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Economic Policy Floating Exchange Rates The Difference Between the Floating Exchange Rates and the Fixed Exchange Rates • When it chooses to maintain a fixed exchange rate, a nation’s central bank shoulders two burdens. • First, it must stand ready to intervene in the foreign exchange market by purchasing and selling foreign-currency-denominated assets. • Second, it must decide whether to sterilize its foreign exchange market interventions. • By permitting the exchange rate to float, a central bank relieves itself from these burdens. Daniels and VanHoose Econoic Policy 2 The Effects of Exchange-Rate Variations in the IS-LM-BP Model • The trigger event: depreciation • How does the IS schedule move? • How does the BP schedule move? Daniels and VanHoose Econoic Policy 3 Exchange-Rate Variations and the IS Schedule • A fall in the value of a nation’s R currency makes imports more expensive, inducing the nation’s residents to reduce their import spending. • Simultaneously, the effective prices of the nation’s export goods faced by R1 other nations’ residents decline. Consequently, expenditures on the nation’s exports increase. • Both of these effects generate a rise in the nation’s aggregate autonomous expenditures at any given nominal interest rate. Hence, the IS schedule shifts to the right. Daniels and VanHoose Econoic Policy A B IS’ IS y1 y2 y 4 Exchange-Rate Variations and the BP Schedule • A currency depreciation causes a nation’s R exports to rise and its imports to fall at any given real income level and at any given nominal interest rate. So a rise in the exchange rate from S1 to S2 generates R1 an improvement in the trade balance that results in a balance-of-payments surplus at point A. • This means that for the balance of payments to return to equilibrium, the real income should increase, or the nominal interest rate should decline. So the BP schedule shifts to the right. Daniels and VanHoose Econoic Policy BP A BP’ B y1 y2 y 5 The Effects of a Currency Depreciation on the IS and BP Schedules Daniels and VanHoose Econoic Policy 6 Monetary Policy under Floating Exchange Rates • Suppose the central bank carry out an expansionary monetary policy. An increase in the money stock from M1 to M2 causes the LM schedule to shift rightward,which will lead to the balance-of-payments deficit regardless of in low capital mobility or in high capital mobility. • When capital mobility is low, the balance-of-payments deficit results from an increase in real income. When capital mobility is high, the balance-of-payments deficit results from the outflow of capital spurred by the decline in the interest rate from R1 to R2. Daniels and VanHoose Econoic Policy 7 The Effects of an Increase in the Money Stock with Floating Exchange Rates Daniels and VanHoose Econoic Policy 8 Conclusion • With either low or high capital mobility, an increase in the money stock tends to induce a rise in equilibrium real income, holding other factors such as the price level unchanged. • Under a floating exchange rate, therefore, an increase in the quantity of money unambiguously constitutes an expansionary policy action that induces at least a near-term increase in a nation’s real income level. Daniels and VanHoose Econoic Policy 9 Fiscal Policy with Low Capital Mobility • An increase in government spending R causes the IS schedule to shift to the right, from IS to IS’. This yields a new IS-LM equilibrium at point B, which lies to the right of the initial BP R3 schedule.Therefore, the immediate effect of the rise in government spending is a R2 balance-of-payments deficit, which press the nation’s currency to depreciate. The R1 resulting rise in the exchange rate, from S1 to a higher level S2 ,induces net export expenditures to increase. This causes the IS schedule to shift rightward once more, and causes the BP schedule to shift rightward. Daniels and VanHoose Econoic Policy BP BP’ LM C B A IS” IS’ IS y1 y2 y3 y 10 Fiscal Policy with High Capital Mobility • When capital is very mobile, a R rise in government spending lead the IS schedule to shift rightward, and induces a balance-R 2 of-payments surplus at point B R 3 above the initial BP schedule. R1 The nation’s currency value appreciates. Hence, the exchange rate declines from S1 to S2. So the IS and BP schedules shift leftward. Daniels and VanHoose Econoic Policy LM B BP’ C BP IS’ A IS” IS y1 y3 y2 y 11 The Effects of an Increase in Government Spending with a Floating Exchange Rate Daniels and VanHoose Econoic Policy 12 Floating Exchange Rates and Perfect Capital Mobility • We assume throughout that there is no anticipated currency depreciation or appreciation, so that the uncovered interest parity condition implies that the nominal interest rate for the small open economy is equal to the large-country nominal interest rate, R*. That is, the BP schedule is horizontal. Daniels and VanHoose Econoic Policy 13 Monetary and Fiscal Policies with Perfect Capital Mobility and Floating Exchange Rates Daniels and VanHoose Econoic Policy 14 Conclusion • With perfectly mobile capital, Monetary policy actions have their largest possible real-income effects if the exchange rate floats. • With perfect capital mobility, fiscal policy actions have minimal real-income effects if the exchange rate floats. Daniels and VanHoose Econoic Policy 15 Perfect Capital Mobility and Fixed versus Floating Exchange Daniels and VanHoose Econoic Policy 16 Real-Income Effects with Perfect Capital Mobility and Fixed Versus Flexible Exchange Rates Exchange-Rate Setting Monetary Policy Effect Fiscal Policy Effect Fixed Exchange Rate Minimum Effect Maximum Effect Flexible Exchange Rate Maximum Effect Minimum Effect Daniels and VanHoose Econoic Policy 17 • • • • • Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A Two-Country Example A Two-Country Model with Perfect Capital Mobility and a floating Exchange Rate The Effects of a Domestic Monetary Expansion The Effects of a Foreign Monetary Expansion The Effects of a Domestic Fiscal Expansion The Effects of a Foreign Fiscal Expansion Daniels and VanHoose Econoic Policy 18 Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A Two-Country Example • Assumption1: A “world” composed of two nations that are of roughly equal size and that engage in international trade of goods, services, and financial assets. Each nation accounts for about half of the world’s output. • Assumption 2: Financial resources flow freely across their borders. • Assumption 3: Prices are unchanged in both the domestic country and the foreign country. Daniels and VanHoose Econoic Policy 19 Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A Two-Country Example • The difference between the two-country model and the small-open-economy framework is that nominal interest rates in both nations may change in response to monetary or fiscal policy actions. • Nevertheless, the free movement of financial resources between the two nations ultimately must drive the countries’ interest rates to the same value. Daniels and VanHoose Econoic Policy 20 The Effects of a Domestic Monetary Expansion R R* IS*(S2,y2) LM(M1/P1) IS(S2,y2*) LM(M2/P1) R1 A BP1 R1* BP2 R2* BP1* A R2 C C B B IS(S2,y1*) IS*(S2,y1) IS(S1,y 1*) y1 y2 y y 2* (a) Daniels and VanHoose BP2* y 1* IS*(S1,y1) y* (b) Econoic Policy 21 The Effects of a Domestic Monetary Expansion • We may conclude that under a floating exchange rate and perfect capital mobility, a domestic monetary expansion can have a beggar-thyneighbor effect on the foreign country. • That is, an increase in the domestic money stock exerts an expansionary effect on the domestic economy but typically tends to depress the equilibrium level of economic activity in the foreign economy. Daniels and VanHoose Econoic Policy 22 The Effects of a Foreign Monetary Expansion R* R IS(S2,y2) LM*(M1/P1) IS*(S2,y2*) LM*(M2/P1) A R1 BP1 R1* BP2 R2* BP1* A C R2 BP2* C B B IS(S2,y1) y2 y1 IS*(S2,y1*) IS(S1,y1) y IS*(S1,y 1*) y1* (a) Daniels and VanHoose y2* y* (b) Econoic Policy 23 The Effects of a Foreign Monetary Expansion • We can conclude that, with a floating exchange rate and perfect capital mobility, a foreign monetary expansion typically generates a beggar-thy-neighbor effect. Daniels and VanHoose Econoic Policy 24 The Effects of a Domestic Fiscal Expansion R LM R* LM* B R’ C C R2 BP2 R1 R2* BP1 BP2* A R1* BP1* A IS (g2,S1,y1*) IS*(S2,y2) IS (g2,S2,y2*) IS*(S1,y1) IS (g1,S1,y1*) y1 y2 y’ y y 1* (a) Daniels and VanHoose y 2* y* (b) Econoic Policy 25 The Effects of a Domestic Fiscal Expansion • Because the equilibrium levels of real income in the two nations exceed their initial values. Thus, under a floating exchange rate and perfect capital mobility, a domestic fiscal expansion has a locomotive effect on the foreign country. • An increase in domestic government spending results in expansions of real income levels in both nations. Daniels and VanHoose Econoic Policy 26 The Effects of a Foreign Fiscal Expansion R R* LM LM* B R*’ C R2 A R1 C BP2 R2* BP2* BP1 R1* BP1* A IS* (g2,S1,y1*) IS(S2,y2) IS* (g2,S2,y2*) IS(S1,y1) y1 y2 IS* (g1,S1,y1*) y y1* (a) Daniels and VanHoose y 2* y’* y* (b) Econoic Policy 27 The Effects of a Foreign Fiscal Expansion • We may conclude that increase in foreign government spending generates, with a floating exchange rate and perfectly mobile capital, increases in equilibrium nominal interest rates and real income levels in both nations. • That is, a foreign fiscal expansion has a locomotive effect on the domestic country. Daniels and VanHoose Econoic Policy 28 Cross-Country Effects In Two-Country Model With Perfect Capital Mobility Exchange-Rate Setting Monetary Policy Effect Fiscal Policy Effect Fixed Exchange Rate Locomotive Effect Beggar-ThyNeighbor Effect Flexible Exchange Rate Beggar-ThyNeighbor Effect Locomotive Effect Daniels and VanHoose Econoic Policy 29