Download Economic Policy in the Open Economy Under Fixed Exchange Rates

Chapter 25
Economic Policy
in the Open
Economy Under
Fixed Exchange
Rates
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
25-1
Learning Objectives
• Explain general equilibrium in the
macroeconomy using the IS/LM/BP model.
• Describe the impact of changes in fiscal
policy on income, trade, and interest rates
under fixed exchange rates.
• Describe the impact of changes in monetary
policy on income, trade, and interest rates
under fixed exchange rates.
• Perceive how varying degrees of capital
mobility alter the effectiveness of fiscal and
monetary policy under fixed exchange rates.
25-2
Targets, Instruments, and
Policy: A Model
• “External balance”
– Any decrease in the interest rate (e.g.,
because of expansionary monetary
policy) will cause a decrease in shortterm capital inflows or an increase in
short-term capital outflows and a BOP
deficit.
– Expansionary fiscal policy (by increasing
Y and M) also leads to a BOP deficit.
• “Internal balance”
– Expansionary monetary policy lowers
interest rates and increases I; this will be
inflationary unless fiscal policy offsets it.
25-3
Targets, Instruments, and
Policy: A Model
• As we discussed in Chapter 24, there
are four situations when there are
internal and external imbalances:
– Case I: BOP deficit; unacceptably rapid
inflation,
– Case II: BOP surplus; unacceptably high
unemployment,
– Case III: BOP deficit; unacceptably high
unemployment, and
– Case IV: BOP surplus; unacceptably rapid
inflation.
25-4
The Mundell-Fleming Diagram
i
IB
IV
EB
II
I
III
To achieve internal and
external balance, fiscal
and monetary policy
must both be used.
G-T
25-5
General Equilibrium in the
Open Economy: the IS/LM/BP
Model
– To understand the effects of
policies on the open economy, we
need to use a general equilibrium
model.
– The IS/LM/BP model is built around
three sorts of equilibria:
1. money market equilibrium (the LM
curve),
2. real sector equilibrium (the IS curve),
and
3. BOP equilibrium (the BP curve).
25-6
Money Market Equilibrium: the
LM Curve
• The LM curve comprises all
combinations of the interest rate (i)
and income (Y) such that money supply
and money demand are equal.
25-7
Money Market Equilibrium:
the LM Curve
– Money supply is assumed to equal
money demand.
– Money supply is fixed.
– Money demand depends inversely
on the interest rate (i) and
positively on income (Y).
• As interest rates rise, the opportunity
cost of holding money rises, and so the
quantity demanded of money
decreases.
• As income rises demand for money
increases.
25-8
Money Market Equilibrium: the
LM Curve
Ms
i
At i1, Ms>Md: people will buy
bonds, reducing i.
At i2, Ms<Md: people will sell
bonds, increasing i.
i1
ie
i2
L = f(i,Y)
money
25-9
Money Market Equilibrium:
the LM Curve
– If income rises, money demand will
exceed money supply, and interest
rates will rise.
– Therefore, the LM curve is the
positive relationship between the
interest rate and income (Y).
– Points to the left of the LM curve
mean there is an excess supply of
money; points to the right imply an
excess demand.
25-10
Money Market Equilibrium:
the LM Curve
i
LM
income
25-11
Money Market Equilibrium:
the LM Curve
– Increases in Ms or decreases in Md
will shift LM to the right.
– Decreases in Ms or increases in Md
will shift LM to the left.
25-12
Real Sector Equilibrium: the
IS Curve
• The IS curve comprises all
combinations of the interest rate (i)
and income (Y) such that the real
sector of the economy is in
equilibrium.
25-13
Real Sector Equilibrium:
the IS Curve
– Investment should depend inversely
on the interest rate (i).
• As interest rates rise, the cost of
borrowing rises, so I falls.
– As before, consumption (C) depends
positively on income (Y).
– Also, exports (X) and government
spending (G) are fixed.
25-14
Real Sector Equilibrium:
the IS Curve
– The IS curve is the relationship
between the interest rate and Y.
• As the interest rate falls, investment
increases, thereby increasing Y.
• As the interest rate rises, investment
decreases, thereby decreasing Y.
– Therefore, the IS curve is
downward- sloping.
25-15
Real Sector Equilibrium: the
IS Curve
i
IS
income
25-16
Real Sector Equilibrium:
the IS Curve
– Increases in autonomous I, X, G or
decreases in T will shift IS to the
right.
– Decreases in autonomous I, X, G or
increases in T will shift IS to the
left.
25-17
BOP Equilibrium: the BP
Curve
• The BP curve comprises all
combinations of the interest rate (i)
and income (Y) such that the balance
of payments is in equilibrium.
25-18
BOP Equilibrium: the BP
Curve
– The BP curve is the relationship
between the interest rate and Y.
• If Y increases and i is unchanged, M
will increase and a BOP deficit will
open.
• To return to BOP balance, i must rise.
This would trigger net short-term
capital inflows.
– Therefore, the BP curve is upwardsloping.
25-19
BOP Equilibrium: the BP
Curve
i
BP
income
25-20
BOP Equilibrium: the BP
Curve
– Points to the left of the BP curve
imply a BOP surplus.
– Points to the right of the BP curve
imply a BOP deficit.
25-21
BOP Equilibrium: the Slope
of the BP Curve
– The slope of the BP curve depends
on how responsive short-term
private capital flows are to changes
in the interest rate.
– Points to the right of the BP curve
represent BOP deficits, triggering
an increase in i, which would cause
an increase in capital inflows.
– If capital inflows are very
responsive, a small Δi will bring us
back to BOP equilibrium (that is, a
relatively flat BP curve).
25-22
BOP Equilibrium: the Slope
of the BP Curve
– The typical upward slope of the BP
curve results from impediments to
capital flows or when the country is
large enough to influence
international interest rates.
– The upward-sloping BP represents
“imperfect capital mobility.”
25-23
BOP Equilibrium: the Slope
of the BP Curve
– Capital could be perfectly mobile.
– This would occur if any deviation of
the domestic i away from the
international rate immediately
triggered capital flows that brought
interest rates back in line.
– When capital is perfectly mobile,
the BP curve is a horizontal line.
25-24
BOP Equilibrium: the Slope
of the BP Curve
– Capital could be perfectly immobile.
– If a country fixes its exchange rate,
it typically maintains strict foreign
exchange controls.
– When capital is perfectly immobile,
the BP curve is a vertical line.
25-25
BOP Equilibrium: the BP
Curve
– A depreciation of the home
currency, an autonomous increase
in exports, or an autonomous
decrease in imports will shift BP to
the right.
– An appreciation of the home
currency, an autonomous decrease
in exports, or an autonomous
increase in imports will shift BP to
the left.
25-26
Equilibrium in the Open
Economy
LM
i
BP
E
iE
Only at point E is the
economy in full
equilibrium.
IS
YE
income
25-27
Equilibrium in the Open
Economy: Adjustments
– Suppose exchange rates are fixed.
– How does the system adjust to a “shock”
such as an increase in foreign income?
– This should increase exports, shifting BP
rightwards to BP′.
– The IS curve will shift rightwards to IS′.
– To maintain the fixed exchange rate, the
central bank must purchase the surplus
foreign currency; this shifts LM
rightwards to LM′.
– Eventually, a new equilibrium is reached
at E''.
25-28
Equilibrium in the Open
Economy
LM
i
LM'
BP
BP'
i*
E
E''
i''
IS
Y*
Y''
IS'
income
25-29
Fiscal Policy Under Fixed
Exchange Rates
– With perfect capital immobility, any
fiscal stimulus initially increases Y
and M (and also i), but because
capital is immobile, a BOP deficit
emerges, decreasing the money
supply and increasing i further.
– In the end, Y returns to its original
level – the fiscal stimulus
completely crowds out domestic
investment (I).
25-30
Fiscal Policy Under Fixed
Exchange Rates
i
LM'
BP
LM
Perfect capital
immobility
E'
i'
iE
E
IS
YE
IS'
income
25-31
Fiscal Policy Under Fixed
Exchange Rates
– With perfect capital mobility, any
fiscal stimulus increases Y and M,
but i does not rise due to capital
inflows.
– To maintain the fixed exchange
rate, the central bank must
increase the domestic money
supply.
– In the end, Y rises, but i stays the
same.
25-32
Fiscal Policy Under Fixed
Exchange Rates
LM
i
LM'
Perfect capital
mobility
E'
iE
E
BP
IS
YE
Y'
IS'
income
25-33
Fiscal Policy Under Fixed
Exchange Rates
– The bottom line:
• When capital is relatively mobile, fiscal
policy is more effective at increasing
national income.
• When capital is relatively immobile,
fiscal policy is less effective at
increasing national income.
25-34
Monetary Policy Under
Fixed Exchange Rates
– With perfect capital immobility, a monetary
stimulus initially increases Y and M (and
lowers i), but because capital is immobile,
a BOP deficit emerges.
– The central bank must sell foreign
exchange (decreasing the money supply)
to maintain the fixed exchange rate.
– In the end, the LM curve returns to its
original place – the monetary stimulus
doesn’t change Y.
25-35
Monetary Policy Under Fixed
Exchange Rates
i
LM LM'
BP
Perfect capital
immobility
iE
E
IS
YE
income
25-36
Monetary Policy Under
Fixed Exchange Rates
– With perfect capital mobility, any
monetary stimulus increases Y and
M, but i does not fall due to capital
inflows.
– Again, to maintain the fixed
exchange rate, the central bank
must decrease the domestic money
supply.
– In the end, the LM curve returns to
its original place – the monetary
stimulus doesn’t change Y.
25-37
Monetary Policy Under Fixed
Exchange Rates
LM
i
LM'
Perfect capital
mobility
iE
E
BP
IS
YE
income
25-38
Monetary Policy Under
Fixed Exchange Rates
– The bottom line:
• When capital is relatively mobile,
monetary policy is ineffective at
increasing national income.
• When capital is relatively immobile,
monetary policy is ineffective at
increasing national income.
– Maintaining a fixed exchange rate
system means losing monetary
policy as an effective tool.
25-39
Effects of Official Changes in
the Exchange Rate System
– Obviously, to maintain a fixed
exchange rate system, a country
would not want to devalue or
revalue the currency often.
– However, such policy actions are
occasionally required: what will be
the effects?
25-40
Effects of Official Changes in
the Exchange Rate System
– If the home country’s exchange rate
is devalued, exports rise and
imports fall.
– This shifts both the IS and BP
curves rightward.
– The money supply must be
expanded – the central bank must
buy foreign exchange.
– This means the LM curve also shifts
rightward.
– The devaluation increases Y.
25-41
Effects of Official Changes in
the Exchange Rate System
– The bottom line:
• When capital is relatively immobile, a
devaluation increases national income.
• When capital is relatively mobile, a
devaluation increases national income
to an even greater extent.
25-42