Short-Run Macroeconomic Policy

The case of Fixed Exchange Rates

Macroeconomic Objectives • Efficient allocation of resources

• Economic growth

• “Acceptable” income distribution

In more limited (short-run) sense:

• Internal Balance• Full employment

• Stable prices

• External Balance • BOP=0 (?)

Internal and External Imbalance

• Unemployment

• Inflation

• BOP surplus

• BOP deficit

Goals and Policy Tools

• Fiscal policy• Monetary Policy • FX policy

Are all policy instruments always available to policy makers?

Do all policy tools always work?

Secondary effects?• A General rule: To achieve n targets we need at

least n policy tools; we need at least one instrument for each policy objective.

Two Polar Cases • Fixed X rates with perfectly immobile

capital : A vertical POB curve

• Fixed X rates with perfectly mobile capital: A horizontal BOP curve

BOP

BOP

o Q

o Q

BOP>0 BOP<0

BOP<0

BOP>0

Fixed X rates with perfectly immobile capital : A vertical POB curve

BOP BOP BOP

Q Q Q

i i i

o o oQe Qe Qo Qo Qe

IS

LMBOP<0 BOP>0

IS IS

LM

LM

Automatic Adjustments Under Fixed X Rates

The case of a BOP deficit:

o

IS

LM

Q

iLM’

Qe

To keep the domestic currency from depreciating the central bank would sell FX.That would reduce the banks’ reserves and thus the money stock. The LM curve would shift to the left until the External balance is restored.

Automatic Adjustments Under Fixed X Rates

The case of a BOP surplus:

o

IS

LM’

Q

iLM

Qe

To keep the domestic currency from appreciating the central bank would buy FX.That would increase the banks’ reserves and thus the money stock. The LM curve would shift to the right until the External balance is restored.

Achieving Internal Balance under a Fixed XR Regime with Immobile Capital

• External balance (BOP equilibrium) is automatically achieved but internal balance (full employment) does not necessarily coincide with external balance

• Policy instruments:• Fiscal policy

• Monetary policy

• FX policy

Fiscal Policy Fixed X Rates, Immobile Capital

Qeb Qib

BOP

LM

IS

IS’

LM’

i

i’

Q

i

Fiscal policy: Ineffective An increase in G spending IS will shift to the right BOP deficit To keep FX rate fixed the central bank

would sell FX Reduction in commercial banks’ reservesReduction in the money stockLM will shift to the left until the BOP is

restoredA return to the original Q, but higher

interest rates

Monetary Policy

Fixed X rates and Immobile Capital

Q

iBOP

Qeb Qibo

IS

LM’LM

Monetary police: Ineffective An expansion of money supply through a

purchase of government bonds An increase in banks’ reserves Expansion of credit An increase in money stock (supply) LM will shift to the right A BOP deficit will result To keep the FX rate fixed the central bank would have to sell FX A reduction in bank’s reserves Money stock will decrease LM will shift back to the left to the original position

Sterilization: Ineffective

Can the central bank buy more g. bonds to off set the effect of the sale of FX?

Every time the LM curve is shifted to the right a BOP deficit will result, forcing it to sell an equivalent amount of FX, thus, rendering the sterilization policy ineffective:

- ΔFXR = Δ GB

FX PolicyFixed X Rates, Immobile Capital

o

BOP BOP

Qeb Qib=Q’eb

i

QIS

LM

IS’

LM’

E

FX Policy: The Case of Unemployment Devaluation of the home currency: An increase in the

X rate, e

A higher level of Q would be needed for BOP to be in equilibrium: The BOP line will shift to the right: A BOP Surplus

R will go down Exports will increase, imports will decline IS will shift to the right

The BOP surplus Purchase of FX Increase in banks’ reserves Money stock will

increase LM curve will shit to the right Internal balance is restored at a higher level of Q

Macroeconomic Policy Under a Fixed X Rate Regime with Mobile Capital • Under perfect capital mobility the capital account

becomes the dominant adjustment mechanism.• The BOP line will become horizontal: Because of the

fixed X rate, e, ef, and ee do not change and i=i*

• In the event of a BOP imbalance (deficit or surplus), say, as a result of an increase in Q that would make imports go up, a capital account surplus would be needed to bring the BOP back in equilibrium.

Qo

BOP

i

Fixed X Rates and Perfect Capital Mobility i

Q

i

LM

ISIS’

LM’

i=i* , BOP

o

An increase in Q (resulting form a shift of the IS curve) would result in inflow of funds and a KAB surplus to off set the CAB deficit: A shift of LM to the right

Fixed X Rates and Perfect Capital Mobility: Fiscal Policy

BOP

LM LM’IS IS’

oQ

i

Fixed X Rates and Perfect Capital Mobility: Monetary Policy

Purchase of bonds by the central bankAn increase in the money stockThe LM curve would shift to the right A fall of domestic interest rate An increase in QCAB deficit and outflow of funds To keep the FX rate fixed the central bank would have

to sell FX Reduction in banks reserve and money stockThe LM curve would shift back to the left rendering

monetary policy ineffective

Sterilization and the Risk Factor Recall that the idea behind sterilization is to off set

the effect of FX sales by buying bonds. But this would push the BOP into deficit requiring selling FX again. What if under perfect capital mobility

i = i* + [(ee –e)/e] + σ ; σ = risk premium

Or, i - i* = [(ee –e)/e] + σ Purchase of government bonds would reduced the

perceived risk of domestic bonds. A reduction in the risk associated with domestic bonds at any given interest rate would make investors less willing to hold FX-denominated assets.

Fixed X Rates and Perfect Capital Mobility: XR Policy (?)

BOP(ee)

BOP (e’e)

LM LM’

IS

IS’

QibQo

i

i

i’

Fixed X Rates with Imperfectly Mobile Capital

o Q

iBOP

BOP>0

BOP<0

Fixed X Rates with Imperfectly Mobile Capital: Relative Slopes of LM and BOP Curves

o Q

iBOP

BOP>0

BOP<0

LM’

LM

Fixed X Rates with Imperfectly Mobile Capital: Fiscal Policy (I)

o Q

iBOPBOP>0

BOP<0

LM

LM’

Qeb Qib

IS

IS’i

i’

Fixed X Rates with Imperfectly Mobile Capital: Fiscal Policy (II)

o Q

iBOPBOP>0

BOP<0

LM

ISIS’

LM’

Qeb Qib

Fixed X Rates with Imperfectly Mobile Capital: Monetary Policy (I)

o Q

iBOP

BOP>0

BOP<0

LM LM’

IS

Qeb

Fixed X Rates with Imperfectly Mobile Capital: Monetary Policy (II)

o Q

iBOPBOP>0

BOP<0

LM

LM’

Qeb

IS

Fixed X Rates with Imperfectly Mobile Capital: FX Rate Policy: Devaluation

o Q

iBOP

BOP>0

BOP<0

LM

IS

(1)

IS’(2)

(3)

LM’

Monetary Policy by a Reserve-Currency Country • Under a fixed exchange rare regime each country

pegs its currency to a reserve currency.• The reserve-currency country would never have to

worry about its exchange rates; through (automatic) interventions (and adjustments) by other countries its exchange rates against other currencies are fixed and its BOP is zero.

• Under a fixed X rate regime a reserve-currency country could conduct monetary policy.

• Monetary policy by a reserve-currency country could affect other countries.

Monetary Policy by a Reserve-Currency Country

Suppose the US as a reserve country (under the Bretton Woods system) would conduct expansionary monetary policy; the Fed purchases government bonds.

Money stock in the US will increaseShift of the US LM curve to the right Lower US interest rates (i*) and increased Q*Lower i* will cause nonreserve country’s BOP line

shift down, creating a surplus for itThe surplus in the nonreserve country would result in

automatic adjustment, shifting its LM curve to the right until the BOP is restored: Higher Q and lower i