Chapter 25: Economic Policy in the Open Economy

Fixed exchange rates

Opening blurb

• The hot currency topic today, as it has been for several years, is the renminbi (aka yuan)

• there has been great debate concerning whether the yuan is undervalued, how much and what is the best policy to deal with it.

• There is also great debate about whether a floating yuan would be better for the world, or whether it would destabilize world markets.

• Is there one answer to these questions? No. But,

Opening blurb

• Is there one answer to what is the right policy at this point in time? No.

• But, in this chapter and the next, we will learn about how countries can effectuate monetary and fiscal policy under fixed and floating exchange rates.

• This will provide a conceptual framework for thinking about these issues.

Targets = instruments

• In most cases, if policy-makers wish to achieve two targets, they need two instruments to do so.

• In the last chapter, we mentioned the use of expansionary and contractionary policy to achieve internal and external balance.

• We noted that if the imbalances required contrary policy direction then we might not be able to easily achieve both targets (balances)

Robert Mundell (nobel 1999)

• The most influential contributor to modelling policy in the open economy is Robert Mundell.

• born in Kingston, Ontario, Mundell argued that under the Bretton-Woods system, the Federal Reserve maintained stability, not the existence of a fixed currency

• analyzed policy in a small, open economy• he also argued that progressive taxes could not

be maintained under flexible exchange rates.• father of supply-side economics and the monetary

approach to the Balance of Payments

Mundell-Fleming Model

• Robert Mundell developed a model where monetary and fiscal policy could be combined to reach both an internal and external balance.

• The trick is to aim one policy at one target and another at a second.

• Note: Mundell defined External balance as ‘overall balance’, the model is not designed to achieve current account balance.

Mundell-Fleming Model

• In this model, both monetary and fiscal policy affect both the internal and external balances

• interest rates affect the external balance much more than the internal balance.– Therefore, monetary policy should be directed

at the external balance

• Fiscal policy also affects the internal balance more than the external balance– therefore fiscal policy should be aimed at the

internal balance

Mundell-Fleming Model

• In the diagrammatic presentation of the model, interest rates summarize monetary policy.

• The relationship between interest rates and fiscal policy (G – T ) that will maintain a balance is positive

Mundell-Fleming Model

• Starting at internal balance:– If (G – T) rises, this causes excess demand,

therefore, a contractionary monetary policy (rise in interest rate) is needed to return to balance.

– therefore, the Internal Balance curve is upward sloping

• Starting at external balance– If (G – T) rises, this causes imports to rise,

and a deficit, therefore an increase in interest rates is needed to attract foreign funds

– therefore the External Balance curve is also upward sloping

Mundell-Fleming Model

• As noted above, the external market responds quickly and greatly to a change in interest rates– therefore a small increase in interest rates

would require a large increase in net government spending (G – T) to restore the external balance.

– Or, from another point of view, a high increase in (G – T) requires only a small upward adjustment in interest rates to restore external balance.

Mundell-Fleming Model

• In the next slide, we have the Mundell-Fleming diagram.

• The IB curve is steeper than the EB curve for reasons noted above.

• To the left (above) IB, fiscal policy and monetary policy are too restrictive for internal balance – to the right of IB, they are both too expansionary for internal Balance

• To the left (above) EB, fiscal and monetary policy are too restrictive for external balance.

Mundell-Fleming diagram

i

III

G - T

• c

i*

G - T

EB• a

IB

I

IV

II

• d

• b

Internal and external imbalances

• Once again, we have four cases for imbalances (they are numbered differently than in the last chapter)

I: (unacceptably) high unemployment; balance of payments surplus

II: rapid inflation; balance of payments surplus

III: rapid inflation; balance of payments deficit

IV: high unemployment; balance of payments deficit

Internal and external imbalances

• In this case, however, we also have clear policy prescriptions:

I: (unacceptably) high unemployment; balance of payments surplus

expansionary fiscal policy accompanied by expansionary monetary policy

II: unacceptably rapid inflation; balance of payments surpluscontractionary fiscal policy accompanied by expansionary monetary policy.

Internal and external imbalances

III: unacceptably rapid inflation; balance of payments deficit

contractionary fiscal policy; contractionary monetary policy

IV: unacceptably high unemployment; balance of payments deficit

expansionary fiscal policy; contractionary monetary policy

Building a macroeconomic model for the open economy

General equilibrium in the open economy:

The IS/LM/BP model

First, review the construction of IS/LM --- starting with LM curve

• Recall from Chapter 22• Equilibrium in the money market is defined

by • Money Supply:

Ms = a(DR+IR) = a(BR + C)• Money supply can be defined using

domestic reserves plus international reserves (both held by central bank)

• or bank reserves plus currency held by non-bank public

LM curve

• Recall from Chapter 22

• Money Demand:

Md = L = f(Y, i , P, W, E(p), O)

• Money demand depends on income (+), interest rate (-), price level (+), wealth (+), expected inflation (-) and other factors (?)

LM curve• We begin by drawing the money market, with the

interest rate as the price of money.• Assuming the money supply is set by the central

bank, Ms is vertical

• Demand for money is a decreasing function of the interest rate.

• All else equal, if the interest rate is too high, there is an excess supply of money (demand = A, supply = B)

• if the interest rate is too low, there is an excess demand for money (demand = A’, supply = B’)

Money supply and demand Building the LM curve

i

ie

Ms

L=f(i)

Money

i1

i2

A.

..

.

.

B’

B

A’

q

LM curve

• To construct an LM curve, however, we need to examine how the demand for money changes with income Y , as well as interest rates.

• Because income is not on the axes of this graph, a change in income will shift the relevant curve

• If income increases, demand for money rises. • The demand curve shifts up, or right.

Money supply and demand Building the LM curve

i

i0

Ms

L=f(Y0,i)

Money

i1

i2

.

.

.

L=f(Y2,i)

L=f(Y1,i)

LM curve

• Transferring this graph to i-Y space interest rate and income…

• we see that there is a positive relationship between the interest rate and the exchange rate.

• We also see that, the stronger the demand reaction to a change in income, the steeper the LM curve.

• In other words, if an increase in income leads to a big jump in the demand for money, then, given fixed supply, a big increase in the price of money (interest rate) is needed to return to equilibrium.

LM curve

• Finally,

– to the right of the LM curve, there is excess demand for money (income is too high for the prevailing interest rate)

– to the left of the LM curve, there is an excess supply of money (income is too low the for prevailing interest rate)

LM curve

i

i0

Ms

L=f(Y0,i)

Money

i1

i2L=f(Y2,i)

L=f(Y1,i)

Y

iLM

Y1

i1

i2

i0

Y0Y2

You do

• Start with an LM curve (just draw one)

• Now show a new curve for each of the following cases:

1. money supply increases

2. the response of liquidity demand for money based on income increases

Next class

• IS curve

• BP curve

• Putting it all together.

IS curve• this curve represents the

Injections = Leakages

– Recall, injections = leakages is simply a rearranging of the income = expenditure equations.

• but, the IS curve it is named for Investment = Savings

– because they are the major components, (and because we assume, even in the simplest model, that investment is affected by the interest rate)

IS curve• Review: Injections = leakages

I + X + G = S + M + T• Saving and imports depend on income, so

I + X + G = S(Y) + M(Y) + T

I+G+X

S+M+T

0

I+G+X

S+M+T

YY0

IS curve

• The IS curve is built by varying the rate of interest and examining the effect of this on the equilibrium income.

• As interest rates fall, investment increases, the I+G+X curve shifts up.– investment and interest rates move in opposite directions

from each other.

• As interest rates increase, investment falls. The I+G+X curve shifts down.

• The level of equilibrium income is higher when interest rates are lower.

IS curve• Assume i1 < i0 and i2 > i0• Result: Y1 > Y0 and Y2 < Y0

I+G+X

S+M+T

0

I(i0) +G+X

S+M+T

YY0

I(i2) +G+X

I(i1) +G+X

Y2 Y1

IS curve

• We can now move the injections = leakages curve to (Y, i ) space.

• This yields the traditional IS curve.

• Each rate of interest and income level along the IS curve represents an equilibrium in the real market.

• That is income = expenditure along the IS curve.

IS curve• Assume i1 < i0 and i2 > i0

I+G+X

S+M+T

0

I(i0) +G+X

S+M+T

YY0

I(i2) +G+X

I(i1) +G+X

Y2 Y1

Y

i0

Y1Y0Y2

i1

i2

IS

i

IS curve

• Notice how the shape of the IS curve is affected by the slope of S(Y) +T+M(Y)– if savings and/ or imports are more responsive to

income, the IS curve is steeper.

• Notice also how the shape of the IS curve depends on the size of the shift in I+G+X when interest rate changes.– if Investment is very responsive to a change in

the interest rate, IS is flatter.

IS curve

• To the right of the IS curve, the interest rate is too high for the level of income

• Therefore, S(Y)+T+M(Y) > I(i) +G+X– The level of income is generating too much

savings for the injections into the economy. The interest rate will fall because of the excess savings and return the economy to equilibrium.

– If the interest rate does not rise, then income will fall as the leakages lower income to equilibrium

IS curve

• From the other perspective: to the right of the IS curve, the income level is too high for the level of interest

• Therefore, S(Y)+T+M(Y) > I(i)+G+X– The level of income is generating too much

savings for the injections into the economy. The interest rate will fall because of the excess savings and return the economy to equilibrium.

– If the interest rate does not fall, then income will fall as the leakages lower income to equilibrium

– Or both these will cause a return to equilibrium

IS Curve: You do

• Draw an IS curve, label it IS0

• Draw a second IS curve, assuming autonomous savings are higher than the level in the first IS curve. label it IS1

• Draw a third IS curve, assuming that the marginal propensity to import is higher than it is in your first IS curve. label it IS2

• Draw an IS curve,assuming that investment is less responsive to a change in interest rates than the case in IS0 , label it IS3

IS-LM : Closed economy equilibrium

• The equilibrium in the IS-LM diagram represents the simultaneous determination of income and interest rate when the monetary sector and real sector of the economy are in equilibrium.

• If the economy is not in equilibrium, market forces push it toward equilibrium.

IS-LM : Closed economy equilibrium

• At point A, the interest rate is too high for both markets.• Lower investment pushes i down while reducing Y• The demand for money is too low for monetary

equilibrium, the excess supply of money also lowers interest rates.

IS

ie

Y

iLM

G

A

Ye

Equilibrium in the Balance of Payments: the BP curve

• The BP curve represents the combinations of income and interest rates that yield equilibrium in the Balance of Payments.

• By equilibrium, we mean both current account plus capital account (or overall balance)

• For this chapter, the BP curve is drawn for a fixed exchange rate

BP curve

• The shape of the BP curve will depend on how the balance of payments are affected by income and interest rates.

• Income affects imports: – as income increases, so do imports.– as imports increase, the Balance of Payments

deteriorates– to offset the effect of imports, an increase in

the interest rate is needed. It will cause capital flows to enter the country, and return the country to BoP equilibrium

BP curve• The shape of the BP curve will depend on

how the balance of payments are affected by income and interest rates.

• We can see from the above, that the responsiveness of capital flows will affect the slope of the BP curve.

• If capital is perfectly mobile, – a small increase in the interest rate causes an

infinite increase in capital inflows,– the BP curve is horizontal

BP curve• If capital is perfectly immobile,

– no capital is allowed to flow into or out of the country.

– then an increase in the interest rate will have no effect on capital flows and the BoP,

– the BP curve is vertical

• In between these two extremes, capital is imperfectly mobile– an increase in the interest rate causes an

inflow of capital– the BP curve is upward sloping.

BP curve

iii

Y0

BP

Y Y0 0

BP

BP

perfectly mobile capitalimperfectly mobile capital perfectly immobile capital

Putting it all together: Fixed Exchange rates

• Equilibrium in the open economy occurs when all three markets are in equilibrium.

• We need:– money market equilibrium– real economy equilibrium (income =

expenditure)– balance of payments equilibrium

Putting it all together: Fixed Exchange rates

• To analyze movement to equilibrium, we will examine how the markets react to a ‘shock’ – A shock is an exogenous change in some

variable in the economy– it is usually represented by a shift in the curves– it may sometimes represent a change in slope

• We will then examine the effects of– fiscal policy– monetary policy

First shock

• There is an increase in exogenous exports.

• Effects:– there is more foreign exchange flowing into the

country.– At the old equilibrium, there is a BoP surplus.

• The BoP curve shifts right.– each interest rate can support a higher income

(and import) level. for BoP equilibrium

First shock: Increase in exports

• Effects:• The BoP curve shifts right.

– each interest rate can support a higher income (and import) level. for BoP equilibrium

• The IS curve shifts right– Injections have increased, therefore at every

interest rate, a higher level of income (and leakages) can occur for real economy equilibrium.

• NOTE: these two shifts are directly caused by the increase in exports.

First shock: Increase in exports

• Effects:• The BoP curve shifts right.• The IS curve shifts right

• The LM curve will also shift right– Under fixed exchange rates, the BoP surplus

causes an increase in the money supply. – the money supply will only be in balance when

the BoP is in balance.

• The LM curve shifts to accommodate the BoP imbalance.

Important to remember

• Under fixed exchange rates

• The IS curve and / or the BP curve may shift due to an initial shock or policy change

• The LM curve ALWAYS shifts to return the economy to equilibrium at the new intersection of the IS and BP curve.

• This is because an imbalance in the balance of payments affect the Money Supply

You do: Autonomous increase in Savings.

• Effects:

• IS curve shifts …. Why?

• BP curve shifts… Why?

• LM curve shifts …Why?

Fiscal policy

• The government increases spending

• This shock is analogous to the increase in exports for the IS curve,

• But it causes no independent shift in the BP curve.

• So, what happens?

Fiscal policy

• need slide here.

Fiscal policy• Fiscal policy is the use of spending and taxes to

affect the economy.Example:• The government increases spending, hoping to

increase income.• This affects the real internal economy directly.• Therefore, the only curve to shift as a direct

result of the policy is the IS curve.• The BP curve does not shift.• The LM curve will shift to adjust the economy

back to equilibrium (under fixed exchange rates)

Fiscal policy• Whether or not fiscal policy affects the

level of income in the economy depends on the degree of capital mobility.

• The effect on the interest rate will also depend on the degree of capital mobility

Fiscal policy• We can consider 4 cases:

1. capital is completely immobile internationally (BP curve vertical)

2. capital is very immobile internationally (BP curve is steeper than LM curve)

3. capital is fairly mobile internationally (such that international capital reacts more to a change in exchange rates than internal money demand) (BP curve is flatter than LM curve)

4. capital is perfectly mobile (BP curve is flat)

Fiscal policy• Cases 1. and 2.• In cases where capital is immobile, either

completely or partly,– the increase in spending causes imports to rise

(recall: M = M(Y) )– this causes a BoP deficit– which results in a decrease in the money supply.

• The LM curve shifts left, and the interest rate rises further.

• This chokes off some or all of the increase in income that would result from fiscal expansion.

Fiscal policy• Cases 3. and 4.• In cases where capital is mobile, completely or

partly,– the increase in spending causes imports to rise

(recall: M = M(Y) )– this causes an increase in the interest rate– which causes an inflow of capital– which leads to a balance of payments surplus– which results in an increase in the money supply.

• The LM curve shifts right and the interest rate falls.

• This increases income more than the closed economy case.

Fiscal policy: graphical analysis

IS

IS’

IS’IS

IS’

IS

IS’

IS

BP

LM’

LM’ LMLM

LM’

LMLM’

LM

i

BP

BP

BP

Y

ii

i

Y

Y

Y

Fiscal policy

• In the case of fixed exchange rates• fiscal policy is most effective at increasing

income when capital is perfectly mobile.– in this case there is no effect on interest rates– the BoP deficit caused by imports is

completely offset by capital flows

• fiscal policy is least effective at increasing income when capital is perfectly immobile– the BoP deficit caused by imports causes a

decrease in money supply, completely choking off any income effect.

Fiscal policy

• You do:

• The government increases autonomous taxes

• What is the effect if capital is relatively immobile (inelastic compared to money demand)?

• What is the effect if capital is perfectly mobile?

Monetary policy under fixed exchange rates

• Given the analysis of shocks and fiscal policy, we can predict the effectiveness of monetary policy under fixed exchange rates

• NONE.• The money supply is determined by the Balance

of Payments.– if there is a surplus, money supply increases– if there is a deficit, money supply falls

• Money supply change will change neither the interest rate nor income.

Monetary policy: graphical analysis

IS

ISIS

IS

BP

LM’

LM’ LMLM

LM’LM

LM’

LM

i

BP

BP

BP

Y

ii

i

Y

Y

Y

Effect of a change in the official exchange rate

• A change in the official exchange rate will have a real effect in all four cases.

• Example: devaluation– imports decrease– exports increase– there is a BoP surplus, BoP curve shifts right– there is also an increase in injections into the

economy and a decrease in leakages, IS curve shifts right

– LM curve shifts to accomodate

Effect of a change in the official exchange rate

• Case 1 and 2 completely immobile or relatively immobile capital:– IS and BP curves shift right– there is a BoP surplus– there are little or no capital inflows, and so the

surplus causes an increase in money supply– the LM curve shifts right

Effect of a change in the official exchange rate

• Case 3 and 4 mobile or completely mobile capital:– IS and BP curves shift right– there is a BoP surplus– at the point of internal equilibrium (new IS, old

LM curve) the interest rate is also too high for external balance.

– both capital flows and expenditure switching contribute to the surplus, causing an increase in money supply

– the LM curve shifts right

Devaluation: graphical analysis

IS

IS’

IS’IS

IS’

IS

IS’

IS

BP

LM’

LM’ LMLM

LM

LM’LM

LM’

i

BP

BP

BP

Y

ii

i

Y

Y

Y

BP’

BP’BP’

Y0 Y2

Y0Y0

Y0

i2

Y2 Y2

Y2

You do:

• Revaluation of currency: (increase in value)– if capital is completely immobile– if capital is very, but not completely mobile.

In sum

• We first learned that, with a foreign sector, internal equilibrium is not a guarantee of external equilibrium

• We then introduced a model where the three markets were in equilibrium.

• In this model, monetary policy is completely ineffective within the country– that is, the external sector balance is

maintained by adjustments to the money supply caused by inflows and outflows of reserves

In sum

• On the other hand, fiscal policy has varying levels of effectiveness depending on the mobility of capital– the higher the mobility of capital, the more effective is

fiscal policy

• Shocks to the real economy or the external economy cause changes in income, the money market adjusts to those shocks

• Shocks to the money market are offset by the reactions of the external markets. The LM curve always adjusts to accomodat the IS-BP equilibrium under fixed exchange rates.