Transcript Economic Policy

Economic Policy
Floating Exchange Rates
The Difference Between the Floating Exchange
Rates and the Fixed Exchange Rates
• When it chooses to maintain a fixed exchange rate,
a nation’s central bank shoulders two burdens.
• First, it must stand ready to intervene in the
foreign exchange market by purchasing and
selling foreign-currency-denominated assets.
• Second, it must decide whether to sterilize its
foreign exchange market interventions.
• By permitting the exchange rate to float, a central
bank relieves itself from these burdens.
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The Effects of Exchange-Rate Variations
in the IS-LM-BP Model
• The trigger event: depreciation
• How does the IS schedule move?
• How does the BP schedule move?
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Exchange-Rate Variations and the IS
Schedule
• A fall in the value of a nation’s
R
currency makes imports more
expensive, inducing the nation’s
residents to reduce their import
spending.
• Simultaneously, the effective prices of
the nation’s export goods faced by
R1
other nations’ residents decline.
Consequently, expenditures on the
nation’s exports increase.
• Both of these effects generate a rise in
the nation’s aggregate autonomous
expenditures at any given nominal
interest rate. Hence, the IS schedule
shifts to the right.
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A
B
IS’
IS
y1
y2
y
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Exchange-Rate Variations and the BP
Schedule
• A currency depreciation causes a nation’s R
exports to rise and its imports to fall at
any given real income level and at any
given nominal interest rate. So a rise in
the exchange rate from S1 to S2 generates R1
an improvement in the trade balance that
results in a balance-of-payments surplus
at point A.
• This means that for the balance of
payments to return to equilibrium, the
real income should increase, or the
nominal interest rate should decline. So
the BP schedule shifts to the right.
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BP
A
BP’
B
y1 y2
y
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The Effects of a Currency Depreciation
on the IS and BP Schedules
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Monetary Policy under Floating
Exchange Rates
• Suppose the central bank carry out an expansionary
monetary policy. An increase in the money stock from M1
to M2 causes the LM schedule to shift rightward,which will
lead to the balance-of-payments deficit regardless of in low
capital mobility or in high capital mobility.
• When capital mobility is low, the balance-of-payments
deficit results from an increase in real income. When
capital mobility is high, the balance-of-payments deficit
results from the outflow of capital spurred by the decline in
the interest rate from R1 to R2.
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The Effects of an Increase in
the Money Stock with Floating Exchange Rates
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Conclusion
• With either low or high capital mobility, an
increase in the money stock tends to induce a rise
in equilibrium real income, holding other factors
such as the price level unchanged.
• Under a floating exchange rate, therefore, an
increase in the quantity of money unambiguously
constitutes an expansionary policy action that
induces at least a near-term increase in a nation’s
real income level.
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Fiscal Policy with Low Capital
Mobility
• An increase in government spending
R
causes the IS schedule to shift to the
right, from IS to IS’. This yields a new
IS-LM equilibrium at point B, which lies
to the right of the initial BP
R3
schedule.Therefore, the immediate effect
of the rise in government spending is a R2
balance-of-payments deficit, which press
the nation’s currency to depreciate. The R1
resulting rise in the exchange rate, from
S1 to a higher level S2 ,induces net export
expenditures to increase. This causes the
IS schedule to shift rightward once more,
and causes the BP schedule to shift
rightward.
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BP
BP’
LM
C
B
A
IS”
IS’
IS
y1 y2 y3
y
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Fiscal Policy with High Capital
Mobility
• When capital is very mobile, a R
rise in government spending lead
the IS schedule to shift
rightward, and induces a balance-R
2
of-payments surplus at point B R
3
above the initial BP schedule.
R1
The nation’s currency value
appreciates. Hence, the exchange
rate declines from S1 to S2. So
the IS and BP schedules shift
leftward.
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LM
B
BP’
C
BP
IS’
A
IS”
IS
y1 y3 y2
y
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The Effects of an Increase in
Government Spending with a Floating Exchange Rate
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Floating Exchange Rates and Perfect
Capital Mobility
• We assume throughout that there is no
anticipated currency depreciation or
appreciation, so that the uncovered interest
parity condition implies that the nominal
interest rate for the small open economy is
equal to the large-country nominal interest
rate, R*. That is, the BP schedule is
horizontal.
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Monetary and Fiscal Policies with Perfect Capital Mobility
and Floating Exchange Rates
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Conclusion
• With perfectly mobile capital, Monetary
policy actions have their largest possible
real-income effects if the exchange rate
floats.
• With perfect capital mobility, fiscal policy
actions have minimal real-income effects if
the exchange rate floats.
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Perfect Capital Mobility and
Fixed versus Floating Exchange
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Real-Income Effects with Perfect Capital Mobility
and Fixed Versus Flexible Exchange Rates
Exchange-Rate
Setting
Monetary Policy
Effect
Fiscal Policy
Effect
Fixed Exchange
Rate
Minimum Effect
Maximum Effect
Flexible Exchange
Rate
Maximum Effect
Minimum Effect
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•
•
•
•
•
Economic Policies with Perfect Capital
Mobility and a Floating Exchange Rate: A
Two-Country Example
A Two-Country Model with Perfect Capital
Mobility and a floating Exchange Rate
The Effects of a Domestic Monetary
Expansion
The Effects of a Foreign Monetary
Expansion
The Effects of a Domestic Fiscal Expansion
The Effects of a Foreign Fiscal Expansion
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Economic Policies with Perfect Capital
Mobility and a Floating Exchange Rate: A
Two-Country Example
• Assumption1: A “world” composed of two nations
that are of roughly equal size and that engage in
international trade of goods, services, and
financial assets. Each nation accounts for about
half of the world’s output.
• Assumption 2: Financial resources flow freely
across their borders.
• Assumption 3: Prices are unchanged in both the
domestic country and the foreign country.
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Economic Policies with Perfect Capital
Mobility and a Floating Exchange Rate: A
Two-Country Example
• The difference between the two-country model
and the small-open-economy framework is that
nominal interest rates in both nations may change
in response to monetary or fiscal policy actions.
• Nevertheless, the free movement of financial
resources between the two nations ultimately must
drive the countries’ interest rates to the same
value.
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The Effects of a Domestic
Monetary Expansion
R
R*
IS*（S2,y2）
LM（M1/P1）
IS（S2,y2*）
LM（M2/P1）
R1
A
BP1
R1*
BP2
R2*
BP1*
A
R2
C
C
B
B
IS（S2,y1*）
IS*（S2,y1）
IS（S1,y 1*）
y1
y2
y
y 2*
(a)
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BP2*
y 1*
IS*（S1,y1）
y*
(b)
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The Effects of a Domestic
Monetary Expansion
• We may conclude that under a floating exchange
rate and perfect capital mobility, a domestic
monetary expansion can have a beggar-thyneighbor effect on the foreign country.
• That is, an increase in the domestic money stock
exerts an expansionary effect on the domestic
economy but typically tends to depress the
equilibrium level of economic activity in the
foreign economy.
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The Effects of a Foreign
Monetary Expansion
R*
R
IS（S2,y2）
LM*（M1/P1）
IS*（S2,y2*）
LM*（M2/P1）
A
R1
BP1
R1*
BP2
R2*
BP1*
A
C
R2
BP2*
C
B
B
IS（S2,y1）
y2
y1
IS*（S2,y1*）
IS（S1,y1）
y
IS*（S1,y 1*）
y1*
(a)
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y2*
y*
(b)
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The Effects of a Foreign
Monetary Expansion
• We can conclude that, with a floating
exchange rate and perfect capital mobility, a
foreign monetary expansion typically
generates a beggar-thy-neighbor effect.
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The Effects of a Domestic Fiscal
Expansion
R
LM
R*
LM*
B
R’
C
C
R2
BP2
R1
R2*
BP1
BP2*
A
R1*
BP1*
A
IS (g2,S1,y1*)
IS*(S2,y2)
IS (g2,S2,y2*)
IS*(S1,y1)
IS (g1,S1,y1*)
y1
y2
y’
y
y 1*
(a)
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y 2*
y*
(b)
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The Effects of a Domestic Fiscal
Expansion
• Because the equilibrium levels of real income in
the two nations exceed their initial values. Thus,
under a floating exchange rate and perfect capital
mobility, a domestic fiscal expansion has a
locomotive effect on the foreign country.
• An increase in domestic government spending
results in expansions of real income levels in both
nations.
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The Effects of a Foreign Fiscal
Expansion
R
R*
LM
LM*
B
R*’
C
R2
A
R1
C
BP2
R2*
BP2*
BP1
R1*
BP1*
A
IS* (g2,S1,y1*)
IS(S2,y2)
IS* (g2,S2,y2*)
IS(S1,y1)
y1
y2
IS* (g1,S1,y1*)
y
y1*
(a)
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y 2*
y’*
y*
(b)
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The Effects of a Foreign Fiscal
Expansion
• We may conclude that increase in foreign
government spending generates, with a
floating exchange rate and perfectly mobile
capital, increases in equilibrium nominal
interest rates and real income levels in both
nations.
• That is, a foreign fiscal expansion has a
locomotive effect on the domestic country.
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Cross-Country Effects In Two-Country Model
With Perfect Capital Mobility
Exchange-Rate
Setting
Monetary
Policy Effect
Fiscal Policy
Effect
Fixed Exchange
Rate
Locomotive
Effect
Beggar-ThyNeighbor Effect
Flexible
Exchange Rate
Beggar-ThyNeighbor Effect
Locomotive
Effect
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