Download Issue 17 - Patrick M. Crowley

ECON3315
International Economic Issues
Instructor: Patrick M. Crowley
Issue 17: The Macroeconomics of Exchange rates
Overview
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Intro
Flexible exchange rates
Fixed exchange rates
Which is better?
Intro: macro effects
 Exchange rate regimes have implications for
macroeconomic policy
 To see these implications we look at implications
for flexible exchange rates on macro variables and
then for fixed exchange rates on macro variables
 Then we can deduce what will happen if we use
fiscal or monetary policy under each of these
“extreme” cases of exchange rate policy
 This is sometimes known as the “Mundell-Fleming
model”
 Basic result is that monetary policy is more
effective with flexible exchange rates, but fiscal
policy less effective, and monetary policy is less
effective but fiscal policy more effective under fixed
exchange rates
Aside: the J-curve
Exports and imports can be
thought of as a combination of
prices and quantities, just like
any revenue stream
X = pX qX and M = pMqM
But when exchange rates
change, pX changes for
foreigners immediately – but
does qX? Answer is no, takes
time.
Similar logic for M – here
prices change immediately,
but quantities change over
time.
Result is that when US$
depreciates, TB worsens
before it improves….
Aside: the J-curve
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When US$ depreciates, in short run TB and CA
will worsen, but in the medium and long run
TB will improve, so GDP will increase….
Q: How long does this take to occur?
A: Depends on i) long term contracts and ii)
how sensitive quantities are to price changes
Most economists think about 6 to 12 months….
Flexible exchange rates
Monetary policy
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If money supply goes up, nominal interest rates fall
Through interest parity this causes exchange rate to depreciate.
This causes the trade balance to improve, increasing real GDP, so
Y goes up.
Obviously vice-versa if money supply falls.
Fiscal policy
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If G goes up then Y goes up.
But through crowding out(?) interest rates increase.
As interest rates increases this causes the exchange rate to
appreciate
This causes the trade balance to deteriorate, reducing Y.
Could potentially completely offset original increase in G.
Fixed exchange rates
Monetary policy
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If money supply goes up, nominal interest rates fall
But interest rates cannot fall otherwise exchange rate will
depreciate.
So if so, central bank has to buy up domestic currency which
automatically reduces money supply!
No effect on Y
Fiscal policy
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If G goes up then Y goes up.
But through crowding out(?) interest rates increase.
As interest rates increase currency will start to appreciate
But this can’t happen – so government sells domestic currency to
increase supply
This causes the money supply to increase.
This increases Y.
Fixed or flexible: which is better?
From Mundell-Fleming model, flexible exchange rates are better for
monetary policy, but fixed exchange rates are better for fiscal
policy.
Many developing countries have problems in making their central bank
monetary policy credible, so that is why many of them choose
more fixity in their exchange rates.
Just recently IMF told CEECs to fix to the euro to avoid further collapse
in their exchange rates – and that way to “import credibility” from
the euro area….good example of how fixed exchange rates can
help!!!