Transcript 4.Flexible vs Fixed Exchange Rate Systems

The Transition
D2
A2
A
1
A
3
D2
In the transition:
P so that DD-curve
D1 shifts to the left
S e  so that AA-curve
shifts to the left
2
A2
S
3
1
A3
D1
A1
Y
Y
F
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A Permanent Fiscal Expansion
S
A
D1
1
(3 - transitory
D2
AA shifts down
e
S

because
A2
1
3
A1
2
D2
Y
A2
D1
fiscal expansion)
F
Y
Result: Monetary policy is effective in the short run while fiscal
policy is not effective.
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Change in
Pt
e
P
(assume that t 1 is given)
D
2
D1
S
S
A2
S
A1
2
D2
A
D1
1
1
A2
SP *

S
Y
Y
L(i, Y ) 
MS

P
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Y
Phillips Curve ) Pte1 given)
Pe  P
YF  Y
P 
 Y 

P
Y
Pe  P
P
Long run
Short Run
YF  Y
Y
0
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Japan 1999

slump
 zero rate of interest (liquidity tramp)
 Expanded Fiscal Policy ( Deficit = 7-8% of GDP )
DD
S
DD’
AA
Y
 Yen appreciated 12 percent in the May - September period
vis a vis $
 Output growth for 2000: 0.5% forecast
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Capital Controls
CA=0
D
 SP *

Y  D
, Y  T , I , G 
 P


S
D
Y   C   C Y  T   I  G

Y    C   C T  I  G 
Results: (1) monetary policy is ineffective
(2) fiscal policy is effective
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Closed Capital Account
 SP *


Y  D
,
Y

T
,
I
,
G
 P



 SP * 
 SP *

  M 
  C   C (Y  T )  I  G  X 
, Y 
 P 
 P

SP *
SP *
  C   C (Y  T )  I  G  x S
 mY Y  mS
P
P
 C  marginal propensity to consume
mY  marginal propensity to import
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Open Capital Account
1   C
 mY Y   C
SP *
SP *
  C T  I  G  xS
 mS
P
P

SP * 
Y  1  C   C T  I  G   x S  mS 

P


1 
1
1   C  mY
open economy multiplier
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Closed Capital Account
(1)
SP *
SP *
const  x S
 mY Y  mS
0
P
P
(2)
Y   C   C Y  T   I  G

Y   2  C   C T  I  G 
1 
1
1   C  mY
1
2 
1C
open economy multiplier
closed economy multiplier
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Exchange-rate/Capital-flows Possibilities Triangle
Capital Controls
flexible
exchange
rate
fixed
exchange
rate
economic
freedom
stabilized exchange
rate fluctuations
stabilized output
fluctuations
3 Policy Targets: (1) stabilized exchange rate fluctuations
(2) stabilized output fluctuations
(3) economic freedom
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