Download Sawyer/Sprinkle Chapter 18

C h a p t e r
1 8
Macroeconomic
Policy and
Floating
Exchange Rates
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
CHAPTER ORGANIZATION
•
•
•
•
•
•
•
Introduction
Fiscal and Monetary Policy
Changes in Fiscal Policy
Changes in Monetary Policy
Monetary and Fiscal Policy in an Open
Economy
Trade Flow Adjustment and Current Account
Dynamics
Summary
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18 – 2
INTRODUCTION
• Fiscal and monetary policies are two
•
macroeconomic policies that governments
employ to affect domestic output
These polices have an effect on the exchange
rate, the current account, interest rates, and short
run capital flows within an environment of
floating exchange rates
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18 – 3
FISCAL AND MONETARY POLICY
• Fiscal policy entails using changes in government
•
•
taxation and/or spending to affect the level of
economic activity GDP
Monetary policy uses changes in the money
supply and/or interest rates to affect a county’s
GDP
Changes in these policies have predictable effects
on the exchange rate, the current account balance,
and short-run capital flows
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18 – 4
FISCAL AND MONETARY POLICY
• The assumption is that the government does not
•
•
employ fiscal and/or monetary policy in an
attempt to generate a balanced current account,
but to affect the output and price level
It used to be common practice for governments to
focus fiscal and/or monetary policy on obtaining
what is known as an external balance
This involves the balancing of the inflows and
outflows included in the current account
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18 – 5
FISCAL AND MONETARY POLICY
• Governments now tend to use monetary and fiscal
•
•
•
policy to focus on a country’s internal balance
Internal balance refers to the levels of
unemployment and inflation that fit the
preferences of the citizens of various economies
The focus on internal balance comes at the
expense of external balance considerations
Policies designed to achieve a desired internal
balance may have large consequences for a
country’s external balance
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18 – 6
CHANGES IN FISCAL POLICY
• In most countries government spending is such a
•
•
large part of the GDP that any changes can have a
critical impact on an economy
Substantial amounts spent on transfer payments
mean tax revenues add to this amount
A portion of total government spending is usually
financed through borrowing, thereby having a
significant impact on country’s domestic financial
markets and interest rates
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18 – 7
CHANGES IN FISCAL POLICY
• Expansionary Fiscal Policy
• The government adopts an expansionary fiscal
•
•
•
policy by choosing to lower tax revenues and/or
have higher government spending
This leads to a government budget deficit (or
larger deficit)
Assume government borrows to finance and does
not print money
This will have a predicable effect on interest rates
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18 – 8
CHANGES IN FISCAL POLICY
• The result of an expansionary fiscal policy in an
•
•
open economy is that less upward pressure is
put on interest rates than would be the case in a
closed economy
A larger federal government budget deficit tends
to increase domestic interest rates which causes
an inflow of foreign capital into the country
The capital flows have an effect on the
equilibrium exchange rate
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18 – 9
CHANGES IN FISCAL POLICY
Figure 18.2
Effects of Expansionary Fiscal Policy on the Exchange Rate
S
Exchange Rate
(XR)
S’
XRe
XR’
E
X
M
D
Foreign Exchange (FX)
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18 – 10
CHANGES IN FISCAL POLICY
• In an economy with a balanced current account, if
•
•
•
the government adopts an expansionary fiscal
policy and domestic interest rates rise, the inflow
of foreign capital requires foreign investors to sell
foreign currency to buy dollars
The supply of foreign exchange increases and the
nominal exchange rate appreciates
This means the domestic currency has appreciated
in nominal terms
There will be a capital account surplus and a
current account deficit
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18 – 11
CHANGES IN FISCAL POLICY
• An expansionary fiscal policy puts upward price
•
•
pressure on domestic interest rates which leads to
an increase in the flow of capital from abroad into
the domestic financial markets
We need to consider the effect of an expansionary
fiscal policy on the domestic economy
In a closed economy this would lead to an
increase in domestic output and price level
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18 – 12
CHANGES IN FISCAL POLICY
• In an open economy the effects are less clear as an
•
•
expansionary fiscal policy has two conflicting
effects
The policy increases aggregate demand as the
government reduces taxes and/or increases
spending, the direct effect
The policy reduces aggregate demand as the
exchange rate appreciates and the current account
balance deteriorates, the indirect effect
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CHANGES IN FISCAL POLICY
• The net effect depends on the magnitude of the
•
two effects
Expansionary fiscal policy in an open economy
is less effective at changing equilibrium output
than in a closed economy
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18 – 14
CHANGES IN FISCAL POLICY
Figure 18.3
Effects of Fiscal Policy on Equilibrium Output and Price Level
Price Level (P)
AS
P’
F
Pe
E
AD’
AD
Ye
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Y’
Real GDP (Y)
18 – 15
CHANGES IN FISCAL POLICY
• Contractionary Fiscal Policy
• A contractionary fiscal policy would entail
•
•
some combination of higher taxes and/or lower
government spending
This reduces a government budget deficit or
increases size of a surplus
Adopting a contractionary fiscal policy causes
the overall demand for loanable funds to shrink
and lowers the interest rate
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18 – 16
CHANGES IN FISCAL POLICY
• The lower domestic interest rate affects capital
•
•
flow into the country as domestic and foreign
investors would tend to invest less and domestic
investors would tend to invest more capital abroad
The net result would be an outflow of capital from
domestic economy and the supply of loanable
funds would decrease lowering interest rates
A contractionary fiscal policy puts less downward
pressure in domestic interest rates in an open
economy than in a closed economy
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18 – 17
CHANGES IN FISCAL POLICY
Figure 18.5
Effects of Contractionary Fiscal Policy on the Exchange Rate
Exchange Rate
(XR)
XR’
S
M
XRe
X
E
D’
D
Foreign Exchange (FX)
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18 – 18
CHANGES IN FISCAL POLICY
• A contractionary fiscal policy lowers the federal
•
•
government budget deficit which decreases
domestic interest rates and causes an outflow of
capital
This increases the demand for foreign exchange
and the exchange rate rises or the domestic
currency depreciates
This causes the capital account to become
negative which causes the current account to
become positive
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18 – 19
CHANGES IN FISCAL POLICY
• In an open economy, a contractionary fiscal policy
•
•
causes aggregate demand to decrease and the
domestic currency to depreciate as the government
increases taxes and/or reduces spending—the
direct effect
The contractionary fiscal policy increases
aggregate demand as the currency depreciates and
the current account balance to improve—the
indirect effect
A contractionary fiscal policy in an open economy
is less effective in changing equilibrium output
than it is in a closed economy
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18 – 20
CHANGES IN FISCAL POLICY
• In open economies with international capital
•
•
mobility, fiscal policy is not as particularly
effective in changing the equilibrium level of
output or the price level
The effects of fiscal policy are not irrelevant,
however
Fiscal policy can affect interest rates, exchange
rates, capital flows and current account balances
and the effects are noticeable in the economy and
have an effect on business decision making
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18 – 21
CHANGES IN MONETARY POLICY
• Most central banks in developed countries use
•
•
discretionary monetary policy in an attempt to
affect the short run performance of the economy
by changing the growth rate of the money supply
and/or interest rates
Recently there has been some increased interest in
the substitution of some form of monetary rule for
discretionary monetary policy
The central bank would focus on controlling a
more limited variable such as the price level
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18 – 22
CHANGES IN MONETARY POLICY
• New Zealand and the EU are currently operating
•
•
•
with a price stabilization rule
But few countries use a nondiscretionary
(monetary rule) monetary policy
In most cases, changes in monetary policy are the
result of discretionary policy decisions
Even with a monetary rule, there are periodic
changes in the money supply and interests rates
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18 – 23
CHANGES IN MONETARY POLICY
• Expansionary Monetary Policy
• An expansionary monetary policy results when a
•
•
central bank increases the money supply or
money supply growth rate
Increases in the money supply increase the
supply of loanable funds initially causing a
decrease in the interest rate
The decrease in interest rates causes a capital
outflow
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18 – 24
CHANGES IN MONETARY POLICY
Figure 18.7
Supply and Demand for Loanable Funds and
Expansionary Monetary Policy
Interest Rate (i)
ie
i’
S
S’
E
F
D
Loanable Funds (L)
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18 – 25
CHANGES IN MONETARY POLICY
• Capital outflow causes supply of loanable funds to
•
•
•
decrease which increase the interest rate
Capital outflows cause demand for foreign
exchange to increase and the currency depreciates
which worsens the capital account causing a
deficit
This translates into a current account surplus as
exports increase and imports decrease
An expansionary monetary policy indirectly leads
to a current account surplus when capital is mobile
between countries
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18 – 26
CHANGES IN MONETARY POLICY
Figure 18.8
Effects of Expansionary Monetary Policy on the
Exchange Rate
Exchange Rate
(XR)
XR’
S
M
XRe
X
E
D’
D
Foreign Exchange (FX)
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18 – 27
CHANGES IN MONETARY POLICY
• In a closed economy, monetary policy is generally
•
•
effective because lower interest rates increase both
consumption and investment spending—the direct
effect
Aggregate demand increases
In an open economy, the fall in interest rates
induces depreciation of the domestic currency and
capital outflow improving the current account as
exports increase and imports decrease—the
indirect effect
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18 – 28
CHANGES IN MONETARY POLICY
• The aggregate demand curve shifts even further to
•
the right
The net result is that in an open economy with
capital mobility, monetary policy is effective in
increasing the level of economic activity
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18 – 29
CHANGES IN MONETARY POLICY
Figure 18.9
Effects of Monetary Policy on Equilibrium Output and
Price Level
Price Level
(P)
AS
P”
G
P’
F
Pe
E
AD”
AD’
AD
Ye
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Y’ Y”
Real GDP (Y)
18 – 30
CHANGES IN MONETARY POLICY
• Contractionary Monetary Policy
• In contractionary monetary policy, the central
•
•
bank decreases the money supply or reduces the
money supply growth rate
The most notable effect is an increase in
domestic interest rates
In developed countries selling government bonds
decreases the supply of loanable funds causing a
rise in interest rates
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18 – 31
CHANGES IN MONETARY POLICY
Figure 18.10
Supply and Demand for Loanable Funds and
Contractionary Monetary Policy
Interest Rate (i)
i’
ie
S’
S
F
E
D
Loanable Funds (L)
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18 – 32
CHANGES IN MONETARY POLICY
• The resulting attraction of foreign capital and
•
•
increase in supply causes a decrease in the
exchange rate
This creates a capital account surplus and a
current account deficit
A contractionary monetary policy is effective in a
closed economy because the increased interest
rate reduces the growth rate of consumption
and/or investment
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18 – 33
CHANGES IN MONETARY POLICY
Figure 18.11
Effects of Contractionary Monetary Policy on the
Exchange Rate
Exchange Rate
(XR)
S
S’
XRe
XR’
E
X
M
D
Foreign Currency (FX)
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18 – 34
CHANGES IN MONETARY POLICY
• The reduction in total spending causes a decease
•
•
•
•
in aggregate demand lowering output and the price
level
In an open economy, the effects are larger
The increase in interest rate induces capital flows
into the country and an appreciation of the
currency
The current account deteriorates as exports fall
and imports rise—the indirect effect
In an open economy, monetary policy is highly
effective in changing equilibrium levels of output
and price
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CHANGES IN MONETARY POLICY
Figure 18.12
Effects of Monetary Policy on Equilibrium Output and
Price Level
Price Level
(P)
AS
Pe
E
P’
F
P”
G
AD
AD’
AD”
Y”
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Y’ Ye
Real GDP (Y)
18 – 36
CHANGES IN MONETARY POLICY
Figure 18.13
Crowding Out in a Closed Economy
Interest Rate (i)
i’
S
G
F
E
ie
D’
D
L’
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L
Loanable Funds (L)
18 – 37
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effects of government policies are often
•
•
•
described in terms of effects on a country’s
external and internal balances
The current account balance represents the
external balance while the equilibrium level of
output and price level is the internal balance
At any point in time, there is an optimal balance
of output level and price level implying full
employment and stable prices
This is rarely observed
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18 – 38
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Governments frequently use fiscal and monetary
•
•
•
policy to achieve an acceptable balance between
output and price level
Fiscal and/or monetary policy can be used to
influence internal or external balance
In many cases, governments cannot balance both
and have to choose which is more important
Typically internal balance is seen as most
important and fiscal and/or monetary policy is
focused on achieving an optimal internal balance
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18 – 39
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Although both fiscal and monetary policy affect
•
•
•
the current account and exchange rates, they are
usually not the primary focus of policy
The public and the press tend to think the
exchange rate and the current account are the
primary targets of macroeconomic policies
While this may be the case, macroeconomic policy
is often focused on a country’s internal balance
The policy mix of a country is the effects of
various combinations of fiscal and monetary
policy
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18 – 40
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Table 18.1
Effects of Different Fiscal and Monetary Policies Under
Flexible Exchange Rates and Capital Mobility
Effect on
Equilibrium
Output
Equilibrium
Price Level
Exchange
Rate
Current
Account
–Direct
Increase
Increase
Appreciates
Deteriorates
–Indirect
Decrease
Decrease
–Net
Little or no Effect
Appreciates
Deteriorates
–Direct
Decrease
Decrease
Depreciates
Improves
–Indirect
Increase
Increase
–Net
Little or no Effect
Depreciates
Improves
–Direct
Increase
Increase
Depreciates
Improves
–Indirect
Increase
Increase
–Net
Large Increase
Depreciates
Improves
–Direct
Decrease
Decrease
Appreciates
Deteriorates
–Indirect
Decrease
Decrease
–Net
Large Decrease
Appreciates
Deteriorates
Fiscal Policy
Expansionary
Contractionary
Monetary Policy
Expansionary
Contractionary
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18 – 41
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Consistent Policy Mixes
• In a recession the real GDP is below the full
•
•
•
employment level
The government want to increase output by
adopting an expansionary monetary policy and/or
expansionary fiscal policy
A combination of both would tend to increase
output and price level
The potential for rising prices may be deemed an
acceptable risk
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18 – 42
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effect on the exchange rate is unclear
•
•
•
depending on magnitude of change in the two
policies on domestic interest rates
The effect on the current account is also unclear
depending on the effect on interest rates
From a policy perspective, battling a recession and
letting the external balance adjust as needed is a
safe option
The domestic economy would improve and the
external balance is unlikely to change by a large
amount in either direction
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18 – 43
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• A similar scenario emerges if the problem is
•
•
•
•
inflation
The economy is temporarily producing output at
greater than full employment levels
The government would employ a combination of
contractionary monetary and fiscal policies
The effects are clear, both equilibrium output and
the price level would fall
The effects on the exchange rate and current
account are unclear since policies move in
opposite directions
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18 – 44
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• This policy mix does not appear to be a problem
•
as the internal balance moves in the desired
direction without dramatic changes in the external
balance
When governments adopt similar fiscal and
monetary policies, the equilibrium level of output
and the price level can be changed without making
drastic changes in the exchange rate or current
account balance
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18 – 45
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• Inconsistent Policy Mixes
• Mixtures of fiscal and monetary policies that are
•
•
•
inconsistent with one another are inconsistent
with internal balance objectives
Why would a government adopt such a mixture
when the effects are unclear?
Often different policy makers are in control of
fiscal and monetary policy
In the U.S., elected officials control the fiscal
policy while the independent Federal Reserve
determines the monetary policy
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• The effect of inconsistent policies can be
•
•
•
ambiguous on the domestic economy
The effect on the external balance is explicit
An expansionary fiscal policy and contractionary
monetary policy leads to an appreciation of the
currency and decreased current account
The policies reinforce one another and the effect
on the external balance can be significant
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18 – 47
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
• A contractionary fiscal policy coupled with an
•
expansionary monetary policy leads to a
depreciation of the domestic currency and an
improvement in the current account balance
The effect of changes in the country’s exchange
rate can have a dramatic impact on the
competitiveness of individual firms with tradable
goods
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.14
Federal Budget Deficit and the Balance on Current
Account for the U.S., 1980-1996
50 –
In Billions of Dollars
0–
–50 –
–100 –
–150 –
–200 –
–250 –
–300 –
1980
1985
1990
1995
Year
Federal Deficit
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Current Account
18 – 49
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.15a
U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
Long-Run Real Interest Rate
9–
6–
3–
0–
–3 –
1980
1985
1990
1995
Year
Real Interest Rate
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18 – 50
MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
Figure 18.15b
U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
Real Exchange Rate 1973 = 100
140 –
130 –
120 –
110 –
100 –
90 –
80 –
1980
1985
1990
1995
Year
Real Exchange Rate
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18 – 51
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• The assumption of no lag in the effects on
•
•
•
macroeconomic variables from monetary and
fiscal policy may be valid in some cases
Financial markets are relatively efficient so
interest rates are affected quickly
High capital mobility allows the exchange rate to
change relatively quickly
However, the response of trade flows to changes
in exchange rates may not always happen quickly
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18 – 52
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• The price of imports and exports may not change
•
•
instantly as the exchange rate changes
International trade may respond slowly to changes
in prices compared to the response of financial
markets
The time it takes for the exchange rate to affect a
country’s exports and imports and the current
account balance could be six months to a year
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18 – 53
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• In the long run, as a country’s currency
•
•
depreciates, its exports expand and imports
contract (and vice versa)
In the short run, as a country’s exchange rate
changes, the response of exports and imports and
current account balance could very easily be in
the opposite direction
In part this is because international trade is often
conducted between parties on a contract basis
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18 – 54
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• Importers agree to purchase a certain amount of a
•
•
•
good at an agreed upon price
If currency depreciates, cost of goods in domestic
currency rises
This causes the value of imports to rise, but the
value of exports in domestic currency does not
change as the price was predetermined by the
contract
The net effect is that the current account may
initially worsen after a depreciation and only
improve after a lag
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18 – 55
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
• The effect on the current account balance has been
•
•
•
called the J-curve
This reflects the tendency for the current account
balance to initially worsen when a currency
depreciates
Only after contracts are renewed to reflect the new
exchange rate will the current account begin to
improve
It is important for policy makers to take the lag
effect into account
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18 – 56
TRADE FLOW ADJUSTMENT AND
CURRENT ACCOUNT DYNAMICS
Figure 18.16
The J Curve
Current Account
Balance
Current Account Surplus
0
t0
t1
Time
Current Account Deficit
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18 – 57
SUMMARY
1. Governments use fiscal policy to change the level
of taxation and/or government spending at the
national level to affect the level of economic
activity (GDP). Governments use monetary policy
to change the money supply or interest rates to
affect a country’s level of economic activity.
2. A country’s exchange rate and its current account
balance represent its external balance
3. Expansionary fiscal policy occurs when a
government chooses to adopt some combination of
lower tax revenue and/or higher government
spending
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18 – 58
SUMMARY
4. In an open economy with international capital
mobility, expansionary fiscal policy leads to a rise
in interest rates which causes and inflow of foreign
capital
5. A contractionary fiscal policy in an open economy
is not very effective in reducing the price level or
real GDP
6. Expansionary monetary policy occurs when a
government chooses to increase the money supply
or the money supply’s growth rate
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18 – 59
SUMMARY
7. In an open economy with international capital
mobility, expansionary monetary policy leads to a
fall in interest rates which causes an outflow of
foreign capital
8. A contractionary monetary policy would lead to
higher interest rates, lower output, and a lower
price level
9. Consistent policy mixes can be effective in solving
internal balance problems
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18 – 60
SUMMARY
10. Mixtures of fiscal and monetary policy that are
inconsistent with one another are also inconsistent
with internal balance objectives
11. In the long run, as a country’s currency
depreciates, its exports expand and imports
contract. In the short run, its current account
balance could very easily move in the opposite
direction.
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18 – 61