Transcript Macroeconomic Policy and Floating Exchange Rates

Macroeconomic Policy and
Floating Exchange Rates
Introduction
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What are fiscal and monetary policy?
Given floating exchange rates, what are
the effects of fiscal and monetary policy
on
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The exchange rate
The current account
Interest rates and
Short run capital flows
Fiscal and Monetary Policy
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Fiscal Policy – uses changes in government
taxes and/or spending at the national level to
affect economic activity
Monetary Policy – uses changes in money
supply and/or interest rates to affect
country’s GDP
What are the effects of fiscal and monetary
policy on the exchange rate, the current
account, and short run capital flows?
Fiscal and Monetary Policy
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Past focus of monetary and fiscal policy
targeted an external balance
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Balancing of the inflows and outflows included in
the current account
Currently, monetary and fiscal policy focus on
a country’s internal balance
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Levels of unemployment and inflation as
preferences of citizens of the economy. Focus on
managing growth rate of real GDP and the price
level
Fiscal and Monetary Policy
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In general, the focus on internal
balance comes at the expense of the
external balance
Policies designed to affect the internal
balance, however, can have a significant
affect on external balance
Changes in Fiscal Policy
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Government spending in most countries
is a significant portion of GDP
Changes in government spending can
have a critical impact on an economy
Government spending usually financed
through borrowing, thereby having a
significant impact on country’s domestic
financial markets
Changes in Fiscal Policy
Expansionary Fiscal Policy
I.
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Assume a balanced budget – government
spending equals government taxes
Government adopts lower tax revenues and/or
higher government spending
Leads to government budget deficit (or larger
deficit)
Assume government borrows to finance – does
not print money
Changes in Fiscal Policy
Expansionary Fiscal Policy
I.
Can show graphically the effects of this policy
on the economy
Demand for loanable funds - total demand for
loans in the economy which is indirectly related
to interest rate
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A.
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Private sector – public’s consumption activities that
must be financed (homes, cars, etc.) and business
demand for investment
Public sector – government needs for funds
Changes in Fiscal Policy
Expansionary Fiscal Policy
I.
B.
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C.
Supply of loanable funds – total amount of
money available to be borrowed
Represented as perfectly inelastic – amount of
loanable funds not related to interest rate
In short run the amount the public want sot
save determines supply of loanable funds
Balanced budget – demand of loanable funds
equals supply at equilibrium interest rate ie.
Loanable Fund Market
Changes in Fiscal Policy
Expansionary Fiscal Policy
I.
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Government’s demand for loanable funds
increases – D to D’
In closed economy, interest rate increases
In open economy, rise in interest rates leads to
inflow of foreign capital
Foreign capital augments supply of loanable
funds (S to S+f)
Interest rate decreases back to ie
Expansionary policy puts less upward pressure
on interest rates in an open economy
Changes in Loanable Funds
Changes in Fiscal Policy
I.
Expansionary Fiscal Policy – Effects on
exchange rate
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Assume initial exchange rate with no inflows of
capital – current account balanced
Inflow of capital required foreign investors to sell
foreign currency to buy dollars
Supply of foreign exchange increases and nominal
exchange rate appreciates
Capital account surplus – current account deficit
Exchange Rate Effects
Changes in Fiscal Policy
Expansionary Fiscal Policy - Effects
on domestic economy?
I.
Aggregate demand increases
Closed economy leads to increased
output and price level
Open economy effects are less clear
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Current account worsens as exports decline
and imports increase
Effect is AD shifts back to the left
Changes in Domestic Market
Changes in Fiscal Policy
Expansionary Fiscal Policy Conclusion
I.
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Net effect on AD, equilibrium output,
and price level depends on magnitude of
two effects
Expansionary fiscal policy in open
economy is less effective at changing
equilibrium output than in a closed
economy
Changes in Fiscal Policy
Contractionary Fiscal Policy
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Combination of higher taxes and/or
lower government spending
Reduces government budget deficit
(increases size of surplus)
Changes in Fiscal Policy
Contractionary Fiscal Policy – Effects
on interest rates
II.
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Demand for loanable funds decreases
Interest rate initially lowers
Less investment by domestic and foreign
investors in domestic economy – outflow
of capital from domestic economy
Supply of loanable funds decreases
lowering interest rates back toward ie
Loanable Funds Market
Changes in Fiscal Policy
Contractionary Fiscal Policy – Effects
on foreign exchange
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Demand for foreign exchange increases
as capital is moved to foreign markets
Currency depreciates
Capital outflow causes a capital account
deficit
Current account surplus – difference
between imports (M) and exports (X)
Foreign Exchange Market
Changes in Fiscal Policy
Contractionary Fiscal Policy – Effects on
domestic market
II.
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Aggregate demand decreases
Closed economy leads to both decrease in
domestic output and price level
Open economy depreciating currency causes
exports to increase and imports to fall
Aggregate demand increases toward original
Domestic Market
Changes in Fiscal Policy
Contractionary Fiscal Policy – Net
Effect
II.
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Net effect on output and price level
depends on magnitude of two effects
Contractionary fiscal policy in an open
economy is less effective in changing
equilibrium output than in a closed
economy
Changes in Fiscal Policy
Conclusions
III.
Given current global conditions with floating
exchange rates and relatively large short run
capital flows, fiscal policy is not as effective at
controlling output and price level
Effects of fiscal policy are not irrelevant,
however
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Interest rate, exchange rate, capital flows and current
account balance change noticably affecting business
decisions
Changes in Monetary Policy
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Central bank attempts to affect the short run
performance of the economy by changing the
growth rate of the money supply and/or
interest rates
Discretionary monetary policy – using
monetary policy in reaction to and/or to
prevent unwanted changes in economy’s
short run performance
Some increased interest in a monetary rule
instead of discretionary policy
Changes in Monetary Policy
Expansionary Monetary Policy – Effects on
interest rate
I.
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Central bank increases money supply or money
supply growth rate
Increases in money supply increase the supply
of loanable funds
Interest rate decreases initially
Capital outflow causes supply of loanable funds
to decrease increasing interest rate
Loanable Funds Market
Changes in Monetary Policy
Expansionary Monetary Policy –
Effects on exchange rate
I.
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Capital outflows cause demand for
foreign exchange to increase
Currency depreciates worsening capital
account - deficit
Current account surplus as exports
increase and imports decrease –
difference between M and X
Foreign Exchange Market
Changes in Monetary Policy
Expansionary Monetary Policy – Effects on
domestic economy
I.
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Aggregate demand increases since both
consumption and investment spending have
increased
Closed economy - Output and price level
increase
Open economy – increasing exports and
decreasing imports increase AD again
Net result: Output and price level increase
Domestic Market
Changes in Monetary Policy
Contractionary Monetary Policy – Effects
on Interest rate
II.
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Central bank decreases money supply or
reduces money supply growth rate
Government bonds are sold
Decreases supply of loanable funds raising
interest rates
Attraction of foreign capital shifts supply of
loanable funds to the right decreasing interest
rates
Loanable Funds Market
Changes in Monetary Policy
Contractionary Monetary Policy –
Effects on exchange rate
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Capital inflow increases supply of foreign
exchange
Currency appreciates
Capital account surplus
Current account deficit – difference
between X and M
Foreign Exchange Market
Changes in Monetary Policy
Contractionary Monetary Policy – Effects
on domestic market
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Reduction in growth rate of interest sensitive
consumption and reducing in investment
growth rate
AD decreases lowering output and price level in
closed economy
Open economy – exports fall and imports rise
AD decreases further
Net effect lowers output and price level
Changes in Monetary Policy
Policy in Open Economy
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Effects of policies described in terms of
effects on external and internal balances
Current account balance – external balance
Equilibrium output and price level – internal
balance
At any point, there is an optimal balance of
output level and price level
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Best implies full employment and stable prices
Policy in Open Economy
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Full employment and stable prices are rarely
met so policy used to achieve a balance
between output level and price level
Fiscal and monetary policy can be used to
influence internal or external balance
In general, government cannot balance both
together so much choose to target one
Policy in Open Economy
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In an open economy with floating exchange
rates, macroeconomic policy tends to focus
on internal balance
Although both fiscal and monetary policy
affect current account and exchange rates,
they are not the primary focus of policy
It is sometimes perceived that exchange rate
and current account are the primary targets
of macroeconomic policies
Policy in Open Economy
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Following table summarizes effects of
different policies on each of the
macroeconomic variables
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Output, price level, exchange rate and
current account
Can use the table to show effects of a
policy mix – various combinations of
fiscal and monetary policy
Policy in Open Economy
Policy in Open Economy
Consistent Policy Mixes - Recession
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Real GDP below full employment level
Government target to increase output
Expansionary monetary policy and/or
expansionary fiscal policy
Combination of both would increase output and
price level
Effect on exchange rate is unclear depending on
magnitude of two policies on interest rates
Policy in Open Economy
Consistent Policy Mixes - Recession
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Effect on exchange rate is unclear depending on
magnitude of two policies on interest rates
Effects on current account are also unclear
again depending on effect on interest rates
Given opposite effects on exchange rates and
current account, neither is likely to change
much in either direction
End result is improvement of economy by
increasing output
Effects of Policy Mix - Expansionary
Yd
Expansionary
Fiscal – Direct
Indirect
Expansionary
Monetary – Direct
Indirect
Net Effect
P
XR
CA
Policy in Open Economy
Consistent Policy Mixes – Inflation
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Producing output greater than full employment
levels
Combination of monetary and fiscal policies
Both equilibrium output and price level fall
Exchange rate and current account effects
unclear since policies move in opposite
directions
Effects of Policy Mix - Contractionary
Yd
Contractionary
Fiscal – Direct
Indirect
Contractionary
Monetary – Direct
Indirect
Net Effect
P
XR
CA
Policy in Open Economy
Consistent Policy Mixes – Conclusion
II.
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When governments adopt similar
consistent fiscal and monetary policy,
the equilibrium level of output and price
level can change without drastic
changes in exchange rate or current
account.
Policy in Open Economy
Inconsistent Policy Mixes
II.
Why adopt opposing fiscal and monetary policy
when conclusions for internal balance is unknown?
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Different policy makers in control of fiscal and monetary
policy – Federal Reserve and Federal Government
Known effects on the country’s external balances
Effects on external balance is extreme strong,
affecting economy’s tradable goods sector
Policy in Open Economy
Inconsistent Policy Mixes
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Expansionary fiscal policy and
contractionary monetary policy lead to
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Appreciated currency and decreased current
account
Contractionary fiscal policy with
expansionary monetary policy lead to
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Depreciated currency and improved current
account
Trade Flow Adjustment & Current
Account Dynamics
We have assumed no lags in effects
on macroeconomic variables from
monetary and fiscal policy
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Financial markets are relatively efficient
so interest rates affected quickly
High capital mobility allows exchange
rate to change relatively quickly
Trade Flow Adjustment & Current
Account Dynamics
Could be lags when the macroeconomic
variables change in response to policy
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Price of imports and exports may not change
instantly as exchange rate changes
International trade may respond slowly to
changes in prices compared to response of
financial markets
Time to affect current account balance could be
six months to a year
Trade Flow Adjustment & Current
Account Dynamics
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In long run, as country’s currency
depreciates, its export expand and
imports contract (and vice versa)
In short run, as country’s currency
exchange rate changes, response of
exports and imports and current
account balance could be easily in
opposite direction
Trade Flow Adjustment & Current
Account Dynamics
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International trade is often conducted
between parties on a contract basis
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Imported agreed to purchase certain
amount of a good at an agreed upon price
If currency depreciates, cost of goods in
domestic currency rises
Value of imports rises but value of exports
n domestic currency does not change
Current account may initially worsen
Trade Flow Adjustment & Current
Account Dynamics
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J-Curve
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Effect on country’s current account balance
If currency depreciates
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Current account balance initially worsens
After contracts are renewed reflecting new
exchange rate, current account begins to
improve
Important for policy makers to take the lag
effect into account
Short run versus long run
J-Curve