Transcript INTERNATIONAL FACTOR MOVEMENT

Chapter 26
Economic Policy
in the Open
Economy Under
Flexible Exchange
Rates
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
26-1
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.
26-2
Introduction
• The effectiveness of monetary and
fiscal policies at influencing national
income differ dramatically under fixed
and flexible exchange rate systems.
• Do flexible exchange rate systems
make countries more vulnerable to
external shocks such as the recent
global recession?
26-3
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.
26-4
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
26-5
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
26-6
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.
26-7
Fiscal Policy Under Flexible
Exchange Rates
i
BP0 BP1
LM
Perfect capital
immobility
i3
i0
IS ''
IS
Y0 Y2
IS'
income
26-8
Fiscal Policy Under Flexible
Exchange Rates
– With perfect capital mobility, 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.
26-9
Fiscal Policy Under Flexible
Exchange Rates
LM
i
Perfect capital
mobility
iE
BP
IS
Y0
IS'
income
26-10
Fiscal Policy Under Flexible
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
26-11
Monetary Policy Under
Flexible 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.
26-12
Monetary Policy Under Flexible
Exchange Rates
i
BP' LM LM'
BP
Perfect capital
immobility
i2
i0
E
IS
Y0 Y2
IS'
income
26-13
Monetary Policy Under
Flexible 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 IS to shift
outwards.
26-14
Monetary Policy Under Flexible
Exchange Rates
LM
i
LM'
Perfect capital
mobility
iE
BP
IS'
IS
Y0
Y2
income
26-15
Monetary Policy Under
Flexible 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.
26-16
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.
26-17
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.
26-18
Policy Coordination: Fiscal
Policy Alone
LM
BPFP
iFP
BP0
iY*
i*
i0
IS
ISFP
IS'FP
Y0YFP Y*
26-19
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.
26-20
Policy Coordination:
Monetary Policy Alone
i
LM
LM'
BP
BP'
i*
i0
i'
IS IS'
Y0 Y' Y*
Y
26-21
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.
26-22
Policy Coordination:
Monetary Policy Alone
i
LM
LM'
BP
i*
i0
IS IS'
Y0
Y*
Y
26-23
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?
26-24
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.
26-25
Foreign Price Shock
i
LM
BP
BP'
i0
IS IS'
Y0
Y
26-26
Foreign Price Shock
i
LM
BP
BP'
i0
IS IS'
Y0
Y
26-27
Foreign Price Shock
i
LM
BP
i0
IS
Y0
Y
26-28
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.
26-29
Domestic Price Shock
LM'
LM
i
BP'
BP
i1
i0
IS'
Y1 Y0
IS
Y
26-30
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.
26-31
Foreign Interest Rate Shock
i
LM
BP'
BP
i0
IS
Y0
IS'
Y
26-32
Foreign Interest Rate Shock
i
LM
BP'
BP''
BP
i1
i0
IS
Y0 Y1
IS'
Y
26-33