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Transcript
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