Module 44 Exchange Rates and Macroeconomic Policy

Module 44 Essential Questions What is the meaning and purpose of devaluation and revaluation of a currency under a fixed exchange rate regime? Why do open-economy considerations affect macroeconomic policy under floating exchange rates?

Exchange Rates and Macroeconomic Policy Why did Britain not adopt the euro? Independence from the rest of Europe National identity The rest of Europe is nuts (positive or normative?) What trade-offs were faced? Increased trade vs managing their own monetary policy What was the opportunity cost of this decision? Britain gave up the ability to become more integrated with the European economy

Devaluation & Revaluation of Fixed Exchange Rates Adjusting a fixed exchange rate: China & USA for Example Devaluation (depreciation) But WHY? Revaluation (appreciation) But WHY? ? Eliminating shortages and surpluses Tool of macroeconomic policy

Devaluation & Revaluation of Fixed Exchange Rates Adjusting a fixed exchange rate: China & USA for Example Devaluation (depreciation) But WHY? Devaluation would make American goods more expensive to consumers in China thus reducing imports from America. China would also experience an increase in net exports to America; aggregate demand would shift to the right, boosting their GDP. Bang! 3. Revaluation (appreciation) But WHY? ? Goods produced in China become more expensive for American consumers but less expensive to consumers in China for American products thus increasing imports from America. China would experience a decrease in net exports to America; aggregate demand would shift to the left, reducing inflation, and GDP. 4. Eliminating shortages and surpluses in FOREX 5. Tool of macroeconomic policy - reduce inflation & recession

Monetary Policy Under a Floating Exchange Rate Regime Ability to pursue independent monetary policy (no interference from other countries) http://en.wikipedia.org/wiki/File:Curre ncy_Exchange_regimes.png Monetary policy results in changes in exchange rates and leads to other macroeconomic effects (Increases/decreases in Agg. Demand) Changes in interest rates have a direct effect in the exchange rates and influence net exports (draw this graph)

Why china does what they do The main use of Monetary policy is to stabilize the economy. It can also have an impact on the foreign exchange market.   Suppose the market for the Yuan is competitive and the exchange rate with the dollar is floating. What would happen if the central bank of China increased the money supply? Interest rates would f________. Domestic investment would i_____________. Aggregate demand would i________________. Foreign investors would seek o_____________ m______________to invest in financial assets The demand for the Yuan would d_____________. Chinese citizens would seek nations with h______________ returns on financial investments so the supply of Yuan would i_____________. With both an i______________supply and d_____________demand, the value of the Yuan will d_______________against the dollar. A depreciated currency will make products made in China l________ expensive to American consumers, thus there would be an i___________ in net exports and another increase in aggregate demand.

Why china does what they do The main use of Monetary policy is to stabilize the economy. It can also have an impact on the foreign exchange market.   Suppose the market for the Yuan is competitive and the exchange rate with the dollar is floating. What would happen if the central bank of China increased the money supply? Interest rates would fall Domestic investment would increase Aggregate demand would increase. Foreign investors would seek other nations to invest in financial assets The demand for the Yuan would decrease. Chinese citizens would seek nations with higher returns on financial investments so the supply of Yuan would increase. With both an increased supply and decreased demand, the value of the Yuan will depreciate against the dollar. A depreciated currency will make products made in China less expensive to American consumers, thus there would be an increase in net exports and another increase in aggregate demand.

International Business Cycle Shocks from abroad: a recession in Canada will cause a decrease in real GDP in the USA. WHY? Synchronized business cycles: Any wonder why the Great Recession was so far reaching? This chain of events is also affected by the exchange rate regime in the U.S. Floating exchange rates should lessen the impact of foreign shocks. HOW? A recession hits the Canadian economy. Canadians d____________ demand for goods made in America. This amounts to a d_____________in the demand for the U.S. dollar, and the U.S. dollar d___________. A depreciating U.S. dollar means that goods made in America become more a____________ to Canadian consumers. Thus the depreciating U.S. dollar puts the brakes on the d_______________exports to Canada and the negative impact on the U.S. economy is l_____________. So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations.

International Business Cycle Shocks from abroad: a recession in Canada will cause a decrease in real GDP in the USA. WHY? Canadians buy many goods made in America, so a recession in Canada means American firms will ship fewer products to Canadian customers. Exports will fall and aggregate demand will fall with it.  Synchronized business cycles: Any wonder why the Great Recession was so far reaching? This chain of events is also affected by the exchange rate regime in the U.S. Floating exchange rates should lessen the impact of foreign shocks… A recession hits the Canadian economy. Canadians decrease demand for goods made in America. This amounts to a decrease in the demand for the U.S. dollar, and the U.S. dollar depreciates. A depreciating U.S. dollar means that goods made in America become more affordable to Canadian consumers. Thus the depreciating U.S. dollar puts the brakes on the diminished exports to Canada and the negative impact on the U.S. economy is lessened. So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations.

Review Module Questions p. Read Module 45 p.

Module 45 Putting it All Together

What you will learn in this Module: How to use macroeconomic models to conduct policy analysis How to approach free-response macroeconomics questions

A Structure for Macroeconomic Analysis A starting point A pivotal event Initial effects of the event Secondary and long-run effects of the event Assume that the United States economy is in a long-run equilibrium. (a) Draw a correctly labeled long run graph of aggregate demand and aggregate supply and show each of the following for the United States. (i) The current equilibrium output level, labeled Ye, and the current equilibrium price level, labeled PLe.   (b) Suppose that consumer confidence in the United States experiences a significant downturn. In the graph drawn in part (a), show the impact of weakened consumer confidence. In the graph, show any changes to the equilibrium price level and the equilibrium output level. (c) Assume that the central bank of the United States is prepared to take action to reverse the economic impacts shown in part (b). (i) Should the central bank buy or sell bonds in an open market operation? (ii) How does the central bank’s action in part (c)(i) affect the nominal interest rate? Explain. (d) The United States and Mexico are major trading partners. How would the weak consumer confidence in the United States affect the balance of payments current account with Mexico? Explain. (e) Consider the foreign exchange market for the United States dollar. Based only upon your response to part (d), how are each of the following affected? (i) The supply of the United States dollar relative to the Mexican peso. (ii) The value of the dollar relative to the peso.

The Starting Point AD/AS Model Long-run macroeconomic equilibrium A recessionary gap An inflationary gap (a) Every question such as this gives the student a starting point. The student must demonstrate that he/she can understand, and usually graph, the situation that is given. In this case, the economy is in long-run equilibrium. If necessary, the instructor should review the implications of long-run equilibrium in the AD/AS model. The student must be aware that, given this starting point, there is neither an inflationary or a recessionary gap. Equilibrium output is current at full-employment output.   1 point: A correctly labeled graph with the AD, SRAS, and LRAS curves all intersecting. 1 point: The equilibrium output level is shown at LRAS. 1 point: The equilibrium price level is shown at the intersection of AD and SRAS.

The Pivotal Event Recession Inflation Expectations change Wealth change Supply shocks (b) In this part of the problem, consumer confidence has significantly fallen. Students should know the factors that shift AD, SRAS, and LRAS and that weaker consumer confidence causes a decrease in AD. This is a great opportunity for the instructor to review all of these “shifters” in the AD/AS model. 1 point: The graph shows a leftward shift of the AD curve. 1 point: The graph indicates a decrease in both the price level and real GDP.  

The Initial Effect of the Event The effects of a curve shifting

Secondary and Long-Run Effects of the Event Secondary Effects Changes in the price level or real interest rate result in changes in some or all of the following: International Capital Flows Net Exports Investment

Secondary and Long-Run Effects of the Event Government budget "Crowding Out" Capital formation Economic growth (c) The central bank, given the weakened demand shown in part (b), should be pursuing expansionary monetary policy. The instructor should take this time to review the tools of the Fed. In the case of this question, the student is asked to focus on open market operations. To expand the money supply, the central bank should buy bonds. (i) 1 point: Buy bonds   The student who understands monetary policy in the face of a recessionary gap also knows why buying bonds is the correct policy prescription. (ii) 1 point: The nominal interest rate decreases. 1 point: Buying bonds shifts the money supply curve to the right. In the money market, this causes the interest rate to fall. (d) This part of the problem tests the student’s understanding of the balance of payments accounts and how international business cycles begin to affect the international flow of goods and money. 1 point: The current account balance in the U.S. will begin to rise.