www.themegallery.com chapter 7 economic policy in the open economy under fixed exchange rates

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Chapter 7

Economic Policy in the Open Economy Under Fixed Exchange Rates

Learning Objectives Explain general equilibrium in the

macroeconomy using the IS/LM/BP model. Describe the impact of changes in fiscal policy

on income, trade, and interest rates under fixed exchange rates.

Describe the impact of changes in monetary policy on income, trade, and interest rates under fixed exchange rates.

Perceive how varying degrees of capital mobility alter the effectiveness of fiscal and monetary policy under fixed exchange rates.

Targets, Instruments, and Policy: A Model

“External balance” Any decrease in the interest rate (e.g.,

because of expansionary monetary policy) will cause a decrease in short-term capital inflows or an increase in short-term capital outflows and a BOP deficit.

Expansionary fiscal policy (by increasing Y and M) also leads to a BOP deficit.

“Internal balance” Expansionary monetary policy lowers

interest rates and increases I; this will be inflationary unless fiscal policy offsets it.

As we discussed in Chapter 24, there are four situations when there are internal and external imbalances:

Case I: BOP deficit; unacceptably rapid inflation

Case II: BOP surplus; unacceptably high unemployment

Case III: BOP deficit; unacceptably high unemployment

Case IV: BOP surplus; unacceptably rapid inflation

The Mundell-Fleming Diagram

G-T

i

EB

IB

IIIV

I

III

To achieve internal and external balance, fiscal and monetary policy must both be used.

General Equilibrium in the Open Economy: the IS/LM/BP

Model To understand the effects of policies

on the open economy, we need to use a general equilibrium model.

The IS/LM/BP model is built around three sorts of equilibria:1.money market equilibrium (the LM curve),2.real sector equilibrium (the IS curve), and3.BOP equilibrium (the BP curve).

Money Market Equilibrium: the LM Curve

The LM curve comprises all combinations of the interest rate (i) and income (Y) such that money supply and money demand are equal.


Money supply is assumed to equal money demand.

Money supply is fixed. Money demand depends inversely on

the interest rate (i) and positively on income (Y).• As interest rates rise, the opportunity cost

of holding money rises, and so the quantity demanded of money decreases.

• As income rises demand for money increases.


money

iMs

L = f(i,Y)

ie

i1

i2

At i1, Ms>Md: people will buy bonds, reducing i.At i2, Ms<Md: people will sellbonds, increasing i.


If income rises, money demand will exceed money supply, and interest rates will rise.

Therefore, the LM curve is the positive relationship between the interest rate and income (Y).

Points to the left of the LM curve mean there is an excess supply of money; points to the right imply an excess demand.


income

iLM


Increases in Ms or decreases in Md will shift LM to the right.Decreases in Ms or increases in Md will shift LM to the left.

Real Sector Equilibrium: the IS Curve

The IS curve comprises all combinations of the interest rate (i) and income (Y) such that the real sector of the economy is in equilibrium.


Investment should depend inversely on the interest rate (i).•As interest rates rise, the cost of

borrowing rises, so I falls. As before, consumption (C)

depends positively on income (Y). Also, exports (X) and government

spending (G) are fixed.


The IS curve is the relationship between the interest rate and Y.•As the interest rate falls, investment

increases, thereby increasing Y.•As the interest rate rises, investment

decreases, thereby decreasing Y. Therefore, the IS curve is

downward- sloping.


income

i

IS

Decreases in

autonomous I,

X, G or

increases in T

will shift IS to

the left.

Real Sector Equilibrium: the IS

Curve

Increases in

autonomous I,

X, G or

decreases in T

will shift IS to

the right.

BOP Equilibrium: the BP Curve

The BP curve comprises all combinations of the interest rate (i) and income (Y) such that the balance of payments is in equilibrium.


The BP curve is the relationship between the interest rate and Y.•If Y increases and i is unchanged, M

will increase and a BOP deficit will open.

•To return to BOP balance, i must rise. This would trigger net short-term capital inflows.

Therefore, the BP curve is upward- sloping.


income

i

BP


Points to the

left of the BP

curve imply a

BOP surplus.

Points to the

right of the BP

curve imply a

BOP deficit.

BOP Equilibrium: the Slope of the BP Curve

The slope of the BP curve depends on how responsive short-term private capital flows are to changes in the interest rate.

Points to the right of the BP curve represent BOP deficits, triggering an increase in i, which would cause in increase in capital inflows.

If capital inflows are very responsive, a small Δi will bring us back to BOP equilibrium (that is, a relatively flat BP curve).


The upward-sloping BP represents “imperfect capital mobility.”

The typical upward slope of the BP curve results from impediments to capital flows or when the country is large enough to influence international interest rates.


Capital could be perfectly mobile. This would occur if any deviation of the

domestic i away from the international rate immediately triggered capital flows that brought interest rates back in line.

When capital is perfectly mobile, the BP curve is a horizontal line.


Capital could be perfectly immobile. If a country fixes its exchange rate, it

typically maintains strict foreign exchange controls.

When capital is perfectly immobile, the BP curve is a vertical line.


A depreciation of the home currency, an autonomous increase in exports, or an autonomous decrease in imports will shift BP to the right.

An appreciation of the home currency, an autonomous decrease in exports, or an autonomous increase in imports will shift BP to the left.

Equilibrium in the Open Economy

income

i

BP

IS

LM

Only at point E is the economy in full equilibrium.

EiE

YE

Equilibrium in the Open Economy: Adjustments

Suppose exchange rates are fixed. How does the system adjust to a “shock”

such as an increase in foreign income? This should increase exports, shifting BP

rightwards to BP′. The IS curve will shift rightwards to IS′. To maintain the fixed exchange rate, the

central bank must purchase the surplus foreign currency; this shifts LM rightwards to LM′.

Eventually, a new equilibrium is reached at E''.

Equilibrium in the Open Economy

income

i

BP

LM

Ei*

Y*

LM'

BP'

IS'IS

E''i''

Y''

Fiscal Policy Under Fixed Exchange Rates

With perfect capital immobility, any fiscal stimulus initially increases Y and M (and also i), but because capital is immobile, a BOP deficit emerges, decreasing the money supply and increasing i further.

In the end, Y returns to its original level – the fiscal stimulus completely crowds out domestic investment (I).


income

iBP

IS

LM

EiE

YE

IS'

E'

i'

LM'

Perfect capital immobility


With perfect capital mobility, any fiscal stimulus increases Y and M, but i does not rise due to capital inflows.

To maintain the fixed exchange rate, the central bank must increase the domestic money supply.

In the end, Y rises, but i stays the same.


income

i

BP

IS

LM

EiE

YE

IS'

E'

LM'

Perfect capital mobility

Y'


The bottom line:

• When capital is relatively mobile, fiscal policy is more effective at increasing national income.

• When capital is relatively immobile, fiscal policy is less effective at increasing national income.

Monetary Policy Under Fixed Exchange Rates

With perfect capital immobility, a monetary stimulus initially increases Y and M (and lowers i), but because capital is immobile, a BOP deficit emerges.The central bank must sell foreign exchange (decreasing the money supply) to maintain the fixed exchange rate.In the end, the LM curve returns to its original place – the monetary stimulus doesn’t change Y.


income

iBP

IS

LM

EiE

YE

LM'

Perfect capital immobility


With perfect capital mobility, any monetary stimulus increases Y and M, but i does not fall due to capital inflows.

Again, to maintain the fixed exchange rate, the central bank must decrease the domestic money supply.

In the end, the LM curve returns to its original place – the monetary stimulus doesn’t change Y.


income

i

BP

IS

LM

EiE

YE

LM'

Perfect capital mobility


The bottom line: • When capital is relatively mobile,

monetary policy is ineffective at increasing national income.

• When capital is relatively immobile, monetary policy is ineffective at increasing national income.

Maintaining a fixed exchange rate system means losing monetary policy as an effective tool.

Effects of Official Changes in the Exchange Rate System

Obviously, to maintain a fixed exchange rate system, a country would not want to devalue or revalue the currency often.

However, such policy actions are occasionally required: what will be the effects?


If the home country’s exchange rate is devalued, exports rise and imports fall.

This shifts both the IS and BP curves rightward.

The money supply must be expanded – the central bank must buy foreign exchange.

This means the LM curve also shifts rightward.

The devaluation increases Y.


The bottom line:When capital is relatively immobile, a devaluation increases national income.When capital is relatively mobile, a devaluation increases national income to an even greater extent.

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www.themegallery.com chapter 7 economic policy in the open economy under fixed exchange rates

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