Download CHAPTER 13 Capital Mobility and the Exchange Rate in the IS

CHAPTER 13
Capital Mobility and the Exchange Rate in the IS-LM Model
Chapter Outline
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Capital Mobility and Interest Parity
Capital Flows and Interest Parity
The Mundell-Fleming Model With Flexible Exchange Rates
A Change in the Foreign Price Level
Fiscal Policy
Monetary Policy
Beggar Thy Neighbor and Competitive Depreciation
Perfect Capital Mobility and Fixed Exchange Rates
Fiscal Policy With a Fixed Exchange Rate
The Endogenous Money Stock
Interest Differentials and Exchange Rate Expectations
Exchange Rate Expectations
Speculative Capital Flows
Working With Data
Changes from the Previous Edition
This chapter has been largely re-written. The chapter now focuses on the Mundell-Fleming
model. We introduce the concept of perfect capital mobility and maintain this assumption throughout the
chapter. In Section 13-1 we derive the BP=0 line from a story comparing the return on one Canadian
dollar invested in Canada and the return on the same Canadian dollar invested in the U.S. Section 13-2
then treats the standard Mundell-Fleming results with a flexible exchange rate, and Section 13-3 dos the
same for the case of fixed exchange rates. Section 13-4 discusses the issues surrounding interest
differentials and exchange rate expectations.
Learning Objectives
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Students should understand that capital flows depend on the interest parity condition. Under the
assumption that agents do not expect a change in the nominal exchange rate, the interest parity
condition collapses to the nominal interest differential.
Students should understand that the BP curve is simply the interest parity condition in this model.
Students should understand that under flexible exchange rates changes in the money supply cause
changes in the exchange rate and changes in income, but fiscal policy changes are crowded out
completely.
Students should understand that under fixed exchange rates monetary policy is completely ineffective
while fiscal policy has full multiplier effects on income
Students should understand how exchange rate expectations play a role in the interest parity
condition.
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Accomplishing the Objectives
The IS-LM model of income determination derived in Chapters 12 and 13 is expanded here to
include international aspects. It considers fixed and flexible exchange rates, but continues to assume that
the domestic price level is fixed and that whatever level of output is demanded will always be supplied.
A key assumption is this chapter is that financial capital is perfectly mobile internationally. This
is an empirically defensible assumption in the very short run. Under this assumption of perfect capital
mobility, the balance of payments equilibrium will only depend upon financial capital flows. Since
financial capital will respond to interest parity conditions, balance of payments equilibrium will hold
when interest parity holds. Under the naïve assumption (which is relaxed in the last section of the
chapter) interest parity (and balance of payments equilibrium, simply depends upon the nominal interest
differential.
From this point, the logic of the model can be summed up in two diagrams. First, Figure 13-1
ties together capital flows and exchange rate movements.
Figure 13-1
Interest Parity, Capital Flows and Exchange Rate Changes
i
i if
Capital inf low
exchange rate appreciation
if
iif
Capital outflow
exchange rate depreciation
Y
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Figure 13-2 shows us that capital inflow will result when i  i f and this will cause a nominal
appreciation, and capital outflow will result when i  i f and this will cause a nominal depreciation. This
can be tied together with movements in the nominal (and real) exchange rate causing shifts in the IS
curve:
Figure 13-3
Exchange Rate Changes and the IS Curve
i, i f
Appreciation
BP  0
i if
Depreciati on
IS
Y
Students may benefit from thinking of the nominal exchange rate as a shift parameter on the IS
curve.
Given the above, the results of the model lend themselves nicely to a certain taxonomy,
summarized in the table below.
Flexible Exchange Rate
Fixed Exchange Rate
Monetary Policy
can change both Y, i
must keep i fixed; cannot change Y
Fiscal Policy
cannot change the level of Y
changes the composition of Y
can change the level of Y
full fiscal multiplier
Essentially, a shift in either curve, in either direction, will cause capital flows and exchange rate
changes, and the students should work through all of the possible cases. One way to look at this model is
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that if there are no capital flows (interest parity holds and the balance of payment are in equilibrium),
there will be no exchange rate changes. Monetary policy has the ability to change the domestic interest
rate, but in doing so, the exchange rate will change due to the capital flows. Therefore, in a flexible
exchange rate system, the monetary authorities must be willing to let the exchange rate change
endogenously.
If the monetary authorities choose to keep the exchange rate fixed, then monetary policy must be
aimed at keeping the interest rate fixed at the level of the foreign interest rate. This is the only manner in
which capital flows will be prevented from changing the exchange rate. In this situation, monetary policy
is prevented from aiming stabilization policy at changing domestic income, as it has (by it’s own choice)
lost the ability to change the interest rate.
From the perspective of fiscal policy, if, for example, expansionary fiscal policy shift the IS curve
outward, there will pressure for an interest rate increase. Under a flexible exchange rate system, capital
flows will appreciate the nominal exchange rate, worsen the terms of trade and reduce net exports.
Students must fully understand that this results in no change in the level of income, but results in a change
in the composition of income. Under a fixed exchange rate system, the monetary authorities must move
to prevent the interest rate increase, so the full multiplier change in the level of income is realized.
In the final section of the chapter, we deal with the relationship between exchange rate
expectations and the interest differential. This will help students to understand why there may be a gap
between, say, Canadian and U.S. nominal interest rates. Students should understand that if the two
interest rates are equal, and, at the same time, agents expect a depreciation in the nominal exchange rate,
holding a Canadian bond means that you expect to incur a loss by being in Canadian currency. Therefore,
you will only hold the Canadian bond if it bears enough of a higher rate of return to compensate for the
excepted loss in currency value.
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Suggestions and Pitfalls
There are several very interesting results in this chapter that can be used to stimulate lively
classroom discussions. Students are always interested in what monetary policy can and cannot
accomplish. The Mundell-Flemming model affords a perfect opportunity to discuss monetary policy
under both a fixed and flexible exchange rate regime. It should be emphasis that monetary policy can be
aimed at domestic stabilization, as long as the exchange rate is flexible. However, if the monetary
authorities wish to run a fixed exchange rate regime, then they must give up independent stabilization
policy. This can actually be related to the monetary policy choice surrounding the recession of the early
1980s, as in the policy in Action box on page 264, or Application Question #7.
Students may have difficulty with the result that fiscal policy with a flexible exchange rate can
change the composition of income but not the level. For those instructors who are willing to enter into a
contentious policy debate, you could describe this result within the framework of application of fiscal
policy within a country that is regionally diverse. Suppose that regions A is a net exporter of goods and
region B is not. Suppose that region A is booming due to an artificially low nominal exchange rate, while
at the same time region B is in a slump. Government spending in region B, which forces up interest rates
and attracts international capital, will cause the nominal exchange rate to appreciate, which will cool off
region A and increase economic activity in region B. There are lots of real world variations on this
theme.
Another interesting result is the beggar-thy-neighbor aspect of expansionary monetary policy
with a flexible exchanger ate. It has to bee emphasized in this result that our depreciation is an
appreciation for our trading partner. Technically, our income increase is their income decrease. This, of
course, could lead to a costly trade war. Given that our largest trading partner is the United States, this
may be a no win situation. This should prompt some lively classroom debate.
Finally, students may have trouble with the last section on interest parity and expectations. For
those who have a technically oriented class, you may want to derive equation (11) from equation (5), by
taking logarithms:
ln( 1  it )  ln( 1  it f )  ln( ete1 )  ln( e t )
Since interest rates are decimals, ln( 1  it )  it , and the same for the foreign interest rate. The
last term is x
x  ln( ete1 )  ln( et )
Therefore, if agents expect next period’s exchange rate to be higher (measured in Canadian dollars) then
they expect an exchange rate depreciation. In equilibrium, if you expect the Canadian dollar to
depreciate, you expect to lose money by holding Canadian dollars. This must be made up by a
correspondingly higher Canadian nominal interest rate.
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Solutions to the Problems in the Textbook:
Discussion Questions:
1. If a U.S. Treasury bill yields 5 percent, and a Canadian Treasury bill yields 10 percent, you would
appear to be losing 5 percent by holding the U.S. bond. However, this ignores the fact that the two
returns are measured in different currencies. If you were to hold the Canadian bond, you would only
make an extra 5 percent if the currency did not change in value. Suppose that you expected the
Canadian dollar to depreciate by 5 percent, so that x=5. In this situation, you expect to gain 5 percent
interest from the U.S. bond, plus an extra 5 percent by being in U.S. dollars. Therefore your expected
return in 10 percent, which is the same expected return from holding the Canadian bond.
2.
This change shifts the BP curve upward.
(i) Reaction to the Shock With A Flexible Exchange Rate
This policy stance is summarized in the diagram below.
LM
i
i f
BP 
i0  i f
BP
IS 
IS
Y0
Y
Y1
The increase in U.S. nominal interest rates shifts the BP curve up to BP’. Under a flexible exchange rate,
monetary policy does not actively intervene in the market in response to this increase in i f . This means
that, initially, the Canadian nominal interest rate is still at i 0 . Therefore, because i  i f , there will be
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capital outflows, and the nominal exchange rate would depreciate. In the short-run, this would cause the
terms of trade to improve, net exports would go up, and the IS curve would shift outward. Therefore,
under a flexible exchange rate, this shock would lead to an increase in domestic output.
(i) Reaction to the Shock With A Fixed Exchange Rate
This policy stance is summarized in the diagram below.
i
i1  i f 
BP 
i0  i f
BP
IS
Y1
Y
Y0
In the case of a fixed exchange rate, when the foreign nominal inters rate increases, the monetary
authorities immediately increase the domestic nominal interest rate to i1 . Therefore, the BP curve shifts
to BP’. This causes domestic income to go down to Y1.
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When capital is perfectly mobile, as we have assumed in this chapter, any interest differential will
prompt flows of capital, which will change the nominal exchange rate. Consider the case of
expansionary monetary policy, which lowers the domestic interest rate. In this case there will be
capital outflows, an excess supply of Canadian dollars, and the nominal exchange rate will depreciate.
This causes a short run improvement in the terms of trade, which will increase net exports. Thus
monetary policy is more effective with perfectly mobile capital as the net export increase causes
domestic income to increase.
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4.
a. When exchange rates are fixed, monetary policy cannot engage in domestic stabilization, as it must be
aimed at keeping the domestic interest rate equal to the foreign. Expansionary fiscal policy will tend
to raise interest rates, which the Bank of Canada must prevent by increasing the money supply.
Therefore, fiscal policy under a fixed exchange rate is very effective at changing output.
b. When the exchange rate is flexible, monetary policy can change the level of output through the net
export multiplier as described in Discussion Question #3. Fiscal policy cannot change the level of
output, but can change its composition, as net exports decrease while government spending increases.
5.
a.
b.
Expansionary monetary policy lowers domestic interest rates. This not only stimulates the level of
domestic investment spending but also results in an outflow of funds that will result in a depreciation
of the currency. This makes domestic goods more competitive on world markets and therefore
stimulates aggregate demand even more by increasing net exports.
The reaction of other countries depends very much on the performance of their economies (their
position in the business cycle) at the time. Policy makers in a country that is in a recession will be
unhappy since the beggar-thy-neighbor policy will lead to more unemployment. Policy makers in a
country that is in a boom may actually welcome an appreciation of their currency. The reason is that
the increase in their public’s demand for imported goods may reduce some of the inflationary
pressure that they may experience in a boom.
c. The policy described in this problem is always a beggar-thy-neighbor policy. However, depending on
their situations, other countries may not mind if they experience inflationary pressure.
Application Questions:
1. An increase in government purchases (G) will increase the level of output (Y) and interest rates (i).
This will cause an inflow of capital resulting in a higher value of the country's currency. The currency
appreciation will lead to a loss in competitiveness, and net exports (NX) will be crowded out to the
point where the demand for domestic goods is reduced to the original level. In the end, the level of
output and the interest rate will remain unchanged. In an IS-LM model, an increase in G will shift the
IS-curve to the right, increasing both the levels of output (Y) and the interest rate (i). But the decrease
in NX will shift the IS-curve back to the left, until interest rates are back to the world level.
2. A country that is faced with both a recession and a current account deficit should employ
expansionary monetary policy. Expansion in money supply will lower domestic interest rates. This
will not only stimulate domestic investment and output, but also result in a depreciation of the
currency. A lower currency value will increase competitiveness and lead to an increase in the demand
for the country's exports, further stimulating output. In other words, under perfect capital mobility and
flexible exchange rates, monetary expansion will lead to output expansion, currency depreciation, and
a trade balance improvement.
At the root of Finland's problem was the collapse of the Soviet Union (an important trade partner)
and the fall in prices of pulp and paper (important export items). Therefore, expansionary monetary
policy probably would not have been sufficient to remedy the situation. Expansionary fiscal policy
(preferably investment subsidies that are designed to help exporting firms develop new markets) in
combination with some protectionist measures would have been a better policy option.
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3. If the Canadian interest rate is i = 4% and you expect the British pound to depreciate by 6%, then the
yield on British government securities would have to be if =10% or more to make the purchase of
British government securities with Canadian dollars profitable. When capital is perfectly mobile, the
domestic interest rate (i) is equal to the foreign interest rate (i f) adjusted for the expected percentage
change in the exchange rate (e), that is,
i = if + (%e) ==> if = i - (%e) = 4% - (-6%) = 10%.
4. Expansionary fiscal policy will have its maximum effect under a fixed exchange rate system with
perfect capital mobility. This is because fiscal expansion must always be combined with monetary
expansion to bring domestic interest rates back in line with foreign interest rates. Expansionary fiscal
policy will increase the level of output demanded and the interest rate. But with perfect capital
mobility, the higher domestic interest rates will attract funds from abroad, which will put upward
pressure on the value of the domestic currency. To avoid currency appreciation, the central bank will
have to increase money supply to bring interest rates back in line with world levels. Therefore, no
crowding out will take place and the level of output will increase by the full multiplier effect.
5. This question can be answered by looking at the appreciation as downward shift in the BP curve.
This would cause a decrease in net exports and the economy could end up in a recession.
Additional Problems:
1. "Fiscal policy cannot change real output under fixed exchange rates and perfect capital
mobility." Comment on this statement.
Expansionary fiscal policy will shift the IS-curve to the right, leading to an increase in the level of output
demanded and a higher interest rate. This will cause an inflow of funds that will result in a currency
appreciation. To maintain a fixed exchange rate, the central bank will have to respond by increasing the
money supply, shifting the LM-curve to the right. Therefore, the level of output demanded will increase
even further. The central bank will continue to increase money supply until the domestic interest rate is
again in line with world interest rates. Since there will be no crowding out and the level of output will
increase by the full multiplier effect, the statement is false.
2. "Under a fixed exchange rate system and perfect capital mobility an increase in foreign interest
rates will cause the level of domestic output to rise." Comment on this statement.
If foreign interest rates rise, a capital outflow will occur, leading to a depreciation of the currency. To
maintain a fixed exchange rate, the central bank will be forced to buy domestic currency by selling its
holdings of foreign currency. This reduction in money supply will lead to higher domestic interest rates
and thus less output demanded. This will cause a recession and the level of domestic output will fall, not
rise.
3. "In the early 1980s, U.S. fiscal policy was very expansionary; this helped to foster economic
growth in the rest of the world." Comment on this statement.
The expansionary fiscal policy of the U.S. government, financed by increased borrowing, led to high U.S.
interest rates, which attracted a capital inflow from abroad. The increased demand for the U.S. dollar
caused the dollar to appreciate and U.S. goods became relatively more expensive, leading to a
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deterioration in the U.S. trade balance. As U.S. citizens bought more import goods, foreign economic
growth was stimulated. The increase in the national income of foreign countries eventually caused an
increase in the foreign demand for U.S. goods, a good example of the repercussion effect.
4. "A decrease in foreign interest rates will cause domestic output to fall under perfect capital
mobility and flexible exchange rates." Comment on this statement.
If interest rates fall abroad, there will be an inflow of capital here. This will cause an appreciation of the
domestic currency. The price of domestic goods will become relatively more expensive on world markets,
resulting in a decrease in net exports. But a decrease in net exports implies a decrease in aggregate
demand for domestic goods, and domestic income and interest rates will go down. (The IS-curve will shift
to the left until a new equilibrium at the new and lower world interest rate is reached.)
5. The re-unification of Germany required a large increase in the German budget deficit since it
became necessary to restructure businesses, provide income support for the unemployed, and
invest in the infrastructure in the new Eastern states. Explain the effects of such massive fiscal
expansion for Germany and its trade partners in the European Union.
The large increase in government spending (which was not financed by an equivalent tax increase or
accommodated by sufficient monetary expansion) resulted in a substantial increase in the German budget
deficit. Since the increase in demand from eastern Germany fell mostly on western German goods, the
Western economy overheated. Interest rates rose sharply, since the Bundesbank did not accommodate the
expansionary fiscal policy. This caused a capital inflow that put upward pressure on the value of the Dmark versus the currencies of non-European trade partners, and a current account deficit resulted.
Initially, Germany's European trade partners opted to essentially maintain the exchange rate of their
currencies versus the D-mark. Hence they had to allow the interest rates in their countries to increase to
match those in Germany to avoid a massive outflow of funds. However, since they did not experience the
same fiscal expansion as Germany, these economies' growth rates slowed sharply. Eventually, some
countries had to allow their currencies to depreciate.
6. "By running large budget deficits, the government will attract funds from abroad, which can
then be used to stimulate private investment. This action would be unwise, however, since
foreign countries respond unkindly to such a beggar-thy-neighbor policy." Comment on this
statement.
Expansionary fiscal policy will increase income and interest rates. Higher domestic interest rates will
crowd out investment but will also cause an inflow of funds, resulting in a higher value of the domestic
currency. This will lead to a loss in competitiveness and the crowding out of net exports, while less
investment is crowded out. Other countries are likely to have a mixed reaction to this policy since, on the
one hand, they will experience an outflow of funds, but, on the other hand, their economies will be
stimulated by the increased demand for their goods. This is definitely not a beggar-thy-neighbor policy. A
beggar-thy-neighbor policy is when a country tries to reduce domestic unemployment by depreciating its
currency. This can be achieved by using expansionary monetary policy, which will lower interest rates,
resulting in a capital outflow, lowering the value of the domestic currency. This will increase the demand
for domestic goods and lower the demand for foreign goods. As a result, domestic unemployment will
decrease while foreign unemployment will increase.
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7. "A depreciation-induced change in the trade balance does not work well when different
countries' economic cycles are highly synchronized." Comment on this statement.
Exchange depreciation creates domestic employment at the expense of other countries (this is why it is
called a beggar-thy-neighbor policy). It shifts demand from one country to another but does not change
the level of world demand. When many countries experience a simultaneous economic downturn,
exchange rate movements do not significantly increase world demand, even though they may affect the
allocation of demand among countries. While an individual country may feel compelled to raise domestic
output by attracting demand from other countries, a better way to increase demand in each country would
be to coordinate fiscal and monetary policy.
8. "Under a fixed exchange rate system, expansionary monetary policy depletes foreign reserves at
the central bank." Comment on this statement.
Expansionary monetary policy shifts the LM-curve to the right. The domestic currency will begin to
depreciate. Under a fixed exchange rate system, however, the central bank cannot allow that to happen
and will have to trade foreign currencies for domestic currency, thereby reducing the supply of money.
This will shift the LM-curve back to the left, and the foreign reserve holdings of the central bank will fall.
i
LM1
IS
LM2
i1
i2
0
Y1
Y2
Y
9. Explain how a recession in the United States can affect the economies of other industrial
nations.
If the U.S. economy enters a recession, private spending in the U.S. will decline, lowering the demand for
imports. U.S. prices are likely to rise less than those of other countries, which will stimulate U.S. exports,
while discouraging imports. As a result, a recession in the U.S. may contribute to a downturn in other
economies around the world.
10. Explain why a cut in government spending has a larger effect under a fixed exchange rate
system and perfect capital mobility than in a closed economy model.
In a closed economy model, restrictive fiscal policy shifts the IS-curve to the left, causing a decrease in
the level of output demanded and the interest rate. The decrease in the interest rate will increase the level
of investment spending. Therefore, the level of output demanded will go down by less than the full
amount of the shift in the IS-curve. In the graph below, we move from 1 to 2.
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i
IS2
IS1
LM2
LM1
i2
3
i2
1
2
0
Y3 Y2
Y1
Y
In an open economy it gets more complicated, since the lower interest rate will cause an outflow of funds.
This will lead to downward pressure on the value of the domestic currency. If the central bank wants to
maintain the exchange rate, it has to decrease money supply. This will shift the LM-curve to the left and
the level of output demanded will decrease even further. With perfect capital mobility, the central bank
will have to decrease money supply until the domestic interest rate is again at the level of the world
interest rate. Therefore, in the end, the level of investment spending will not be affected and we will have
the full multiplier effect. In the graph above, we will move from 1 to 3.
11. How does a protectionist measure, such as the levying of tariffs on foreign goods, affect the
trade balance, the exchange rate, and the level of domestic output if there is perfect capital
mobility?
If a tariff is imposed, the relative price of imported goods will increase and, as a consequence, the demand
for domestic goods will increase. Domestic income and interest rates will increase, leading to capital
inflows and an appreciation of the currency. This will, in turn, lower the relative price of imported goods
again. With perfect capital mobility the currency appreciation will eventually progress to the point where
the overall change in net exports will be zero. Therefore, the level of domestic output and the interest rate
will also be unaffected.
12. Explain how restrictive fiscal policy affects the level and composition of output under flexible
exchange rates and perfect capital mobility.
Restrictive fiscal policy under perfect capital mobility and flexible exchange rates will cause a
depreciation of the domestic currency that will induce a dollar for dollar increase in net exports such that
the level of output demanded will remain unchanged. When government spending is reduced, the IScurve will shift to the left and the domestic interest rate will decline below the level of the world interest
rate. A capital outflow will occur, leading to a depreciation of the domestic currency. Therefore, net
exports will increase since the relative price of domestic goods will now be lower. The decrease in net
exports will shift the IS-curve back to its original location. Therefore, the level of output will not change,
although its composition will.
i
IS1
LM
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IS2
i1
i2
0
Y2
Y1
Y
13. With the help of an IS-LM diagram show the effect of restrictive monetary policy on output
under flexible exchange rates and with perfect capital mobility.
A decrease in money supply shifts the LM-curve to the left, so interest rates rise while the level of output
demanded decreases. The higher interest rates cause an inflow of capital, which causes the currency to
appreciate. This leads to a decline in exports and an increase in imports, since the relative price of
domestic goods on world markets has increased. The decline in net exports causes the IS-curve to shift to
the left. A new equilibrium will be established at the original interest rate (the world interest rate) but at a
lower level of domestic output.
i
IS2
IS1
LM2
2
LM1
i2
3
i1
1
0
Y3 Y2
Y1
Y
14. "In a flexible exchange rate system with perfect capital mobility, expansionary fiscal policy will
always crowd out net exports." Comment on this statement.
Under perfect capital mobility, the BP-curve is horizontal and domestic interest rates are equal to those in
the rest of the world. Expansionary fiscal policy will shift the IS-curve to the right, increasing the level of
output and interest rates. When domestic interest rates are above those in the rest of the world, there will
be a capital inflow that will cause the currency to appreciate. This will lead to a fall in exports and an
increase in imports, since the relative price of domestic goods will increase. This reduction in net exports
will shift the IS-curve back to its original position. In the end, the expansionary fiscal policy will be fully
crowded out by a decrease in net exports.
i
IS1
IS2
LM
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i2
i1
BP
0
Y1
Y2
Y
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