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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