Transcript Output Interest rates

Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 25
Open economy
macroeconomics
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Open economy macroeconomics
• … is the study of economies in which international
transactions play a significant role
– international considerations are especially
important for open economies like the UK,
Germany or the Netherlands
• Domestic macroeconomic policy in such countries
cannot ignore the influence of the rest of the world
– especially via the exchange rate.
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Open economy macroeconomics
• In highly connected global financial markets,
regulation or taxation by a country in isolation
risks driving mobile financial business to all the
other countries that have not raised taxes or
imposed regulations.
• Even if a tax on capital transactions (a Tobin tax)
is desirable,
• it would require simultaneous introduction in
most important financial centres.
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According to the IMF’s Chief
Economist
• Perfect international capital mobility is an
idealized benchmark against which to compare
actual capital mobility, which would differ in
different countries.
• Countries can pursue expected rates of return
on assets that might differ slightly from the world
average.
• But when major strains emerge – as in the case
of Greece in 2010 – the extent of national
autonomy from speculation is quickly eroded.
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Macroeconomic policy under fixed
exchange rates
• Under fixed exchange rates, there is a crucial link between
external imbalance and domestic money supply.
• When the government intervenes to maintain the exchange
rate, there is a direct effect on money supply.
• Sterilization
– an open market operation between domestic money
and domestic bonds to neutralize the tendency of
balance of payments surpluses and deficits to change
domestic money supply.
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Monetary policy under fixed
exchange rates
Assume: perfect capital mobility, sluggish prices
• An increase in nominal money supply
– tends to reduce interest rates
– leads to a capital outflow
– reducing money supply as the government
seeks to maintain the exchange rate
• so monetary policy is powerless
– the government cannot fix independent targets
for both money supply and the exchange rate
– domestic and foreign interest rates cannot
diverge
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Fixed exchange rates and the loss
of monetary sovereignty
LM
LM’
The exchange rate is fixed to a
foreign currency
Interest rates
r* is the foreign interest rate
r*
Beginning at A, a monetary
expansion lowers r to r’, leading
to capital outflows.
A
r’
IS
Y*
Output
This is caused by the interest
rate falling below r*, and will
continue until r* is restored.
The need to match r* leads to a
loss of monetary sovereignty
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Fiscal policy under fixed exchange
rates
Assume: perfect capital mobility, sluggish prices
• An increase in government expenditure, in the
short run,
– stimulates output
– money supply expands
– there is no crowding-out
– as interest rates cannot rise
• in the long run,
– wages and prices adjust, affecting
competitiveness
– the economy returns to potential output
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Fixed exchange rates and fiscal
expansion
Interest rates
LM
r*
A
B
IS’
IS
Y*
LM’
Y’
Output
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Beginning at A, a fiscal
expansion shifts the IS curve
to IS’.
Ordinarily, interest rates
would rise to dampen some
of the increase in Y. Since
rates cannot rise above r*,
extra money supply (LM to
LM’) has to accommodate
the extra demand for
money.
A fiscal expansion leads to
a big short-run effect on
output, i.e. from Y* to Y’.
Monetary policy under floating
exchange rates
e
The long run equilibrium nominal exchange rate is e*
To be constant this requires no
inflation differential cross countries.
e0
The Fisher hypothesis then means
that interest rate differentials are
also eliminated in the long run
e*
e1
Time
For a country with temporary high
Interest rates, the exchange rate
begins at e0 and moves to e* over
time,
similarly for too low interest rates
beginning at e1.
In either case expected exchange rate differentials offset interest
differentials.
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Monetary policy
under floating exchange rates (2)
• This analysis suggests that with floating
exchange rates
• monetary policy is highly effective in the
short run,
• but the effect is only transitional.
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Fiscal policy under floating
exchange rates
• Following an increase in government
expenditure,
• the crowding-out effect of higher interest
rates is enhanced by appreciation of the
exchange rate,
– which dampens export demand.
• So fiscal policy is less effective under
floating exchange rates.
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PPP and the short run
• The purchasing power parity (PPP) path of the nominal
exchange rate is the path that offsets differential inflation
rates across countries, maintaining a constant real
exchange rate.
• However, in the short run, the real exchange rate can
fluctuate a lot. If the vast stock of internationally mobile
funds were all to move in a short period between two
currencies:
• this could not possibly be offset by the small net flows that
occur on the current account during that time.
• Under freely floating exchange rates there is no
government intervention and no official financing. The
forex market could not clear.
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But clear it does!
• UK interest rates rise and are 4% above US interest
rates.
• If people think that the UK exchange rate will fall at
2% a year, the extra UK interest rate more than
compensates for capital losses on sterling.
• Everyone tries to move into pounds. Almost instantly,
this bids up the $/£ exchange rate until it reaches
such a high level that people expect the pound
then to fall by 4% a year.
• The capital losses expected on funds lent in pounds
offsets the 4% interest differential.
• This restores interest parity and ends one-way traffic.
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Devaluation
• A devaluation (revaluation) reduces (increases) the
par value of a pegged (fixed) exchange rate.
• With sluggish price adjustment, devaluation raises
competitiveness and –eventually – impacts on the
current account.
• In the long run, devaluation is unlikely to have
much effect.
• In passing on higher import prices and seeking costof-living wage increases, firms and workers offset
the competitive advantage of devaluation.
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Devaluation: Impact on real
exchange rate
Devaluation leads to an immediate
increase in competitiveness and
decline in the real exchange rate
from e1 to e2 .
But firms may respond by raising
prices and hence not all the impact
may be on competitiveness.
e
e1
e2
Devaluation leads to a temporary
but not a permanent rise in
competitiveness.
Time
But devaluation may be the
simplest way to change
competitiveness quickly.
In the long run, changes in one
nominal variable eventually induce
offsetting changes in others to
restore real variables to their
equilibrium values.
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Devaluation: Impact on current
account balance
Current account
Initially, the devaluation is
effectively a price cut – until
quantities can respond, making
exports cheaper actually harms
export revenue. The current
account worsens.
Time
In the medium run, the induced
quantity rise in exports benefits the
current account in value terms,
provided quantities respond
sufficiently to price incentives.
Eventually, since the real exchange
rate is restored to its original level,
so is the current account.
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