Chapter Sixteen Short-Run Macroeconomic Policy under Fixed Exchange Rates

Chapter Sixteen

Short-Run Macroeconomic Policy under Fixed Exchange

Rates

© 2003 South-Western/Thomson Learning

2

Chapter Sixteen Outline

1. Introduction

2. Macroeconomic Goals in an Open Economy

3. Macroeconomic Policy with Immobile Capital

4. Macroeconomic Policy with Perfectly Mobile Capital

5. Macroeconomic Policy with Imperfectly Mobile Capital

6. A Special Case: The Reserve Country

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Introduction

• Effectiveness of various macroeconomic policies depends on nature and extent of country’s linkages with world economy.– magnitude of trade in goods and services, – integration of financial markets reflected in capital flows, – type of exchange rate regime used for facilitating currency

transactions.

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Introduction

• This chapter:– examines the goals of macroeconomic policy in an open

economy;– defines some general principles useful in designing policies

to meet those goals; and– explores the effectiveness of the three major types of

macroeconomic policy: fiscal, monetary, and exchange rate policy.

5

Introduction

• Why analyze a fixed exchange rate regime when the U.S. and most other industrialized economies use the flexible regime?1. Exchange rates for most currencies have been fixed

throughout most of modern economic history;2. Two important groups of countries continue to

maintain less flexible exchange rates (the EU and the many developing countries who peg their currencies to the dollar); and

3. All governments engage in FX market intervention on occasion.

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Macroeconomic Goals in an Open Economy

• Internal and external balance– Two primary macroeconomic goals of an open

economy:1. Internal balance: involves the full use of an economy’s

resources, or full employment, along with a stable price level.

2. External balance: when the quantity demanded of foreign exchange equals the quantity available.

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Target and Instruments

• The objectives of macroeconomic policy in an open economy is to achieve internal and external balance.– These objectives are targets: the desired

consequences of policy.– Instruments: the policy tools available to use to

pursue the targets.• Include fiscal policy (taxation), monetary policy

(changes in money stock), and exchange rate policy (devaluation).

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Target and Instruments

• Important relationship between the number of targets and the number of available instruments:– Rule of successful policy making: at least one

instrument must be available for each target.

• Primary determinants of effective instruments for the policy maker include:1. Degree of international capital mobility; and

2. Nature of the exchange rate regime.

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Macroeconomic Policy with Immobile Capital

• Capital immobility: absence of private international capital flows (KAB = 0).

• Figure 16.1 depicts internal and external balance with immobile capital.– Economy is in equilibrium at intersection of IS,

LM, and BOP curves.• As drawn, the equilibrium income satisfies both internal

balance (full employment, represented by QIB) and external balance (BOP equilibrium, represented by QEB).

See Figure 16.1

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Figure 16.1: Internal and External Balance with Immobile Capital

QIB Q

i

0 = QEB

IS

LM

BOP

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• Fiscal policy– Expansionary fiscal policy can take the form of

increased government spending on goods and services or of decreased taxes.

• Lower taxes leave a larger share of income available for consumption.

– Crowding out: occurs when interest rates are so high as to curtail the level of private investment spending.

• When capital is immobile, increased government spending (which cause rates to rise) completely crowds out private investment.

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• Fiscal policy (cont.)– Figure 16.2 illustrates the short-run effects of fiscal

policy with immobile capital:• An increase in government purchases raises total

expenditure and shifts the IS curve to the right.– Initially, income rises as the economy moves to the intersection

of the new IS curve with the LM curve.– Rise in income increases imports, producing a BOP deficit. The

central bank must intervene to supply FX, reducing FX reserves and the money stock.

• LM curve shifts left and restores equilibrium at original income, but at a higher interest rate. Complete crowding out renders fiscal policy ineffective for achieving internal balance.

See

Figure

16.2

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Figure 16.2: Short-Run Effect of Fiscal Policy with Immobile Capital

QEB Q

i

0 Q IB

IS

BOP

IS0

1

LM1

LM0

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• Monetary policy– Monetary policy also turns out to be incapable of

achieving internal balance under fixed exchange rates and capital immobility.

• Under fixed exchange rates, the central bank must intervene in the foreign exchange market to maintain external balance; otherwise,the fixed exchange rate cannot be maintained.

– This intervention alters the money stock.

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• Monetary policy (cont.)– Figure 16.3 illustrates the basic problem:

• Any attempt to increase the money stock (from LM0 to LM1) temporarily raises income and imports, causing a BOP deficit.

– The deficit requires intervention in the foreign exchange market to supply foreign exchange.

• Reserves fall, offsetting the initial increase in the money stock (from LM1 to LM2).

See

Figure 16.3

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Figure 16.3: Short-Run Effects of Monetary Policy with Immobile Capital

QEB Q

i

0 QIB

IS

BOP

0

LM 0

LM 1

= LM 2

2

1

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• Sterilization– Policy that appeals to many central bankers who

want to follow an expansionary money policy.– Objective: to prevent the loss of foreign exchange

reserves from affecting the money stock, thereby maintaining LM1 and QIB (see Fig. 16.3).

• To sterilize, the central bank simply buys more government bonds to offset any loss of foreign exchange reserves, or:

GB = -FXR

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• Sterilization (cont.)– Incentive: Sterilization attempts to prevent the

realities of external requirements from interfering with domestic priorities.

• Such attempts are likely to fail.

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• Exchange rate policy with immobile capital.– Figure 16.4 illustrates the use of exchange rate

policy – in particular, a devaluation – to effect an internal and external balance.

• The devaluation lowers the relative price of domestic goods. Exports rise, shifting the IS and BOP curves to the right.

– Initial effect is to create a BOP surplus. Intervention in the FX market then increases money stock.

• This increase restores equilibrium (and internal and external balance).

See Figure 16.4

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Figure 16.4: Short-Run Effects of a Devaluation with Immobile Capital

Q

i

BOP0

0 QEB0

BOP1

LM1

LM0

IS1

IS0

QIB= QEB1

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Macroeconomic Policy with Perfectly Mobile Capital

• Assumption of international capital immobility has become increasingly unrealistic in recent years.– Assumption of perfect capital mobility means that

investors, in deciding which assets to hold, consider only interest rates and exchange rates, including the forward rate and the expected future spot rate.

• Under perfect capital mobility, the capital account plays the dominant role in the foreign exchange markets.

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• Figure 16.5 graphically represents perfect capital mobility and the slope of the BOP line.– The BOP line is horizontal in this case.

• Given the values of the foreign interest rate and of spot, forward, and expected future spot exchange rates, even a tiny increase in domestic interest rate causes capital inflows.

– Moving to the right along the BOP line, the current account moves toward a deficit as a result of rising income and imports, and the capital account moves toward a surplus.

See Figure 16.5

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Figure 16.5: Perfect Capital Mobility and the Slope of the BOP Line

Q0

i

Current-account deficitCapital-account surplus

BOP > 0

BOP < 0

BOP(i*i0A B

, e, ef, ee)

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• Fiscal policy– With perfect capital mobility in response to global interest

differentials, fiscal policy is highly effective in raising income and achieving simultaneous internal and external balance.

• Figure 16.6 traces the effects of an expansionary fiscal policy:– Raising income causes the interest rate to rise. Response is a capital

inflow that more than offsets the move toward deficit on the current account.

– Because the BOP is in surplus, FX market intervention increases the domestic money stock. This increase prevents a crowding-out effect.

• Thus, total expenditure and income are both raised.

See Figure 16.6

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Figure 16.6: Short-Run Effect of Fiscal Policy with Perfectly Mobile Capital

Q

i

QIB0

LM0

LM

BOP

1

IS1

IS0

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• Monetary policy– Expansionary monetary policy (as depicted in Fig.

16.7’s shift from LM0 to LM1) initially lowers the domestic interest rate and raises income, resulting in capital outflows as well as a current-account deficit.

• The BOP deficit requires sales of foreign exchange reserves until the money stock falls back to its original level.

See

Figure

16.7

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Figure 16.7: Short-Run Effect of Monetary Policy with Perfectly Mobile Capital

Q

i

0 QIB

IS0

BOP

LM1

LM0 = LM2

i0

12

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• Monetary policy (cont.)– Could policy makers prevent the shift of LM back

to LM2 in Fig, 16.7 through sterilization?• Given the model developed so far…no!

– Sterilization is not viable in the long-run, because as long as the central bank pursues such a policy, the interest rate remains below the rate consistent with interest parity and the economy cannot reach external balance.

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• Monetary policy (cont.)– Figure 16.8 shows how sterilization blocks

monetary adjustment to cure a BOP deficit.• Intervention reduces the money stock and raises the

domestic interest rate in panel (b). Which reduces demand for foreign-currency-denominated deposits in panel (a).

– Sterilization uses open market operations to offset intervention’s effect on the money stock.

• The domestic interest rate fails to rise, and the BOP deficit persists.

See Fig. 16.8

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Figure 16.8: Sterilization Blocks Monetary Adjustment to Cure a BOP Deficit

0

e

Quantity of Foreign-currency-denominated Deposits(a) Foreign Exchange Market

e0

SFX

DFX(i0 , i*,ee ,e f)

DFX(i1, i*,ee,ef)

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Figure 16.8: Sterilization Blocks Monetary Adjustment to Cure a BOP Deficit

0

i

i

i1

(M/P)1

L(Q, i)

Quantity of Real Money Balances(b) Money Market

(M/P)0

(M1 < M0)

0

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• Monetary policy (cont.)– If assets denominated in different currencies vary

in their perceived riskiness, the interest parity condition will contain a risk premium, , that represents the extra return investors require to compensate them for the additional risk in holding a particular currency.

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• Monetary policy (cont.)– Figure 16.9 illustrates the implications for a

country with a BOP deficit:• Sterilized intervention reduces the quantity of

government bonds held by the public.– If this reduces the risk premium demanded by market

participants, the demand for foreign-currency deposits falls, and the BOP deficit is eliminated in panel (a), even though sterilized intervention fails to alter the size of the money stock or the interest rate in panel (b).

See

Figure 16.9

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Figure 16.9a: Sterilized Intervention with a Risk Premium

)

)

0

e

Quantity of Foreign-currency-denominated Deposits

a) Foreign ExchangeMarket

e0

SFX

DFX(i0, i*,ee,ef, 0

DFX(i0, i*,ee,ef, 1

( 1 < 0)

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Figure 16.9b: Sterilized Intervention with a Risk Premium

0

i

i0

L(Q, i)

Quantity of Real Money Balances

b) Money Market

(M/P)0

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• Monetary policy (cont.) – Studies of sterilized intervention’s effectiveness

lead to mixed results because:1. Detailed intervention data often are kept secret; and2. The risk-premium and signaling hypotheses rest on

effects that one might expect to vary across time and across countries.

– Most agree that sterilized intervention cannot be used to overcome trends in the FX market or to avoid the fundamental monetary adjustment necessary to achieve external balance under a fixed exchange regime.

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• Exchange Rate Policy– As with fiscal policy, changes in the exchange rate

can achieve internal balance under a fixed rate regime with perfect capital mobility.

• Figure 16.10 indicates the short-run effects of a devaluation with perfectly mobile capital.

– A devaluation of domestic currency shifts the IS curve to the right.

• At first, the BOP moves to a surplus due to increased capital inflow.

• Intervention in the FX market increases domestic money stock and shifts the LM curve from LM0 to LM1.

• Interest rate returns to i0.

See

Figure

16.10

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Figure 16.10: Short-Run Effects of a Devaluation with Perfectly Mobile Capital

Q

i

LM0

0

i1i0

QIB

LM1

IS1

IS0

BOP

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• Changes in Exchange Rate Expectations– Figure 16.11 illustrates the short-run effects of an

expected devaluation with perfectly mobile capital:• An expected devaluation in domestic currency (a rise in

ee) shifts BOP line from BOP0 to BOP1.– At i0, domestic BOP is in deficit.

– As central bank intervenes to supply foreign exchange, the domestic money stock falls and LM shifts from LM0 to LM1.

• A new equilibrium occurs at the intersection of IS0, LM1, and BOP1.

See Figure 16.11

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Figure 16.11: Short-Run Effects of an Expected Devaluation with Perfectly Mobile Capital

Q

i

(e1e

0

i1

i0

> e0e) LM1

LM0

BOP1 (ee1)

BOP0 (ee0)

IS0

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Macroeconomic Policy with Imperfectly Mobile Capital

– Fiscal policy is effective in raising income, but some degree of crowding out occurs.

– Monetary policy remains ineffective.– A devaluation can still achieve internal balance.

• Fiscal Policy– The effects are shown in Figure 16.12:

• Expansionary fiscal policy shifts IS to the right.• Rise in the interest rate generates capital inflows, and

FX market intervention increases money stock.• New equilibrium occurs at higher income and interest

rate.See Figure 16.12

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Figure 16.12: Short-Run Effects of Fiscal Policy with Imperfectly Mobile Capital

Q

i

0

LM0

LM1

BOP

IS1

IS0

QIB

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• Monetary Policy– Regardless of the degree of capital mobility,

monetary policy cannot raise income under a fixed exchange rate regime -- Fig. 16.13 shows this:

• Expansionary monetary policy shifts LM to right and lowers the interest rate.

– Capital outflows cause a BOP deficit.

• Central bank must intervene to sell foreign exchange.

• Decline in FX reserves cuts money stock back to its original level.

• New equilibrium is at original income and interest rate.

See

Figure

16.13

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Figure 16.13: Short-Run Effects of Monetary Policy with Imperfectly Mobile Capital

Q

i

QIB0

1

2

IS

BOP

LM1

LM0 = LM2

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• Exchange Rate Policy– Figure 16.14 indicates that a devaluation of

domestic currency shifts both IS and BOP to right by lowering relative prices of domestic goods and services.

• The BOP surplus results in an increase in domestic money stock.

• New equilibrium occurs at higher income level and lower interest rate.

See

Figure

16.14

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Figure 16.14: Short-Run Effects of a Devaluation with Imperfectly Mobile Capital

Q

i

0

LM0

LM1

BOP0

IS1

IS0

Q IB

BOP1

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Special Case: The Reserve Country

• Countries agree, either implicitly or explicitly, on a single currency to act as the reserve currency.– Under the Bretton Woods system of fixed exchange

rate (WWII to 1973), the U.S. dollar was reserve currency.

– Existence of reserve currency creates special situation for policy makers in reserve-currency country:

• It never has to intervene in FX market, because each non-reserve central bank handles the task of keeping its exchange rate fixed relative to the reserve currency.

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• The monetary policy by a reserve-currency: Figure 16.15– The reserve-currency country does not face the

usual BOP constraint on its monetary policy.• Expansionary monetary policy shifts LM to right and

lowers its interest rate.

– In the non-reserve-currency country, the decline in reserve-country interest rate shifts BOP down - decline in i* lowers expected return on deposits denominated in reserve currency, making portfolio owners content to hold non-reserve-currency deposits at a lower interest rate than before.

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– At i0, the non-reserve country has BOP surplus.• It intervenes by purchasing reserve-currency deposits in

FX market.

– Domestic money stock rises and shifts LM to right.

– Expansionary monetary policy by the reserve country expands not only its own money stock, but that of the non-reserve country as well.

See

Figure

16.15

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Figure 16.15: Monetary Policy by a Reserve-Currency Country

0

i*

i*1

i*0

(a) Reserve Country (b) Non-reserve Country

Q*0 Q*1 Q*

IS

LM1

LM0

0

i

i1

i0

Q0 Q1 Q

IS

LM1

LM0

BOP0 (i*0)

BOP1(i*1)

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Note on Case One: More on German Unification

• Figure 16.16 illustrates the pre-unification economic conditions in Germany and Britain, when all three markets in both countries are in equilibrium.– The accelerated expenditure and tight monetary

policy that accompanied unification in Germany exerted two main influences on trading partners, represented here by Britain.

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Note on Case One: More on German Unification

1. Increased demand for their exports shifted IS to the right and exerted an expansionary influence on trading-partner economies.

2. The increased German interest rate shifted trading partners’ BOP lines upward.

– To keep their currencies from depreciating against the mark, trading partners had to intervene to supply marks, shifting their LM curves to the left.• Net effect on trading partner economies –

expansionary or contractionary – depends on the relative sizes of the two effects.

See Fig. 16.16

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Figure 16.16: The Macroeconomics of German Unification

G0

iG

iG0

(a) Germany

QG0

ISG1

LMG

QG1 Q

iG1

ISG0

(b) Britain

0

iB

iB0

iB1

QB1 QB

0 QB

LMB0

LMB1

BOPB0 (i

G0 )

ISB0

ISB1

BOPB1 (i

G1)

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Note on Case Five: The Two Faces of Capital Flows

• Figure 16.17 illustrates that countries have moved toward more liberal policies toward capital-account transactions, although many restrictions remain in place.– Liberal: no restrictions.– Mostly liberal: a few restrictions by industry.– Partly liberal: many restrictions on size and timing of

transactions.– Restrictive: domestic investment by foreigners or

foreign investment by domestic residents requires official approval.

See Figure 16.17

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Figure 16.17: Rules Governing International Capital Transactions for 102 Countries

Number of Countries

45

40

35

30

25

20

15

10

5

0

19751985

1994

Liberal Mostly Liberal Partly Liberal Restrictive Very Restrictive

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Key Terms in Chapter 16

• Internal balance

• External balance

• Targets

• Instruments

• Crowding out

• Sterilization policy

• Perfect capital mobility

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Key Terms in Chapter 16

• Risk premium

• Signal

• Reserve currency

• Bretton Woods

Documents

Chapter Sixteen Short-Run Macroeconomic Policy under Fixed Exchange Rates