Chapter 11 Economic Policy with Fixed Exchange Rates INTERNATIONAL MONETARY AND FINANCIAL ECONOMICS Chapter 11 Economic Policy with Fixed Exchange Rates Third Edition Joseph P. Daniels David D. VanHoose Copyright © South-Western, a division of Thomson Learning. All rights reserved.

The Objectives of Policy Internal Balance Objectives Real Income Goals Employment Goals Inflation Goals External Balance Objectives Trade Balance Other Balance-of-Payments components balance

Annual Growth of Per Capital Real GDP 70-79 80-89 90-04 Canada 3.4 2.1 1.3 France 1.8 1.4 Germany 2.9 1.9 1.2 Italy 2.7 2.3 1.5 Japan 4.0 3.6 UK 2.2 2.5 1.7 US

Unemployment Rates in Seven Nations 2000 2002 2004 Australia 6.6 6.3 5.7 Canada 6.8 7.6 6.9 France 9.7 8.8 9.1 Germany 7.8 8.2 Hong Kong 5.0 7.3 Italy 10.6 9.0 Japan 4.7 5.4

The Costs of Inflation and Inflation Variability

Capital Mobility and the Slope of the BP Schedule The left-hand panel illustrates that the BP schedule is relatively steep when there is low capital mobility, whereas the right-hand panel illustrates that the BP schedule is relatively shallow with higher capital mobility. With low capital mobility, a relatively large increase in the nominal interest rate is needed to induce foreign residents to overcome barriers to capital inflows sufficient to achieve a new balance-of-payments equilibrium at point B.

The BP Schedule with Perfect Capital Mobility With perfect capital mobility, it follows from the uncovered interest parity condition that the domestic interest rate, R, is equal to the foreign interest rate R*. This implies that the domestic BP schedule is horizontal under perfect capital mobility.

The Effects of Expansionary Monetary Policy An increase in the nominal quantity of money in circulation causes, with fixed prices, an increase in the supply of real money balances. The equilibrium interest rate declines from R1 to R3, which results in a rightward shift of the LM schedule. As real income rises from y1 to y2, however, the demand for real money balances increases, causing the real interest rate to rise to R2. On net, the rise in the nominal money stock causes a reduction in the equilibrium nominal interest rate and an increase in equilibrium real income.

The Initial Effects of Monetary Policy with a Fixed Exchange Rate In the left-hand panel, a decline in the interest rate that results from a movement from point A to point B generates little capital outflow but the rise in real income stimulates greater import spending and a balance-of-payment deficit results at point B. With high capital mobility the decline in the interest rate spurs a significant capital outflow, resulting in a balance-of-payments deficit at point B. Hence, the difference is whether the deficit is generated by import spending or capital outflows.

The Effects of a Monetary Policy Expansion with Nonsterilized Interventions. Whether the balance-of-payments deficit stems from import spending or capital outflows, it implies an increased demand for foreign currencies which tends to depress the value of the nation’s currency in foreign exchange markets. To keep the exchange rate from changing, the nation’s central bank must sell foreign exchange reserves. If this action is not sterilized, the intervention causes a reduction in the quantity of money in circulation and an ultimate movement back to point A, regardless of the degree of capital mobility.

The Effects of Expansionary Fiscal Policy An increase in government spending shifts the IS schedule rightward shown by the move from point A to point C. The increase in real income induces an increase in the demand for real money balances thereby increasing the equilibrium nominal interest rate. The higher interest rate reduces desired investment expenditures shown by the movement from point C to point B. Hence, the rise in government expenditures crowds out some of the desired investment expenditures.

The Initial Effects of Expansionary Fiscal Policy with a Fixed Exchange Rate In both panels, the resulting higher interest rate induces greater capital inflows while a higher level of real income spurs additional import expenditures. In the left-hand panel, which illustrates a situation of low capital mobility, higher real income stimulates relatively greater import spending as the higher interest rate generates little capital inflow, resulting in a balance-of-payments deficit. In the right-hand panel, the higher interest rate stimulates relatively greater capital inflows that more than offset higher imports, resulting in a balance-of-payments surplus.

The Effects of an Increase in Government Spending without Sterilization The left-hand figure illustrates a BOP deficit, implying an increase in demand for the foreign currency. To keep the value of the domestic currency unchanged, the domestic central bank must sell foreign exchange reserves, reducing the quantity of money in circulation and raising the interest rate − shown by a movement to point C − and partially offsetting the effect of the rise in government spending. In the right-hand figure, the BOP surplus implies a rise in the value of the nation’s currency. To maintain the exchange value of the domestic currency the central bank must purchase foreign exchange reserves which increases the quantity of money in circulation and reinforces the effect of the increase in government spending.

Monetary Policy with Perfect Capital Mobility and Fixed Exchange Rates An increase in the quantity of money results in a rightward shift of the LM schedule along the IS schedule from point A to point B. The resulting decline in the nominal interest rate induces capital outflows and a BOP deficit. To keep the domestic currency from depreciating, the central bank must sell foreign exchange reserves, causing the nation’s money stock to fall back to its original level. Hence, unsterilized monetary policy actions have no long-lived effects on equilibrium real income.

Fiscal Policy with Perfect Capital Mobility and Fixed Exchange Rates An increase in real 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 and a BOP surplus. To keep the domestic currency from appreciating, the central bank must purchase foreign exchange reserves, causing the nation’s money stock to rise and shifting the LM schedule rightward to a final equilibrium at point C.

A Two-Country Framework with Perfect Capital Mobility and a Fixed Exchange Rate This figure shows how equilibrium real income levels and nominal interest rates arise in two nations whose borders are fully open to flows of financial resources. In the absence of any domestic currency depreciation, uncovered interest parity implies that the equilibrium domestic interest rate, R1, must equal the equilibrium foreign interest rate, R*1.

The Effects of a Foreign Monetary Expansion An increase in the foreign money stock shifts the foreign LM schedule to the right, causing a decline in the foreign interest rate and inducing a flow of financial resources from the foreign country to the domestic country. To keep its currency from appreciating, the domestic central bank must purchase foreign exchange reserves, resulting in a rightward shift of the LM schedule and reducing the domestic interest rate. Eventually interest rates in both nations fall to the same level, pushing the balance of payments back into equilibrium. Real income rises in both nations, so there is a locomotive effect associated with the foreign monetary expansion.

The Effects of a Foreign Fiscal Expansion An increase in foreign government spending shifts the foreign IS curve rightward, causing an increase in the foreign interest rate and inducing a flow of financial resources from the domestic nation to the foreign nation. To keep the domestic currency from depreciating, the domestic central bank must sell foreign exchange reserves. If the interventions are unsterilized, they cause the domestic money stock to decline and the LM schedule to shift leftward. If the rise in domestic exports caused by the rise in foreign real income is insufficient to offset the decline in domestic investment caused by the higher domestic interest rate, then domestic real income falls. this is an example of a beggar-thy-neighbor effect.

The Effects of a Domestic Monetary Expansion An increase in the domestic money stock causes the LM schedule to shift rightward, which pushes down the domestic interest rate and induces a flow of financial resources from the domestic nation to the foreign nation. To keep the domestic currency from depreciating, the domestic central bank must sell foreign exchange reserves. If the interventions are unsterilized, they cause the domestic money stock to decline and the LM schedule to eventually shift leftward to its original position. This implies that the domestic central bank’s policy of a fixed exchange rate insulates the foreign economy from the effects of domestic policy actions.

The Effects of a Domestic Fiscal Expansion An increase in domestic government spending shifts the domestic IS curve rightward, causing an increase in the domestic interest rate and inducing a flow of financial resources from the foreign nation to the domestic nation. The increase in foreign exports due to the rise in domestic real income causes the foreign IS curve to shift rightward. the rise in foreign real income cause an additional rightward shift of the domestic IS curve. To keep the domestic currency from appreciating, the domestic central bank must purchase foreign exchange reserves. If the interventions are unsterilized, they cause the domestic money stock to increase and the LM schedule to shift rightward.