Transcript Fiscal Policy Under Flexible Exchange Rates

Chapter 8
Economic Policy in
the Open Economy
Under Flexible
Exchange Rates
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Learning Objectives
Analyze the impact of fiscal policy on
income, trade, and exchange rates
under flexible exchange rates.
Analyze the impact of monetary
policy on income, trade, and
exchange rates under flexible
exchange rates.
Show how external economic shocks
affect the domestic economy under
flexible exchange rates.
Introduction
The effectiveness
Do flexible
of monetary and
exchange rate
fiscal policies at
systems make
influencing
countries more
national income
vulnerable to
differ dramatically
external shocks
under fixed and
such as the recent
flexible exchange
global recession?
rate systems.
The Effects of Fiscal and
Monetary Policy Under
Flexible Exchange Rates
Under a flexible exchange rate
system, combinations of income and
interest rates not on the BP curve will
cause disequilibrium in foreign
exchange markets, and force an
adjustment in the exchange rate.
This will cause the BP curve to shift.
The Effects of a Currency
Depreciation on the BP Curve
i
BP0
BP1
A depreciation
expands exports and
contracts imports.
For any given level of
Y, a lower i is
required to balance
the BOP.
Y
The Effects of a Currency
Appreciation on the BP Curve
i
BP1
BP0
An appreciation
contracts exports and
expands imports. For
any given level of Y, a
higher i is required to
balance the BOP.
Y
Fiscal Policy Under Flexible
Exchange Rates
 With perfect capital immobility, any
fiscal stimulus increases Y and i.
 This creates an incipient BOP
deficit, causing a depreciation and
a rightward shift of the BP curve.
 The depreciation increases exports,
decreases imports, and shifts IS
even farther rightwards.
 This continues until IS, LM, and BP
intersect at a common point.
Fiscal Policy Under Fixed
Exchange Rates
i
BP0 BP1
LM
Perfect capital
immobility
i3
i0
IS ''
IS
Y0 Y2
IS'
income
Fiscal Policy Under Flexible
Exchange Rates
 With perfect capital immobility, any
fiscal stimulus increases Y and i.
 This creates an incipient BOP
surplus, causing an appreciation of
the currency.
 The appreciation decreases exports,
increases imports, and shifts IS
back to the left.
Fiscal Policy Under Fixed
Exchange Rates
LM
i
Perfect capital
mobility
iE
BP
IS
Y0
IS'
income
Fiscal Policy Under Fixed
Exchange Rates
 The bottom line:
• When capital is relatively immobile,
fiscal policy is more effective at
increasing national income.
• When capital is relatively mobile, fiscal
policy is less effective at increasing
national income.
• Between these two extremes, the
effect on the exchange rate depends
on the relative slopes of LM and BP.
– BP steeper than LM: depreciation
– LM steeper than BP: appreciation
Monetary Policy Under
Fixed Exchange Rates
 With perfect capital immobility, a
monetary stimulus increases Y, and
the increase in imports causes an
incipient BOP deficit to emerge.
 As currency depreciates, BP shifts
rightward.
 Depreciation also shifts IS
rightwards.
Monetary Policy Under Fixed
Exchange Rates
i
BP' LM LM'
BP
Perfect capital
immobility
i2
i0
E
IS
Y0 Y2
IS'
income
Monetary Policy Under
Fixed Exchange Rates
 With perfect capital mobility, any
monetary stimulus increases Y.
 This generates a large capital
outflow and a depreciation of the
home currency.
 The depreciation causes LM to shift
outwards.
Monetary Policy Under Fixed
Exchange Rates
LM
i
LM'
Perfect capital
mobility
iE
BP
IS'
IS
Y0
Y2
income
Monetary Policy Under Fixed
Exchange Rates
The bottom line:
When capital is relatively
immobile, monetary policy is
effective at increasing national
income.
When capital is relatively mobile,
monetary policy is particularly
effective at increasing national
income.
Policy Coordination Under
Flexible Exchange Rates
 Coordination of fiscal and
monetary policy may make the
attainment of other targets
besides income possible.
 Examples of alternative
targets include interest rates
and exchange rates.
 Consider an income and
interest rate target of Y* and
i*as an example.
Policy Coordination Under
Flexible Exchange Rates
If fiscal policy alone is used to reach Y*, it
is likely that the interest rate will
overshoot the target of i*.
In addition, the fiscal policy creates an
incipient BOP surplus, appreciating the
currency, and shifting BP back to the left.
The depreciation also shifts IS part of the
way back to the left.
In the end, neither target is reached.
Policy Coordination: Fiscal
Policy Alone
LM
BPFP
iFP
BP0
iY*
i*
i0
IS
Y0YFP Y*
ISFP
IS'FP
Policy Coordination Under
Flexible Exchange Rates
 If monetary policy alone is used
to reach Y*, the increase in Ms
will cause a currency
depreciation, and a rightward
shift in BP.
 In addition, the monetary policy
shifts IS rightwards.
 In the end, neither target is
reached.
Policy Coordination: Monetary
Policy Alone
i
LM
LM'
BP
BP'
i*
i0
i'
IS IS'
Y0 Y' Y*
Y
Policy Coordination Under
Flexible Exchange Rates
 If monetary and fiscal policies are
used, both i* and Y* can be attained.
 Expansionary fiscal policy allows Y
to increase without the expenditure
switching effects.
Policy Coordination: Monetary
Policy Alone
i
LM
LM'
BP
i*
i0
IS IS'
Y0
Y*
Y
Effects of Shocks in the
IS/LM/BP Model (Imperfect
K-Mobility)
 So far, we’ve examined the effects
of fiscal and monetary policy
holding a number of factors
constant, including
• domestic and foreign prices,
• foreign interest rate, and
• expected exchange rate changes.
 How are changes in such variables
(“shocks”) transmitted through the
economy?
Effects of Shocks: A
Foreign Price Shock
 If the foreign price level were to
increase, the home economy would
expand due to increases in exports
and decreases in imports (IS shifts
right).
 The BP also shifts right due to
expenditure switching effects of
higher foreign prices.
 Both effects cause i to rise, and the
currency to appreciate.
 These shift IS and BP back to
where they started.
Foreign Price Shock
i
LM
BP
BP'
i0
IS IS'
Y0
Y
Foreign Price Shock
i
LM
BP
BP'
i0
IS IS'
Y0
Y
Foreign Price Shock
i
LM
BP
i0
IS
Y0
Y
Effects of Shocks: A Domestic
Price Shock
 If the domestic price level were
to increase, the real money
supply would fall, shifting LM
leftwards.
 Exports will fall and imports
rise, so IS shifts leftwards.
 The BP curve will also shift left
in order to bring the BOP back
into equilibrium.
Domestic Price Shock
LM'
LM
i
BP'
BP
i1
i0
IS'
Y1 Y0
IS
Y
Effects of Shocks: A Foreign
Interest Rate Shock
If the foreign interest rate were to
increase, the home country should
experience an outflow of short-term
capita; BP shifts leftwards.
The home currency depreciates.
This shifts
the IS curve rightward, and
the BP curve back toward the right.
Foreign Interest Rate Shock
i
LM
BP'
BP
i0
IS
Y0
IS'
Y
Foreign Interest Rate Shock
i
LM
BP'
BP''
BP
i1
i0
IS
Y0 Y1
IS'
Y
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