Short-Run Macroeconomic Policy The case of Fixed Exchange Rates

Macroeconomic Objectives Efficient allocation of resources Economic growth “Acceptable” income distribution In more limited (short-run) sense: Internal Balance Full employment Stable prices External Balance BOP=0 (?)

Internal and External Imbalance Unemployment Inflation BOP surplus BOP deficit

Goals and Policy Tools Fiscal policy Monetary Policy FX policy Are all policy instruments always available to policy makers? Do all policy tools always work? Secondary effects? A General rule: To achieve n targets we need at least n policy tools; we need at least one instrument for each policy objective.

Two Polar Cases Fixed X rates with perfectly immobile capital : A vertical POB curve Fixed X rates with perfectly mobile capital: A horizontal BOP curve BOP BOP>0 BOP<0 o Q BOP>0 BOP BOP<0 Q o

Fixed X rates with perfectly immobile capital : A vertical POB curve BOP BOP BOP i i i LM BOP>0 BOP<0 LM LM IS IS IS Q Q o o o Qe Qo Qo Qe Qe Q

Automatic Adjustments Under Fixed X Rates The case of a BOP deficit: To keep the domestic currency from depreciating the central bank would sell FX. That would reduce the banks’ reserves and thus the money stock. The LM curve would shift to the left until the External balance is restored. i LM’ LM IS Q o Qe

Automatic Adjustments Under Fixed X Rates The case of a BOP surplus: To keep the domestic currency from appreciating the central bank would buy FX. That would increase the banks’ reserves and thus the money stock. The LM curve would shift to the right until the External balance is restored. i LM LM’ IS Q o Qe

Achieving Internal Balance under a Fixed XR Regime with Immobile Capital External balance (BOP equilibrium) is automatically achieved but internal balance (full employment) does not necessarily coincide with external balance Policy instruments: Fiscal policy Monetary policy FX policy

Fiscal Policy Fixed X Rates, Immobile Capital LM’ i BOP i’ LM i IS’ IS Q Qeb Qib

Fiscal policy: Ineffective An increase in G spending IS will shift to the right BOP deficit To keep FX rate fixed the central bank would sell FX Reduction in commercial banks’ reserves Reduction in the money stock LM will shift to the left until the BOP is restored A return to the original Q, but higher interest rates

Monetary Policy Fixed X rates and Immobile Capital BOP LM’ LM IS Q o Qeb Qib

Monetary police: Ineffective An expansion of money supply through a purchase of government bonds  An increase in banks’ reserves  Expansion of credit  An increase in money stock (supply)  LM will shift to the right  A BOP deficit will result  To keep the FX rate fixed the central bank would have to sell FX  A reduction in bank’s reserves  Money stock will decrease  LM will shift back to the left to the original position

Sterilization: Ineffective Can the central bank buy more g. bonds to off set the effect of the sale of FX? Every time the LM curve is shifted to the right a BOP deficit will result, forcing it to sell an equivalent amount of FX, thus, rendering the sterilization policy ineffective: - ΔFXR = Δ GB

FX Policy Fixed X Rates, Immobile Capital BOP BOP LM LM’ E IS’ IS Q o Qeb Qib=Q’eb

FX Policy: The Case of Unemployment Devaluation of the home currency: An increase in the X rate, e A higher level of Q would be needed for BOP to be in equilibrium: The BOP line will shift to the right: A BOP Surplus R will go down  Exports will increase, imports will decline  IS will shift to the right The BOP surplus  Purchase of FX Increase in banks’ reserves  Money stock will increase  LM curve will shit to the right Internal balance is restored at a higher level of Q

Macroeconomic Policy Under a Fixed X Rate Regime with Mobile Capital Under perfect capital mobility the capital account becomes the dominant adjustment mechanism. The BOP line will become horizontal: Because of the fixed X rate, e, ef, and ee do not change and i=i* In the event of a BOP imbalance (deficit or surplus), say, as a result of an increase in Q that would make imports go up, a capital account surplus would be needed to bring the BOP back in equilibrium. i BOP Q o

Fixed X Rates and Perfect Capital Mobility An increase in Q (resulting form a shift of the IS curve) would result in inflow of funds and a KAB surplus to off set the CAB deficit: A shift of LM to the right LM LM’ i i=i* , BOP IS’ IS Q o

Fixed X Rates and Perfect Capital Mobility: Fiscal Policy LM LM’ IS IS’ BOP Q o

Fixed X Rates and Perfect Capital Mobility: Monetary Policy Purchase of bonds by the central bank An increase in the money stock The LM curve would shift to the right A fall of domestic interest rate An increase in Q CAB deficit and outflow of funds To keep the FX rate fixed the central bank would have to sell FX Reduction in banks reserve and money stock The LM curve would shift back to the left rendering monetary policy ineffective

Sterilization and the Risk Factor Recall that the idea behind sterilization is to off set the effect of FX sales by buying bonds. But this would push the BOP into deficit requiring selling FX again. What if under perfect capital mobility i = i* + [(ee –e)/e] + σ ; σ = risk premium Or, i - i* = [(ee –e)/e] + σ Purchase of government bonds would reduced the perceived risk of domestic bonds. A reduction in the risk associated with domestic bonds at any given interest rate would make investors less willing to hold FX-denominated assets.

Fixed X Rates and Perfect Capital Mobility: XR Policy (?) LM LM’ BOP (e’e) i’ BOP(ee) i IS’ IS Q o Qib

Fixed X Rates with Imperfectly Mobile Capital BOP BOP>0 BOP<0 Q o

Fixed X Rates with Imperfectly Mobile Capital: Relative Slopes of LM and BOP Curves Q o

Fixed X Rates with Imperfectly Mobile Capital: Fiscal Policy (I) LM i LM’ BOP>0 BOP i’ IS’ i IS BOP<0 Q o Qeb Qib

Fixed X Rates with Imperfectly Mobile Capital: Fiscal Policy (II) BOP>0 BOP LM’ LM IS’ IS BOP<0 Q o Qeb Qib

Fixed X Rates with Imperfectly Mobile Capital: Monetary Policy (I) LM LM’ i BOP>0 BOP IS BOP<0 Q o Qeb

Fixed X Rates with Imperfectly Mobile Capital: Monetary Policy (II) BOP>0 BOP LM’ LM BOP<0 IS Q o Qeb

Fixed X Rates with Imperfectly Mobile Capital: FX Rate Policy: Devaluation LM LM’ (3) i BOP BOP>0 (1) (2) IS’ IS BOP<0 Q o

Monetary Policy by a Reserve-Currency Country Under a fixed exchange rare regime each country pegs its currency to a reserve currency. The reserve-currency country would never have to worry about its exchange rates; through (automatic) interventions (and adjustments) by other countries its exchange rates against other currencies are fixed and its BOP is zero. Under a fixed X rate regime a reserve-currency country could conduct monetary policy. Monetary policy by a reserve-currency country could affect other countries.

Monetary Policy by a Reserve-Currency Country Suppose the US as a reserve country (under the Bretton Woods system) would conduct expansionary monetary policy; the Fed purchases government bonds.  Money stock in the US will increase Shift of the US LM curve to the right Lower US interest rates (i*) and increased Q* Lower i* will cause nonreserve country’s BOP line shift down, creating a surplus for it The surplus in the nonreserve country would result in automatic adjustment, shifting its LM curve to the right until the BOP is restored: Higher Q and lower i