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Chapter Sixteen. Short-Run Macroeconomic Policy under Fixed Exchange Rates. Introduction Macroeconomic Goals in an Open Economy Macroeconomic Policy with Immobile Capital Macroeconomic Policy with Perfectly Mobile Capital Macroeconomic Policy with Imperfectly Mobile Capital

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Chapter sixteen l.jpg

Chapter Sixteen

Short-Run Macroeconomic Policy under Fixed Exchange Rates


Chapter sixteen outline l.jpg

Introduction

Macroeconomic Goals in an Open Economy

Macroeconomic Policy with Immobile Capital

Macroeconomic Policy with Perfectly Mobile Capital

Macroeconomic Policy with Imperfectly Mobile Capital

A Special Case: The Reserve Country

Chapter Sixteen Outline


Introduction l.jpg
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.


Introduction4 l.jpg
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.


Introduction5 l.jpg
Introduction

  • Why analyze a fixed exchange rate regime when the U.S. and most other industrialized economies use the flexible regime?

    • Exchange rates for most currencies have been fixed throughout most of modern economic history;

    • 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

    • All governments engage in FX market intervention on occasion.


Macroeconomic goals in an open economy l.jpg
Macroeconomic Goals in an Open Economy

  • Internal and external balance

    • Two primary macroeconomic goals of an open economy:

      • Internal balance: involves the full use of an economy’s resources, or full employment, along with a stable price level.

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


Target and instruments l.jpg
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).


Target and instruments8 l.jpg
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:

    • Degree of international capital mobility; and

    • Nature of the exchange rate regime.


Macroeconomic policy with immobile capital l.jpg
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).


Figure 16 1 internal and external balance with immobile capital l.jpg
Figure 16.1: Internal and External Balance with Immobile Capital

i

BOP

LM

IS

0

Q

= Q

Q

IB

EB


Macroeconomic policy with immobile capital11 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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.


Macroeconomic policy with immobile capital12 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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.


Figure 16 2 short run effect of fiscal policy with immobile capital l.jpg
Figure 16.2: Short-Run Effect of Fiscal Policy with Immobile Capital

i

BOP

1

LM

0

LM

1

IS

0

IS

0

Q

Q

Q

EB

IB


Macroeconomic policy with immobile capital14 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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.


Macroeconomic policy with immobile capital15 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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).


Figure 16 3 short run effects of monetary policy with immobile capital l.jpg
Figure 16.3: Short-Run Effects of Monetary Policy with Immobile Capital

i

BOP

0

2

LM

= LM

1

LM

2

1

0

IS

0

Q

Q

Q

EB

IB


Macroeconomic policy with immobile capital17 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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


Macroeconomic policy with immobile capital18 l.jpg
Macroeconomic Policy with Immobile Capital

  • Sterilization (cont.)

    • Incentive: Sterilization attempts to prevent the realities of external requirements from interfering with domestic priorities.

      • Such attempts are likely to fail.


Macroeconomic policy with immobile capital19 l.jpg
Macroeconomic Policy with Immobile Capital

  • 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).


Figure 16 4 short run effects of a devaluation with immobile capital l.jpg
Figure 16.4: Short-Run Effects of a Devaluation with Immobile Capital

i

0

1

BOP

BOP

0

LM

1

LM

1

IS

0

IS

0

1

0

Q

Q

= Q

Q

EB

IB

EB


Macroeconomic policy with perfectly mobile capital l.jpg
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.


Macroeconomic policy with perfectly mobile capital22 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 5 perfect capital mobility and the slope of the bop line l.jpg
Figure 16.5: Perfect Capital Mobility and the Slope of the BOP Line

i

Current-account deficit

Capital-account surplus

BOP > 0

A

B

*

f

e

i

BOP(i

, e, e

, e

)

0

BOP < 0

0

Q


Macroeconomic policy with perfectly mobile capital24 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 6 short run effect of fiscal policy with perfectly mobile capital l.jpg
Figure 16.6: Short-Run Effect of Fiscal Policy with Perfectly Mobile Capital

i

0

LM

1

LM

BOP

1

IS

0

IS

0

Q

Q

IB


Macroeconomic policy with perfectly mobile capital26 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 7 short run effect of monetary policy with perfectly mobile capital l.jpg
Figure 16.7: Short-Run Effect of Monetary Policy with Perfectly Mobile Capital

i

0

2

LM

= LM

1

LM

i

BOP

0

2

1

0

IS

0

Q

Q

IB


Macroeconomic policy with perfectly mobile capital28 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Macroeconomic policy with perfectly mobile capital29 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 8 sterilization blocks monetary adjustment to cure a bop deficit l.jpg
Figure 16.8: Sterilization Blocks Monetary Adjustment to Cure a BOP Deficit

e

S

FX

e

0

D

(i

, i*,e

,e

)

FX

e

f

0

D

(i

, i*,e

,e

)

FX

e

f

1

0

Quantity of

Foreign-currency-

(a) Foreign Exchange Market

denominated Deposits


Figure 16 8 sterilization blocks monetary adjustment to cure a bop deficit31 l.jpg
Figure 16.8: Sterilization Blocks Monetary Adjustment to Cure a BOP Deficit

(M

/P)

(M

/P)

i

1

0

(M

< M

)

i

1

0

1

i

0

L(Q

, i)

0

Quantity of

Real Money

(b) Money Market

Balances


Macroeconomic policy with perfectly mobile capital32 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Macroeconomic policy with perfectly mobile capital33 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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).


Figure 16 9a sterilized intervention with a risk premium l.jpg
Figure 16.9a: Sterilized Intervention with a Risk Premium

e

FX

S

a) Foreign Exchange

Market

(

)

<

1

0

e

0

FX

e

f

D

(i

, i*,e

,e

,

)

0

0

FX

e

f

D

(i

, i*,e

,e

,

)

0

1

0

Quantity of

Foreign-currency-

denominated Deposits


Figure 16 9b sterilized intervention with a risk premium l.jpg
Figure 16.9b: Sterilized Intervention with a Risk Premium

(M

/P)

i

0

b) Money Market

i

0

L(Q

, i)

0

Quantity of

Real Money

Balances


Macroeconomic policy with perfectly mobile capital36 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • Monetary policy (cont.)

    • Studies of sterilized intervention’s effectiveness lead to mixed results because:

      • Detailed intervention data often are kept secret; and

      • 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 cannotbe 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.


Macroeconomic policy with perfectly mobile capital37 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 10 short run effects of a devaluation with perfectly mobile capital l.jpg
Figure 16.10: Short-Run Effects of a Devaluation with Perfectly Mobile Capital

i

0

LM

1

LM

i

1

i

BOP

0

1

IS

0

IS

0

Q

Q

IB


Macroeconomic policy with perfectly mobile capital39 l.jpg
Macroeconomic Policy with Perfectly Mobile Capital

  • 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.


Figure 16 11 short run effects of an expected devaluation with perfectly mobile capital l.jpg
Figure 16.11: Short-Run Effects of an Expected Devaluation with Perfectly Mobile Capital

i

1

LM

e

e

(e

> e

)

1

0

0

LM

1

e

i

BOP

(e

)

1

1

0

e

i

BOP

(e

)

0

0

0

IS

0

Q


Macroeconomic policy with imperfectly mobile capital l.jpg
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.


  • Figure 16 12 short run effects of fiscal policy with imperfectly mobile capital l.jpg
    Figure 16.12: Short-Run Effects of Fiscal Policy with Imperfectly Mobile Capital

    i

    0

    LM

    1

    LM

    BOP

    1

    IS

    0

    IS

    0

    Q

    Q

    IB


    Macroeconomic policy with imperfectly mobile capital43 l.jpg
    Macroeconomic Policy with Imperfectly Mobile Capital

    • 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.


    Figure 16 13 short run effects of monetary policy with imperfectly mobile capital l.jpg
    Figure 16.13: Short-Run Effects of Monetary Policy with Imperfectly Mobile Capital

    i

    0

    2

    LM

    = LM

    1

    LM

    BOP

    2

    1

    IS

    0

    Q

    Q

    IB


    Macroeconomic policy with imperfectly mobile capital45 l.jpg
    Macroeconomic Policy with Imperfectly Mobile Capital

    • 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.


    Figure 16 14 short run effects of a devaluation with imperfectly mobile capital l.jpg
    Figure 16.14: Short-Run Effects of a Devaluation with Imperfectly Mobile Capital

    i

    LM0

    LM1

    BOP0

    BOP1

    IS1

    IS0

    0

    Q

    Q

    IB


    Special case the reserve country l.jpg
    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.


    Special case the reserve country48 l.jpg
    Special Case: The Reserve Country

    • 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.


    Special case the reserve country49 l.jpg
    Special Case: The Reserve Country

    • 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.


    Figure 16 15 monetary policy by a reserve currency country l.jpg
    Figure 16.15: Monetary Policy by a Reserve-Currency Country

    i*

    i

    LM

    LM

    0

    LM

    0

    1

    LM

    BOP

    (i*

    )

    1

    0

    0

    i*

    i

    0

    0

    BOP

    (i*

    )

    1

    1

    i*

    i

    1

    1

    IS

    IS

    0

    Q*

    Q*

    Q*

    0

    Q

    Q

    Q

    0

    1

    1

    0

    (a) Reserve Country

    (b) Non-reserve Country


    Note on case one more on german unification l.jpg
    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.


    Note on case one more on german unification52 l.jpg
    Note on Case One: More on German Unification

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

    • 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.


  • Figure 16 16 the macroeconomics of german unification l.jpg
    Figure 16.16: The Macroeconomics of German Unification

    G

    i

    B

    i

    B

    LM

    G

    LM

    1

    B

    LM

    0

    B

    G

    BOP

    (i

    )

    1

    1

    G

    i

    B

    i

    1

    1

    B

    G

    BOP

    (i

    )

    0

    0

    G

    i

    B

    i

    0

    0

    G

    IS

    1

    B

    IS

    1

    G

    IS

    B

    IS

    0

    0

    G

    G

    0

    Q

    G

    Q

    Q

    B

    B

    0

    Q

    Q

    B

    Q

    0

    1

    0

    1

    (a) Germany

    (b) Britain


    Note on case five the two faces of capital flows l.jpg
    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.


    Figure 16 17 rules governing international capital transactions for 102 countries l.jpg
    Figure 16.17: Rules Governing International Capital Transactions for 102 Countries

    Number of Countries

    45

    40

    35

    30

    1994

    25

    1985

    1975

    20

    15

    10

    5

    0

    Liberal

    Mostly Liberal

    Partly Liberal

    Restrictive

    Very Restrictive


    Key terms in chapter 16 l.jpg
    Key Terms in Chapter 16

    • Internal balance

    • External balance

    • Targets

    • Instruments

    • Crowding out

    • Sterilization policy

    • Perfect capital mobility


    Key terms in chapter 1657 l.jpg
    Key Terms in Chapter 16

    • Risk premium

    • Signal

    • Reserve currency

    • Bretton Woods


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