Transcript Financial Performance

Chapter Sixteen
Short-Run Macroeconomic
Policy under Fixed Exchange
Rates
© 2003 South-Western/Thomson Learning
Chapter Sixteen Outline
1. Introduction
2. Macroeconomic Goals in an Open Economy
3. Macroeconomic Policy with Immobile
Capital
4. Macroeconomic Policy with Perfectly
Mobile Capital
5. Macroeconomic Policy with Imperfectly
Mobile Capital
6. A Special Case: The Reserve Country
2
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.
3
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.
4
Introduction
• Why analyze a fixed exchange rate regime
when the U.S. and most other industrialized
economies use the flexible regime?
1. Exchange rates for most currencies have been
fixed throughout most of modern economic
history;
2. 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
3. All governments engage in FX market
intervention on occasion.
5
Macroeconomic Goals in an Open Economy
• Internal and external balance
– Two primary macroeconomic goals of an open
economy:
1. Internal balance: involves the full use of an economy’s
resources, or full employment, along with a stable
price level.
2. External balance: when the quantity demanded of
foreign exchange equals the quantity available.
6
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).
7
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:
1. Degree of international capital mobility; and
2. Nature of the exchange rate regime.
8
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).
See Figure 16.1
9
Figure 16.1: Internal and External Balance with Immobile
Capital
i
BOP
LM
IS
0
QIB = QEB
Q
10
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.
11
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.
See
Figure
16.2
– 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.
12
Figure 16.2: Short-Run Effect of Fiscal Policy with
Immobile Capital
i
BOP
LM
1
LM
0
IS
IS
0
QEB Q IB
1
0
Q
13
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.
14
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).
See
Figure 16.3
15
Figure 16.3: Short-Run Effects of Monetary Policy with
Immobile Capital
i
BOP
0
LM = LM
LM
2
1
2
1
0
IS
0
QEB QIB
Q
16
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
17
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.
18
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).
See Figure 16.4
19
Figure 16.4: Short-Run Effects of a Devaluation with
Immobile Capital
i
BOP0
BOP1
LM0
LM1
IS1
IS0
0
Q0EB
QIB= Q1EB
Q
20
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.
21
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.
See Figure 16.5
22
Figure 16.5: Perfect Capital Mobility and the Slope of
the BOP Line
i
Current-account deficit
Capital-account surplus
BOP > 0
i0
A
B
BOP(i,* e, e,f ee)
BOP < 0
0
Q
23
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.
See Figure 16.6
24
Figure 16.6: Short-Run Effect of Fiscal Policy with
Perfectly Mobile Capital
i
LM 0
LM 1
BOP
IS1
IS0
0
QIB
Q
25
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.
See
Figure
16.7
26
Figure 16.7: Short-Run Effect of Monetary Policy with
Perfectly Mobile Capital
i
LM0 = LM2
LM1
i0
BOP
2
1
IS0
0
QIB
Q
27
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.
28
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.
See Fig. 16.8
29
Figure 16.8: Sterilization Blocks Monetary Adjustment to
Cure a BOP Deficit
SFX
e
e0
DFX(i0 , i*,e e ,e f)
DFX(i1, i*,e e,ef )
0
(a) Foreign Exchange Market
Quantity of
Foreign-currencydenominated Deposits
30
Figure 16.8: Sterilization Blocks Monetary Adjustment to
Cure a BOP Deficit
i
(M/P)1
i1
(M/P) 0
(M1 < M 0)
i0
L(Q, i)
0
(b) Money Market
Quantity of
Real Money
Balances
31
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.
32
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).
See
Figure 16.9
33
Figure 16.9a: Sterilized Intervention with a Risk
Premium
e
SFX
( 1<  0)
a) Foreign Exchange
Market
e0
DFX(i0, i*,ee,ef,  0 )
DFX(i0, i*,ee,ef, 1)
0
Quantity of
Foreign-currencydenominated Deposits
34
Figure 16.9b: Sterilized Intervention with a Risk
Premium
i
(M/P)0
b) Money Market
i0
L(Q, i)
0
Quantity of
Real Money
Balances
35
Macroeconomic Policy with Perfectly Mobile
Capital
• Monetary policy (cont.)
– Studies of sterilized intervention’s effectiveness
lead to mixed results because:
1. Detailed intervention data often are kept secret; and
2. 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 cannot be
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.
36
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.
See
Figure
16.10
– 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.
37
Figure 16.10: Short-Run Effects of a Devaluation with
Perfectly Mobile Capital
i
LM0
LM1
i1
i0
BOP
IS1
IS0
0
QIB
Q
38
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.
See Figure 16.11
39
Figure 16.11: Short-Run Effects of an Expected
Devaluation with Perfectly Mobile Capital
i
(ee1 > ee0)
LM1
LM0
i1
BOP1 (ee1)
i0
BOP0 (ee0)
IS0
0
Q
40
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.
See Figure 16.12
41
Figure 16.12: Short-Run Effects of Fiscal Policy with
Imperfectly Mobile Capital
i
LM0
LM1
BOP
IS1
IS0
0
QIB
Q
42
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.
See
Figure
16.13
– 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.
43
Figure 16.13: Short-Run Effects of Monetary Policy
with Imperfectly Mobile Capital
i
LM0 = LM2
LM1
BOP
2
1
IS
0
QIB
Q
44
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.
See
Figure
16.14
45
Figure 16.14: Short-Run Effects of a
Devaluation with Imperfectly Mobile Capital
i
LM0
LM1
BOP0
BOP1
IS1
IS0
0
Q IB
Q
46
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.
47
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.
48
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.
See
Figure
16.15
49
Figure 16.15: Monetary Policy by a ReserveCurrency Country
i*
LM0
i
LM0
LM1
i*
0
LM1
BOP0 (i*0)
i0
BOP1(i*1)
i*1
i1
IS
0
Q*0 Q*1
(a) Reserve Country
IS
Q* 0
Q
Q 0 Q1
(b) Non-reserve Country
50
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.
51
Note on Case One: More on German
Unification
1. Increased demand for their exports shifted IS to the
right and exerted an expansionary influence on
trading-partner economies.
2. 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.
See Fig. 16.16
52
Figure 16.16: The Macroeconomics of German
Unification
iG
iB
G
LM
LMB1
LMB0
BOPB1 (iG1 )
iG1
iB1
BOPB0 (iG0 )
iG0
iB0
ISG1
ISB1
ISB0
ISG0
0
QG0
QG1
(a) Germany
Q
G
0
B
QB1 Q0
QB
(b) Britain
53
Note on Case Five: The Two Faces of Capital
Flows
• Figure 16.17 illustrates that countries have moved
toward more liberal policies toward capitalaccount 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.
See Figure 16.17
54
Figure 16.17: Rules Governing International Capital
Transactions for 102 Countries
Number of Countries
45
40
35
30
25
1994
1985
20 1975
15
10
5
0
Liberal
Mostly Liberal Partly Liberal
Restrictive
Very Restrictive
55
Key Terms in Chapter 16
• Internal balance
• External balance
• Targets
• Instruments
• Crowding out
• Sterilization policy
• Perfect capital mobility
56
Key Terms in Chapter 16
• Risk premium
• Signal
• Reserve currency
• Bretton Woods
57