Chapter 26 Economic Policy in the Open Economy

Chapter 26 Economic Policy in the Open Economy Under Flexible Exchange Rates Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 26 -1

Learning Objectives • Analyze the impact of fiscal policy on income, trade, and exchange rates under flexible exchange rates. • Analyze the impact of monetary policy on income, trade, and exchange rates under flexible exchange rates. • Show external economic shocks affect the domestic economy under flexible exchange rates. 26 -2

Introduction • The effectiveness of monetary and fiscal policies at influencing national income differ dramatically under fixed and flexible exchange rate systems. • Do flexible exchange rate systems make countries more vulnerable to external shocks such as the recent global recession? 26 -3

The Effects of Fiscal and Monetary Policy Under Flexible Exchange Rates • Under a flexible exchange rate system, combinations of income and interest rates not on the BP curve will cause disequilibrium in foreign exchange markets, and force an adjustment in the exchange rate. • This will cause the BP curve to shift. 26 -4

The Effects of a Currency Depreciation on the BP Curve i BP 0 BP 1 A depreciation expands exports and contracts imports. For any given level of Y, a lower i is required to balance the BOP. Y 26 -5

The Effects of a Currency Appreciation on the BP Curve i BP 1 BP 0 An appreciation contracts exports and expands imports. For any given level of Y, a higher i is required to balance the BOP. Y 26 -6

Fiscal Policy Under Flexible Exchange Rates – With perfect capital immobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP deficit, causing a depreciation and a rightward shift of the BP curve. – The depreciation increases exports, decreases imports, and shifts IS even farther rightwards. – This continues until IS, LM, and BP intersect at a common point. 26 -7

Fiscal Policy Under Flexible Exchange Rates i BP 0 BP 1 LM Perfect capital immobility i 3 i 0 IS '' IS Y 0 Y 2 IS' income 26 -8

Fiscal Policy Under Flexible Exchange Rates – With perfect capital mobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP surplus, causing an appreciation of the currency. – The appreciation decreases exports, increases imports, and shifts IS back to the left. 26 -9

Fiscal Policy Under Flexible Exchange Rates LM i Perfect capital mobility i. E BP IS Y 0 IS' income 26 -10

Fiscal Policy Under Flexible Exchange Rates – The bottom line: • When capital is relatively immobile, fiscal policy is more effective at increasing national income. • When capital is relatively mobile, fiscal policy is less effective at increasing national income. • Between these two extremes, the effect on the exchange rate depends on the relative slopes of LM and BP. – BP steeper than LM: depreciation – LM steeper than BP: appreciation 26 -11

Monetary Policy Under Flexible Exchange Rates – With perfect capital immobility, a monetary stimulus increases Y, and the increase in imports causes an incipient BOP deficit to emerge. – As currency depreciates, BP shifts rightward. – Depreciation also shifts IS rightwards. 26 -12

Monetary Policy Under Flexible Exchange Rates i BP' LM LM' BP Perfect capital immobility i 2 i 0 E IS Y 0 Y 2 IS' income 26 -13

Monetary Policy Under Flexible Exchange Rates – With perfect capital mobility, any monetary stimulus increases Y. – This generates a large capital outflow and a depreciation of the home currency. – The depreciation causes IS to shift outwards. 26 -14

Monetary Policy Under Flexible Exchange Rates LM i LM' Perfect capital mobility i. E BP IS' IS Y 0 Y 2 income 26 -15

Monetary Policy Under Flexible Exchange Rates – The bottom line: • When capital is relatively immobile, monetary policy is effective at increasing national income. • When capital is relatively mobile, monetary policy is particularly effective at increasing national income. 26 -16

Policy Coordination Under Flexible Exchange Rates – Coordination of fiscal and monetary policy make the attainment of other targets besides income possible. – Examples of alternative targets include interest rates and exchange rates. – Consider an income and interest rate target of Y* and i*as an example. 26 -17

Policy Coordination Under Flexible Exchange Rates – If fiscal policy alone is used to reach Y*, it is likely that the interest rate will overshoot the target of i*. – In addition, the fiscal policy creates an incipient BOP surplus, appreciating the currency, and shifting BP back to the left. – The depreciation also shifts IS part of the way back to the left. – In the end, neither target is reached. 26 -18

Policy Coordination: Fiscal Policy Alone LM BPFP i. FP BP 0 i. Y* i* i 0 IS ISFP IS'FP Y 0 YFP Y* 26 -19

Policy Coordination Under Flexible Exchange Rates – If monetary policy alone is used to reach Y*, the increase in Ms will cause a currency depreciation, and a rightward shift in BP. – In addition, the monetary policy shifts IS rightwards. – In the end, neither target is reached. 26 -20

Policy Coordination: Monetary Policy Alone i LM LM' BP BP' i* i 0 i' IS IS' Y 0 Y' Y* Y 26 -21

Policy Coordination Under Flexible Exchange Rates – If monetary and fiscal policies are used, both i* and Y* can be attained. – Expansionary fiscal policy allows Y to increase without the expenditure switching effects. 26 -22

Policy Coordination: Monetary Policy Alone i LM LM' BP i* i 0 IS IS' Y 0 Y* Y 26 -23

Effects of Shocks in the IS/LM/BP Model (Imperfect K-Mobility) – So far, we’ve examined the effects of fiscal and monetary policy holding a number of factors constant, including • domestic and foreign prices, • foreign interest rate, and • expected exchange rate changes. – How are changes in such variables (“shocks”) transmitted through the economy? 26 -24

Effects of Shocks: A Foreign Price Shock – If the foreign price level were to increase, the home economy would expand due to increases in exports and decreases in imports (IS shifts right). – The BP also shifts right due to expenditure switching effects of higher foreign prices. – Both effects cause i to rise, and the currency to appreciate. – These shift IS and BP back to where they started. 26 -25

Foreign Price Shock i LM BP BP' i 0 IS IS' Y 0 Y 26 -26

Foreign Price Shock i LM BP BP' i 0 IS IS' Y 0 Y 26 -27

Foreign Price Shock i LM BP i 0 IS Y 0 Y 26 -28

Effects of Shocks: A Domestic Price Shock – If the domestic price level were to increase, the real money supply would fall, shifting LM leftwards. – Exports will fall and imports rise, so IS shifts leftwards. – The BP curve will also shift left in order to bring the BOP back into equilibrium. 26 -29

Domestic Price Shock LM' LM i BP' BP i 1 i 0 IS' Y 1 Y 0 IS Y 26 -30

Effects of Shocks: A Foreign Interest Rate Shock – If the foreign interest rate were to increase, the home country should experience an outflow of short-term capita; BP shifts leftwards. – The home currency depreciates. – This shifts • the IS curve rightward, and • the BP curve back toward the right. 26 -31

Foreign Interest Rate Shock i LM BP' BP i 0 IS Y 0 IS' Y 26 -32

Foreign Interest Rate Shock i LM BP'' BP i 1 i 0 IS Y 0 Y 1 IS' Y 26 -33