Transcript IPE4 (vnd.ms-powerpoint, it, 481 KB, 4/19/11)

International Political Economy
Lesson 4
Section 4.1
INTERNATIONAL IMBALANCE
• Balance of payments surpluses and deficits
mean the international sector of our economy
is in disequilibrium.
• The importance of the balance of payments is
that it measures imbalance in our
international sector, thereby pointing to
economic forces for change.
• So is necessary to identify these forces and
how they bring about change.
• Monetary and fiscal policies are shocks to the economy
that affect many economic variables, such as income,
interest rates, and prices.
• Changes in these variables create imbalances in the
international sector, which in turn set in motion forces that
modify the impact of these policies on the economy
• Is necessary to examine how our earlier discussions of
monetary and fiscal policies must be adjusted to recognize
the influence of forces generated through the international
sector of the economy
• The recent increase in the openness of the world requires
that macroeconomic analysis pay more attention to these
forces.
Interest
rate
Fiscal
policy
Income
Monetary
policy
Price level
Surplus
International
imbalance
Deficit
• Exactly what are the forces for change that an
imbalance in the balance of payments
engenders?
• This is a crucial question, the answer to which
depends on whether the economy is
operating on a flexible or a fixed exchange rate
system
Flexible exchange
rate
Fixed exchange
rate
Fiscal policy
Monetary policy
Effective
Effective
Ineffective
Ineffective
Effective
Effective
Ineffective
Ineffective
Lesson 4
Session 4.2
INTERNATIONAL IMBALANCE WITH
FLEXIBLE EXCHANGE RATE
Export > Import
BoP surplus
Domestic currency
Demand > supply
Exchange rate
increase
BoP balance
Exchange rate
decrease
Export < Import
BoP deficit
Domestic currency
Demand < supply
BoP surplus
Exchange
rate
Domestic
currency
demand
Domestic
currency
supply
P*
P1
S1
D1
Domestic
currency
BoP deficit
Exchange
rate
Domestic
currency
demand
Domestic
currency
supply
P2
P*
D2
S2
Domestic
currency
• Under a flexible exchange rate system, the government
allows the forces of supply and demand to determine the
exchange rate.
• If there is a balance of payments surplus, demand for our
currency on the foreign exchange market exceeds its
supply, so market forces cause a rise in the value of our
currency.
• Those who want the extra, unavailable dollars try to
obtain them by offering extra foreign currency for them,
so our currency becomes more valuable in terms of
foreign currency
• This process operates in reverse if there is a balance of
payments deficit.
• In this case, the demand for our currency on the foreign
exchange market is less than its supply, so market forces
cause a fall in its value
• Note that under a flexible exchange rate system, any
tendency toward a balance of payments surplus or
deficit is automatically and instantaneously eliminated
by a flexing of the exchange rate, so that our measure
of the imbalance (the balance of payments) is always
zero.
• The balance of payments measure is nonzero only if
the government engages in some net buying or selling
of foreign currency.
• In the context of a flexible exchange rate, the
terminology "balance of payments surplus or deficit"
must be interpreted as reflecting a surplus or deficit
that would appear if the exchange rate were not
permitted to adjust instantaneously.
• Under a flexible exchange rate, therefore, the initial reaction of the
economy to an imbalance in the balance of payments is a change in the
exchange rate, which in turn creates additional forces for change in the
economy.
• If, with other variables constant, the exchange rate rises, demand for
our exports falls because foreigners find our exports more expensive in
terms of their currency.
• Furthermore, imports become cheaper to us (because our currency
now buys more foreign exchange), so there is a fall in demand for
domestically produced goods and services that compete with imports.
• Both phenomena imply that aggregate demand for domestically
produced goods and services falls
• Similarly, if the exchange rate falls, demand for exports and importcompeting goods and services should be stimulated, implying a rise in
demand for domestically produced goods and services
• To summarize, if the economy has a
flexible exchange rate, an imbalance in
the international sector of the economy,
measured by the balance of payments,
automatically causes the exchange rate
to change;
• This change in turn causes the importcompeting and export sectors of the
economy to adjust, thus affecting
aggregate demand for goods and services
Flexible
Exchange
Rate
Imbalance
BoP surplus
BoP deficit
Exchange
rate
increase
Export decrease
Exchange
rate
decrease
Import increase
Export increase
BoP=0
Import decrease
Lesson 4
Section 4.3
INTERNATIONAL IMBALANCE WITH
A FIXED EXCHANGE RATE
BoP surplus
Exchange
rate
Domestic
currency
demand
Domestic
currency
supply
Pcb
S1
D1
Domestic
currency
BoP deficit
Exchange
rate
Domestic
currency
demand
Domestic
currency
supply
Pcb
D1
S1
Domestic
currency
• Under a fixed exchange rate system, the government does
not allow the forces of supply and demand to determine
the exchange rate.
• Instead, the government fixes the exchange rate at what it
believes is the "right" rate, and the central bank, armed
with a stockpile of foreign exchange reserves, stands ready
to buy or sell foreign currency at that rate.
• If there is a balance of payments surplus, the demand for
our currency by foreigners is greater than the supply, so
some of these foreigners will seek extra, unavailable
domestic currency.
• Under a flexible exchange rate, they would have to get our
currency by offering more foreign exchange, but under a
fixed exchange rate this higher cost can be avoided because
the Central Bank will exchange their foreign currency for
domestic currency at the fixed rate
• When the Central Bank does so, it takes the extra foreign
exchange currency and in return provides domestic
currency.
• The most important implication of this process is that the
domestic money supply increases by the increase in
domestic currency times the money multiplier
• When there is a balance of payments deficit, the opposite
occurs.
• We are supplying more domestic currency on the foreign
exchange market (seeking foreign currency to take
vacations abroad, for example) than there is foreign
demand for domestic currency, so those of us unable to
obtain foreign currency from foreigners go to the Central
Bank to buy foreign exchange at the fixed rate.
• To buy the foreign currency we give the Central Bank
currency, removing them from public circulation and
thereby decreasing the domestic money supply.
• To summarize, if the economy has a fixed
exchange rate, an imbalance in the
international sector of the economy,
measured by the balance of payments,
automatically causes the money supply
to change, in turn affecting economic
activity.
• Armed with these two general results—that
international imbalance causes exchange-rate
changes under a flexible exchange rate system
and money-supply changes under a fixed
exchange rate system—we can examine how
monetary and fiscal policy are affected by
repercussions from the international sector.
• To maintain simplicity, all analysis ignores pricelevel changes and inflation. Incorporating them
would not change the general results, only the
breakdown of nominal income changes into real
changes and price changes.
Lesson 4
Section 4.4
FISCAL POLICY UNDER FLEXIBLE
EXCHANGE RATES
• An increase in government spending leads to an
increase in income and an accompanying increase
in the interest rate, causing some crowding out.
• The increase in income increases imports,
creating a balance of payments deficit, but the
increase in the interest rate causes capital
inflows, creating a balance of payments surplus.
• Which will dominate?
– The consensus among economists on this empirical
question is that the latter will outweigh the former.
• Because of the high mobility of international capital, a slight
increase in our interest rate causes a substantial capital
inflow, outweighing the impact on the balance of payments
of the accompanying rise in imports.
• Once this empirical question is settled, it is easy to see how
international forces modify the impact of fiscal policy.
• Under a flexible exchange rate system, the balance of
payments surplus created by a stimulating dose of fiscal
policy causes the exchange rate to appreciate.
• This increase decreases exports—directly decreasing
demand for domestically produced goods and services.
• It also in creases imports, thereby decreasing demand for
domestically produced goods and services that compete
against imports.
• The decrease in aggregate demand for domestically
produced goods and services partially offsets the impact on
the economy of the stimulating dose of fiscal policy,
decreasing the strength of fiscal policy in affecting the
income level
Lesson 4
Session 4.5
FISCAL POLICY UNDER FIXED
EXCHANGE RATES
• When the exchange rate is fixed, the balance of
payments surplus created by a stimulating dose
of fiscal policy does not cause the exchange rate
to rise.
• Instead, it causes an increase in the money
supply as the central bank buys foreign currency
(the balance of payments surplus) with domestic
currency.
• This increase in the money supply augments the
stimulating effect of the policy dose, making fiscal
policy stronger in affecting the income level.
Reaction to Fiscal Policy
This flowchart shows the reaction of the economy to an increase in government spending
under both flexible and exchange rate systems (source: Kennedy 1999).
Lesson 4
Section 4.6
MONETARY POLICY UNDER FLEXIBLE
EXCHANGE RATES
• An increase in the money supply lowers the
interest rate, and the lower interest rate
stimulates aggregate demand and moves the
economy to a higher level of income.
• This rise in income increases imports, creating
a balance of payments deficit, and the fall in
the interest rate reduces capital inflows, thus
augmenting this balance of payments deficit.
• Under a flexible exchange rate system, the
balance of payments deficit causes the exchange
rate to depreciate.
• This lower exchange rate increases exports—
directly increasing demand for domestically
produced goods and services. It also decreases
imports—increasing demand for domestically
produced goods and services that compete
against imports.
• The rise in aggregate demand for domestically
produced goods and services augments the
impact on the economy of the stimulating dose of
monetary policy, thus giving greater strength to
monetary policy in affecting the income level
Reaction to Monetary Policy
This flowchart shows the reaction of the economy to an increase in money supply under both f
lexible and fixed exchange rate systems (source Kennedy 1999).
Lesson 4
Section 4.7
MONETARY POLICY UNDER FIXED
EXCHANGE RATES
• When the exchange rate is fixed, the balance of
payments deficit created by a stimulating dose of
monetary policy does not cause the exchange
rate to fall.
• Instead, it causes a decrease in the money supply
as the Central Bank buys domestic currency with
foreign exchange to prevent the balance of
payments deficit from lowering the exchange
rate.
• The decrease in the money supply diminishes the
stimulating effect of the policy dose, making
monetary policy weaker in affecting the income
level
• There is more to this story however.
– An increase in the money supply created the balance
of payments deficit, and an automatic decrease in the
money supply is decreasing the deficit.
– Consequently, only when the original money supply
increase has been completely wiped out will the
deficit be eliminated.
– The economy will regain equilibrium back where it
started, so the end result of this monetary policy is no
change.
– This reflects an extremely important general result:
• under a fixed exchange rate, monetary policy is completely
ineffective as a policy tool.
• Monetary policy implicitly is being used to fix the exchange
rate, so is not available for other purposes
Flexible exchange
rate
Fixed exchange
rate
Fiscal policy
Monetary policy
Effective
Effective
Ineffective
Ineffective
Effective
Effective
Ineffective
Ineffective
Lesson 4
Session 4.8
STERILIZATION POLICY
• Monetary policy in the context of a fixed exchange rate is
ineffective because an expansionary monetary policy creates a
balance of payments deficit, which automatically decreases the
money supply, offsetting and eventually eliminating the
original increase in the money supply.
• What if, however, the monetary authorities take monetary
action to counteract the automatic change in the money
supply, allowing the original monetary dose to be maintained?
• As the money supply decreases automatically in the preceding
example, the monetary authorities could annually increase the
money supply by exactly the same amount
• This policy is called a sterilization policy because it "sterilizes"
the automatic money-supply change that results from an
imbalance in international payments under fixed exchange
rates.
• Pursuing this policy maintains the original monetary policy
dose and allows monetary policy to retain its effectiveness
• Unfortunately, there is a catch:
– the sterilization policy maintains the imbalance in
international payments.
– In the example, the balance of payments deficit,
which would normally disappear as it
automatically decreased the money supply, now
persists as this automatic mechanism is
"sterilized."
• What are the implications of of a continuing
balance of payments deficit?
• Consider how the government, through its
agent the central bank, deals with the balance
of payments deficit.
• The deficit means that the supply of dollars on
the foreign exchange market exceeds the
demand, so those unable to obtain foreign
exchange for their currency go to the
government to exchange them at the fixed
rate.
• The government sells foreign currency to them at
the fixed rate, as it has promised to do, and in
return obtains domestic currency, which normally
would thereby be removed from public
circulation, thus decreasing the money supply.
• Under a policy of sterilization, of course, the
central bank arranges to have these dollars put
back into circulation.
• The key point here is that during this process the
government is selling off its holdings of foreign
exchange. As long as the balance of payments
deficit continues, the government's stock of
foreign exchange—its foreign exchange
reserves—steadily falls.
• The major problem with sterilization policy should now be
evident.
– By maintaining the balance of payments deficit, the
sterilization policy causes the government's foreign exchange
reserves to run low, threatening its ability to continue this
policy, and worse, alerting foreign exchange speculators that
the dollar may soon have to be allowed to fall.
– The resulting foreign exchange crisis usually results in a
devaluation (a substantive fall in the fixed exchange rate
value), creating embarrassment for the government and
profits for speculators.
– If a balance of payments surplus is being maintained by a
sterilization policy, however, opposite results are obtained.
– Foreign exchange reserves cumulate to embarrassingly high
levels, ultimately causing an upward revaluation of the
currency and, once again, profits for speculators.
Lesson 4
Session 4.9
GOVERNMENT INFLUENCE ON THE
EXCHANGE RATE
• It is rare to find an exchange rate system that is
fully flexible.
• Usually, government intervenes in the operation
of the foreign exchange market to "modify" the
natural forces of supply and demand.
• Sometimes intervention is intended to prop up an
exchange rate for reasons of prestige, and at
other times it is intended to push down the
exchange rate in order to produce jobs through
stimulation of demand for exports and importcompeting goods and services
• Neither of these interventions can be viewed
with favor because they attempt to set the
exchange rate at an unnatural level.
• A more convincing rationale for government
interference in this market is that without such
interference the exchange rate may be volatile, so
volatile that it is disruptive to international
business activity.
• Government action designed to cushion
temporary shocks to the exchange rate, rather
than to influence its long-run level, is thought to
be a legitimate policy
• The government employs two main mechanisms
to influence the exchange rate.
– First, it can intervene directly in the foreign exchange
market, buying or selling dollars. This intervention is
viable as long as the government's stock of foreign
exchange reserves is not threatened, as it would be,
for example, if it tried to keep the exchange rate
above its long-run level through continual purchases
of dollars with its foreign exchange reserves.
– Second, government can influence the exchange rate
by using monetary policy to change the real interest
rate; changes in the interest rate in turn affect capital
inflows and outflows and thus the exchange rate.
• Most governments, through their central banks,
adopt a combination of these two policies.