Chapter 12 Economic Policy with Floating Exchange Rates INTERNATIONAL MONETARY AND FINANCIAL ECONOMICS Chapter 12 Economic Policy with Floating Exchange Rates Third Edition Joseph P. Daniels David D. VanHoose Copyright © South-Western, a division of Thomson Learning. All rights reserved.

Floating Exchange Rates When policymakers decide to peg the exchange rate, the central bank shoulders two burdens. First, it must be willing to intervene in the foreign exchange market, buying or selling foreign exchange reserves. Second, it must decide if it will sterilize these interventions or sacrifice control of the quantity of money in circulation. By permitting the exchange rate to float, a central bank relieves itself from these burdens. The are, however, consequences for the potency of monetary and fiscal policy actions.

The Effects of Exchange Rate Variation Before we consider the impact of monetary and fiscal policy actions, we must consider how changes in the exchange rate affect the IS-LM-BP framework. A depreciation stimulates a rise in the expenditures on the nation’s aggregate autonomous expenditures and the IS curve shifts to the right. A depreciation causes the BP schedule to shift to the right.

The Effects of a Currency Depreciation on the IS Schedule A decline in the value of a nation’s currency from S1 to S2 makes imports more expensive for a nation’s residents and, at the same time, the nation’s export goods become less expensive for foreign residents. Together, these effects cause an increase in the nation’s aggregate autonomous expenditures at any given nominal interest rate, the real income level consistent with an income–expenditure equilibrium increases from y1 at point A to y2 at point B. Consequently, the IS schedule shifts rightward.

The Effects of a Currency Depreciation on the BP Schedule At a given real income–interest rate combination, such as at point A, an increase in the exchange rate from S1 to S2 results in an improvement in the trade balance. Consequently, a balance-of-payments surplus occurs at point A. Reattainment of balance-of-payments equilibrium requires an increase in the nation’s real income to a level such as y2, which generates a sufficient increase in import expenditures to return the trade balance to its previous level. Hence, point B lies on the scheduled denoted BP(S2), which implies that a currency depreciation causes the BP schedule to shift to the right.

The Effects of an Increase in the Money Stock with a Floating Exchange Rate An increase in the money stock causes the LM schedule to shift rightward. Because point B lies below and to the right of the BP(S1) schedule, there is a balance-of payments deficit at point B in both panels. The rise in import spending and acquisition of foreign financial assets by the nation’s residents and the reduction in export spending and acquisition of domestic financial assets by foreign citizens causes the home currency to depreciate, so the exchange rate rises from S1 to S2. As a result, the IS and BP schedules shift rightward. At the final equilibrium point C, balance-of-payments equilibrium is reattained in both panels.

The Effects of an Increase in Government Spending with a Floating Exchange Rate In both panels, an increase in government expenditures causes an initial rightward shift in the IS schedule, which leads to an increase in the equilibrium nominal interest rate and an increase in equilibrium real income. In panel (a), in which the relatively steep slope of the BP schedule implies low capital mobility, greater import spending more than offsets a small capital inflow in causing a balance-of-payments deficit to arise at point B. This induces a currency depreciation that shifts both the IS and BP schedules to the right, leading to a final equilibrium with a balance-of-payments equilibrium at point C. In panel (b), in which the relatively shallow slope of the BP schedule implies high capital mobility, significant capital inflows more than offset greater import expenditures in causing a balance-of-payments surplus to occur at point B. This induces a currency appreciation that shifts both the IS and BP schedules leftward, leading to a final balance-of-payments equilibrium at point C.

The Effects of an Increase in the Money Stock with a Floating Exchange Rate and Perfect Capital Mobility If there is perfect capital mobility under a floating exchange rate, an increase in the amount of money in circulation causes a rightward shift of the LM schedule along the IS schedule, from point A to point B, which induces a decline in the nominal interest rate that leads, in turn, to capital outflows. The resulting balance-of-payments deficit causes the nation’s currency to depreciate. This results in higher export spending and lower expenditures, so the IS schedule shifts rightward to a final equilibrium at point C.

The Effects of an Increase in Government Spending with a Floating Exchange Rate and Perfect Capital Mobility If there is perfect capital mobility under a floating exchange rate, an increase in government expenditures shifts the IS schedule rightward along the LM schedule, from point A to point B. The resulting rise in the nominal interest rate induces capital inflows that lead to a balance-of-payments surplus that causes a currency appreciation. Consequently, export spending declines and export expenditures increase, causing the IS schedule to return to its original position at point A.

The Effects of a Domestic Monetary Expansion in the Two-Country Model with a Floating Exchange Rate An increase in the domestic money stock shifts the domestic LM schedule rightward in panel (a). The resulting decline in the domestic interest rate causes financial resources to flow from the domestic country to the foreign country, thereby causing the domestic currency to depreciate. The rise in the equilibrium exchange rate from S1 to S2 induces a rise in net expenditures on domestic output and a decline in net spending on foreign output, so on net the domestic IS schedule shifts rightward in panel (a), while the foreign IS schedule shifts leftward in panel (b). At the final equilibrium points labeled points C, domestic real income is higher, and foreign real income is lower. Thus, the domestic monetary expansion has a beggar-thy-neighbor effect on the foreign country.

The Effects of a Domestic Fiscal Expansion in the Two-Country Model with a Floating Exchange Rate An increase in domestic government expenditures causes the domestic IS schedule to shift rightward in panel (a). The resulting increase in the domestic interest rate induces an inflow of financial resources from the foreign country that causes an appreciation of the domestic currency. The fall in the equilibrium exchange rate from S1 to S2 induces a reduction in net expenditures on domestic goods and services, which causes the domestic IS schedule to shift leftward in panel (a), and it causes an increase in net spending on foreign goods and services, which causes the foreign IS schedule to shift rightward in panel (b). At points C, the equilibrium levels of real income in the two nations are higher than their initial values, so the domestic fiscal expansion has a locomotive effect on the foreign country.

Exchange rate Volatility under Floating Exchange Rates Since the last years of the Bretton Woods system of fixed exchange rates, the dollar’s value has exhibited several periods of variability. The variability was most pronounced during the 1980.

The Effects of a Decline in Aggregate Autonomous Expenditures A decline in real income in the rest of the world, from y*1 to y*2, causes foreign residents to reduce their expenditures on domestic exports, resulting in a fall in domestic aggregate autonomous expenditures and a leftward shift in the IS schedule. Consequently, equilibrium domestic real income declines from y1 at point A to y2 at point B, which indicates that volatility in real income in the rest of the world results in domestic real income instability.

Real-Income Stability in the Face of a Decline in Aggregate Autonomous Expenditures with Perfect Capital Mobility Panel (a) shows that a fall in foreign real income with a fixed exchange rate causes the domestic IS schedule to shift leftward. The resulting domestic balance-of-payments deficit places downward pressure on the value of the nation’s currency. To keep the exchange rate fixed, the central bank must reduce the money stock and shift the LM schedule leftward. This yields a final equilibrium at point C in panel (a) and reinforces the real income effect of the fall in foreign real income. Panel (b) indicates that under a floating exchange rate, the fall in foreign real income causes the equilibrium exchange rate to rise from S1 to S2, which induces a rise in net export spending and a rightward shift in the IS schedule. Hence, real income is more stable under a floating exchange rate as compared with a fixed exchange rate.

The Effects of a Rise in the Demand for Real Money Balances A rise in the demand for money caused by any factor other than an increase in real income causes an increase in the equilibrium nominal interest rate, from R1 in panel (a) to R′. At the initial level of real income, new real income–interest rate combination that maintains money market equilibrium, given by point B in panel (b), lies above the initial combination given by point A. Thus, an increase in the demand for real money balances not stemming from a rise in real income generates an upward and leftward shift in the LM schedule. This causes equilibrium real income to decline to y2 in panel (b), which induces a leftward shift in the money demand schedule in panel (a). The net effect is a rise in the equilibrium interest rate and a decline in equilibrium real income.

Real-Income Stability in the Face of a Rise in the Demand for Real Money Balances In panel (a), a rise in the demand for real money balances under a fixed exchange rate causes the LM schedule to shift leftward. The resulting rise in the domestic interest rate causes a capital inflow. To keep the exchange rate fixed, the domestic central bank must purchase foreign assets, which leads to a rise in the domestic money stock and causes the LM schedule to shift back to the right. In panel (b), the movement to point B caused by a rise in the demand for real money balances with a floating exchange rate leads to a decline in the equilibrium exchange rate from S1 to S2. As a result, there is decline in net export expenditures that causes the IS schedule to shift leftward to the final equilibrium point C. At this point, real income is below the initial equilibrium income level, so real income is less stable in the face of money demand variations under a floating exchange rate.