e
Y*
Y
e*
Internal Changes

First consider how some internal shocks might
affect business cycles. Fiscal Policy:
 An
increase in G or a cut in T increases ADt.
 Animal Spirits: An increase in AC or AI increases
AD.

Each of these will increase demand at any
given interest rate shifting out the IS curve.
Shift in Autonomous Demand:
AD↑
LMP
i
i$ +(eLR/e)-1
i
i**
i*
IS
Y*
Y**
Y
e**
e*
e
Shift in Autonomous Demand:
AD↓
LMP
i
i$ +(eLR/e)-1
i
i*
i***
IS
Y***
Y*
Y
e*
e*
e
The Wall Comes down. In 1989,
Germany was reunited and German
spending increased.
Deficit as a Share of GDP
2.50%
2.00%
%
1.50%
1.00%
0.50%
0.00%
1987
-0.50%
1988
1989
1990
1991
1992
1993
1994
1995
1996
Rise in Interest Rates Strengthening
Mark
German Exchange and Interest Rates
10
8
6
2.5
4
2.4
2
2.3
2.2
2.1
1987
1988
1989
1990
e
1991
i
1992
1993
Monetary Policy

LMP represents a schedule of interest rates at
different levels of output
 Central
bank may create an expansionary
monetary policy by reducing interest rates at every
level of output.
 Contractionary monetary policy will increase
interest rates at every level of output.
Expansionary Monetary Policy
LMP
i
i$ +(eLR/e)-1
i
i*
i**
IS
e
Y*
Y**
Y
e*
e**
Contractionary Monetary Policy
LMP
i
i$ +(eLR/e)-1 + rp
i
i***
i*
IS
Y*** Y*
Y
e***
e*
e
Bank of Japan wants to stimulate an economy
recovering from stock market crash.
Japan Interest Rates and Exchange Rates
2.5
2.0
1.5
1.0
140
0.5
130
0.0
120
110
100
90
1994
1995
1996
e
1997
i
1998
Expansion and the Trade Balance
An IS based expansion will increase domestic
output and income and appreciate the
exchange rate. Both of these will lead to a
decline in NX.
 An LMP based expansion will increase
domestic output and depreciate the exchange
rate. This will have ambiguous effects on NX.

German Trade Balance
Net Exports
3.50%
3.00%
% of GDP
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
1987
-0.50%
1988
1989
1990
1991
1992
1993
1994
1995
Japanese Trade Balance
Net Exports
2.50%
% of GDP
2.00%
1.50%
1.00%
0.50%
0.00%
1994
1995
1996
1997
1998
In many countries, the trade-balance
tends to be counter-cyclical.
Korean Business Cycles and Trade Balance
15.00%
10.00%
%
5.00%
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
0.00%
-5.00%
-10.00%
Output Gap
Trade Balance (% of GDP)
Japan’s lost decade




Japan has a continuing slump of investment demand over the
course of the 1990’s.
Central bank has adjusted interest rate until it reaches zero.
At zero interest rates, money are just as good as bonds, so
households are willing to hold as much money as the central
bank prints at zero interest rate.
Since 1999, Japan has increased its money supply rapidly (a
policy called quantitative easing) to convince forex markets
that the long-term fundamental exchange rate, eLR, is weaker.
This will weaken spot rate at any given interest rate
increasing net exports and shifting out the IS curve.
Investment Slump
Japan
35.00%
30.00%
25.00%
% of GDP
20.00%
15.00%
10.00%
5.00%
0.00%
1988 1990 1992 1994 1996 1998 2000 2002
Investment
Growth Slowdown
Real GDP Growth Rate
% Growth Rate
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
1963-73
1973-83
1983-93
1993-2003
Liquidity Trap: Expansionary Monetary Policy at Zero Lower
Bound has no effect on interest rate, output or exchange rate.
i
i
i$ +rp+(eLR/e)-1
LMP
IS
i*
i**
Y*=Y**
Y
e**
e
Since 1999, Japan has been in a
liquidity trap.
Short-term Interest Rate
8
7
6
4
3
2
1
0
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
%
5
Money Market
m
m’
i
M
P
Quantitative Easing if thought to be permanent can depreciate
the exchange rate without changing the exchange rate
stimulating demand.
i
i
LMP
IS
i$ +rp+(eLR/e)-1
IS’
i*
i$ +rp+(eLR’/e)-1
i**
Y**
Y**
Y
e**
e***
e
At least initially, the exchange rate
depreciated.
(US cut its interest rate drastically in 2001).
Exchange Rate
140
120
Yen per $
100
80
60
40
20
0
1999
2000
2001
2002
2003
2004
Fixed Exchange Rates and Interest
Rate Policy

Only one interest rate consistent with a fixed exchange
rate given by
LR

i*  i $  e


e
FIX
  rp
Given these forex factors, the central bank cannot
adjust the exchange rate either in response to change
in Y or for contractionary/policy.
Shifts in IS have stronger effect on equilibrium output
under fixed exchange rates than in a floating
exchange rate in which the interest rate adjusts.
Equilibrium
i
i
i$ +(eLR/e)-1
i*
IS
e
Y*
Y
eFIX
AD↑
IS
IS’
i
i
i$ +(eLR/e)-1
i*
Y*
Y**
e
Y
eFIX
AD↓
i
i
IS’
i$ +(eLR/e)-1
i*
IS
Y**
e
Y*
Y
eFIX
Fixed Exchange rates and Devaluation





Under fixed exchange rates, the central bank cannot adjust interest
rates to domestic economic conditions.
However, they might affect the economy by changing the level of the
exchange rate.
A devaluation of the exchange rate, eFIX ↑, will shift out the IS curve
directly.
Change in the level of fixed exchange rates may affect markets
perception of the long-run exchange rate, eLR ↑.
Equilibrium effect on output, will depend on the effect of devaluation
on interest rates which will .



If devaluation is perceived temporary , eFIX’ > eLR’, eFIX’ > eLR’, then i*↓
If devaluation is perceived as permanent, , eFIX’ =eLR’ then i* is unchanged.
If devaluation is thought to presage future devaluations, , eFIX’ < eLR’ and i*↑
eFIX devalues.
Temporary devaluation,
Permanent devaluation, Presaging devaluation
Presaging
i
i$ +(eLR/e)-1
i
IS
IS’
i*
Perm
Temp
Y*
Y
Y
eFIX
eFIX’
e
Singapore’s Devaluation: 1997
5
4
3
2
1.8
1
1.7
0
1.6
1.5
1.4
1.3
1995
1996
1997
Exchange Rate
1998
1999
2000
Nominal Interest Rate
External Business Cycles

The state of other countries business cycles
affect domestic economy in two ways.

Foreign output level has a positive effect on IS
curve through the channel of exports.
 Foreign interest rates have a positive effect on IS
curve under flexible exchange rates
 Foreign interest rates increase the domestic
interest rate under fixed exchange rates.

Effects of recession in domestic economy
depend on domestic monetary policy and
cause of foreign recession.
Recession in Foreign Trading Partner YF ↓,
Domestic IS←
Additional Effects depend on type of shock and domestic
exchange rates.
Fixed
Flexible
IS Driven
Recession (i$↓)
i ↓, Y*?
e ↓, IS←, Y* ↓
LMP Driven
Recession (i$↑)
i ↑, Y* ↓
e ↑ , IS→, Y* ?

AD driven recession in a foreign economy will have
 Negative
effects under flexible exchange rates as low foreign
interest rates will cause an appreciation of domestic currency
and low export demand.
 Ambiguous effects under fixed exchange rates as low foreign
interest rates will reduce domestic interest rates.

An LMP driven recession in a foreign economy will
have:
 Ambiguous
effects under flexible exchange rates as high
foreign interest rates will cause the domestic exchange rate to
depreciate.
 Negative effects under fixed exchange rates as high foreign
interest rates mean high domestic interest rates.
Korean and US Output Gap
In 1980’s, many East Asian countries moved closely
with US. In 1990’s, not so much.
0.1
0.05
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
0
-0.05
-0.1
-0.15
USA
Korea