1. Short-Run Macroeconomic Policy
The case of Fixed Exchange Rates

2. 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 (?)

3. Internal and External Imbalance
Unemployment
Inflation
BOP surplus
BOP deficit

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

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

11. 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

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

13. 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

14. 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

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

16. 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

17. 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

18. 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

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

20. 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

21. 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.

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

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

24. Fixed X Rates with Imperfectly Mobile Capital: Relative Slopes of LM and BOP CurvesQ o

25. 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

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

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

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

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

30. 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.

31. 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