CHAPTER 27
ECONOMIC POLICY IN THE OPEN ECONOMY:
Flexible Exchange Rates
I.
Outline
Introduction
The Effects of Fiscal and Monetary Policy under Flexible Exchange Rates with
Different Capital Mobility Assumptions
- The Effects of Fiscal Policy under Different Capital Mobility Assumptions
- The Effects of Monetary Policy under Different Capital Mobility
Assumptions
- Policy Coordination under Flexible Exchange Rates
The Effects of Exogenous Shocks in the IS/LM/BP Model with Imperfect Mobility
of Capital
Summary
II.
Special Chapter Features
Box 1: Real and Financial Factors that Influence the BP Curve
Case Study 1: Commodity Prices and U.S. Real GDP, 1973-1995
Case Study 2: Macroeconomic Policy Coordination, the IMF, and the G-7
V.
Answers to End-of-Chapter Questions and Problems
1.
If the intersection of the IS and LM curves is at a point below the BP curve, there will be
an incipient BOP deficit and depreciation of the home currency. Assuming that the MarshallLerner conditions are met, as the currency depreciates exports expand and imports contract,
leading to a downward shift in the BP curve and to a rightward shift in the IS curve. These
adjustments continue until there again is equilibrium on all three curves at some point on the
unchanged LM curve.
2.
The position of the BP curve is influenced by any factor other than domestic income and
the interest rate that impacts upon the capital and current accounts in the balance of payments.
Therefore, foreign and domestic prices, expected prices, foreign and domestic tastes and
preferences for traded goods, foreign income, and foreign and domestic trade policy are examples
of factors that influence the current account and hence the BP curve. The financial account is
influenced by such things as the foreign interest rate, expected exchange rates, domestic and
foreign rates of return on investment, foreign and domestic tax policy, foreign and domestic
financial reforms, and relative economic/political stability.
3.
Fiscal policy is completely ineffective when capital is perfectly mobile. This occurs
because the upward pressure on the domestic interest rate generated by expansionary fiscal action
(rightward shift in the IS curve) generates, because of large-scale capital inflows, an incipient
BOP surplus and an appreciation of the currency. The appreciation leads to an increase in imports
and a decrease in exports (leftward shift in the IS curve). The appreciation and trade (price)
adjustment process will continue until the initial effect of the expansionary fiscal policy is exactly
offset and any upward pressure on the interest rate is removed.
4.
Under a fixed-rate system, the country is committed to maintain the exchange rate either
through unobstructed gold movements or by appropriately buying or selling foreign exchange. As
a result, the central bank loses control of the money supply as an instrument for meeting domestic
targets other than external balance. Even if the automatic money supply changes are sterilized by
policy action, this can only be a temporary stopgap. Under a flexible-rate system, external balance
is maintained automatically through changes in the exchange rate, assuming that the MarshallLerner conditions hold. There is thus no constraint on the central bank regarding the size of the
money supply necessary for maintaining relative currency value. In fact, as explained in the
answer to Question #5 immediately below, the foreign sector relative price adjustments that
accompany monetary policy actions tend to reinforce the intent of the policy.
5.
Under a flexible-rate system, expansionary monetary policy puts downward pressure on
the interest rate which, in turn, puts downward pressure on the value of the home currency as
investors shift out of financial investments denominated in the home currency. Depreciation of
the currency expands exports and reduces imports. There is thus a two-fold expansionary effect
on the economy, a stimulus for greater real investment at lower interest rates and a greater
demand for domestic goods and services as exports rise and imports fall. The price adjustment
process thus complements the monetary action, whereas under fixed rates the adjustment process
leads to a loss in reserves and a contraction in the money supply that offset the initial policy
action.
6.
Expansionary monetary policy will increase exports and domestic export prices and
decrease imports through higher import prices as downward pressure is put on the interest rate
and, subsequently, the value of the home currency (assuming that the Marshall-Lerner conditions
are met). Thus, one would expect those associated with export industries and import-competing
industries to favor such a policy. On the other hand, those who consume relatively more traded
goods (both imports and exports) and merchants involved in the retailing of imports would likely
not favor such a policy.
7.
Without additional information the precise impact of expansionary fiscal policy on the
exchange rate is ambiguous because it depends on the interest-responsiveness of short-term
capital internationally compared to the interest-responsiveness of the domestic money market (i.e.,
is the BP curve flatter or steeper than the LM curve?). In the case where the BP curve is flatter
than the LM curve (relatively greater responsiveness internationally), there will be an appreciation
of the home currency. This will offset at least some of the initial stimulus to income provided by
the expansionary fiscal policy. In the case where the BP curve is steeper than the LM curve
(relatively less responsiveness internationally), expansionary fiscal policy will lead to a
depreciation of the home currency, and there will be additional income expansion beyond that
provided by the initial expansionary fiscal policy.
8.
If there is a rise in the expected appreciation of the foreign currency, there will be an
incentive for investors to shift toward foreign currency-denominated financial assets. Thus, for
every level of income, it will now take a higher domestic interest rate to balance the balance of
payments, i.e., the BP curve will shift upward (to the left), and there will now be an incipient BOP
deficit. The domestic currency will thus begin to depreciate (BP curve now begins shifting
downward or to the right), stimulating exports and reducing imports. Assuming a normal price
adjustment to the changing exchange rate (the Marshall-Lerner conditions are met), the current
account balance improves and stimulates greater income and interest rates (i.e., the IS curve shifts
to the right along the fixed LM curve). The BP curve continues to shift downward and the IS
curve rightward until a new three-way intersection of IS, LM, and BP occurs. Income and the
interest rate will both be higher than original and most likely so will the interest rate. (See the
discussion following Figure 8 regarding the interest rate change.)
9.
Under a flexible-rate system, the foreign price increases in petroleum and food would
stimulate U.S. exports and reduce U.S. imports, leading to upward pressure on income and
interest rates and an appreciation of the currency. The stronger dollar offsets, at least in part, the
foreign price increases and the economy settles back close to the original equilibrium level. (See
the last part of the chapter for a discussion of foreign price shocks using the IS-LM-BP model.)
In contrast, under fixed exchange rates the improved trade balance leads to upward pressure on
income and interest rates, which results in an inflow of short-term capital and, consequently, an
increase in the money supply. This money supply increase stimulates an even greater increase in
income and, quite likely, an increase in domestic prices. Under fixed rates, then, foreign price
increases are passed on to the domestic economy whereas, under flexible rates, the foreign price
increases are filtered out by increases in the exchange rate.
10.
With the increase in interest rates in the EU, there will be an increase in demand for
foreign exchange (e.g., French francs) to invest abroad in order to take advantage of the higher
earning potential (i.e., the BP curve will shift up, indicating that it will now take a higher domestic
interest rate at every level of income to balance the balance of payments). The increased demand
for foreign exchange will cause the dollar to depreciate in the spot market. The depreciation of
the dollar will stimulate U.S. exports and reduce U.S. imports, which will put upward pressure on
income and interest rates (i.e., the IS curve will shift to the right). Thus, the statement is correct.
(See Figure 8 for a graphical explanation.) In addition, if the higher foreign interest rate reduces
the home demand for money (via a portfolio balance effect) the LM curve will shift to the right,
exerting even more upward pressure on income.