CHAPTER 23
INTERNAL AND EXTERNAL BALANCE
WITH FIXED EXCHANGE RATES
Objectives of the Chapter
Reconciling the policy goals of full employment, price stability, and overall payments balance is a
difficult undertaking for a government determined to keep the exchange rate fixed. Starting from some
states of disequilibrium, the choice of fiscal and monetary policies that would move the economy toward
both internal and external equilibrium (or balance) might be quite easy. Starting from some other
disequilibrium states, the choice is less obvious.
Chapter 23 analyzes the effects of fiscal and monetary policies on the product market, the money market
and the foreign exchange market. A set of recommendations for the proper policy mix is then derived for
the case of imperfect capital mobility. Finally, the analysis of the feedback from the balance of payments
to the money supply and the case of perfect capital mobility highlights the limitations of discretionary
monetary policy under fixed exchange rates.
After studying Chapter 23 you should know
1. the connection between official intervention in the foreign exchange market and the domestic
money supply.
2. how official intervention affects a country’s balance of payments and macroeconomic performance
goals.
3. the reasons for, and methods of, sterilized intervention by monetary authorities.
4. how monetary and fiscal policies affect internal and external balance under fixed exchange rates.
5. the effectiveness of monetary policy and fiscal policy under perfect capital mobility.
6. when aggregate demand policies can and cannot achieve both internal and external balance.
7. how, under imperfect capital mobility, an appropriate mix of monetary and fiscal policies can
achieve internal and external balance in the short run.
8. when a country might want to abandon its defense of a fixed exchange rate.
9. how much the trade balance will respond to a change in the exchange rate.
Important Concepts
Aggregate demand policy
dilemma:
Refers to the difficulty of improving the levels of both national
income and the balance of payments by manipulating only the
level of aggregate demand.
Assignment rule:
A guideline for assigning goals to fiscal and monetary policies.
Fiscal policy should aim at achieving internal balance, while
monetary policy should aim at achieving external balance.
Capital flight:
When investors flee a country (taking their capital with them)
because of doubts about government policies.
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Central bank:
The official authority that controls monetary policy and (usually)
undertakes the official intervention in the foreign exchange market.
Endogenous shocks:
Shocks caused by factors within the model or system.
Exogenous shocks:
Shocks caused by factors outside a model that are independent of
other factors in the model or system.
External shocks:
Sudden changes in international capital flows or in international
trade.
Internal shocks:
Sudden changes in domestic spending or in the financial sector
(money demand or supply).
J curve:
When the price effect of a currency devaluation occurs more rapidly
than the volume effect, the initial impact of a devaluation is to
worsen the current account. After a period of months, the volume of
imports falls and the volume of exports rises, causing the current
account to improve. A trace of this time pattern in the current
account results in the “J” shape.
Monetary base:
Currency and deposits at a country’s central bank; they provide the
pool of funds used in sterilization.
Monetary-fiscal policy mix:
A short-run solution to the aggregate demand policy dilemma; it
exploits the opposite impacts of fiscal and monetary policies on the
interest rate and, in consequence, on the balance of payments. Under
fixed exchange rates and with imperfect capital mobility, the policy
mix suggested by the assignment rule will allow a country to achieve
both internal and external balance in the short run.
Perfect capital mobility:
In this situation, a practically unlimited amount of lending moves
between countries in response to the slightest change in one
country’s interest rate.
Rules of the game:
Also known as “classical medicine.” Under fixed exchange rates or
the gold standard, the “rules of the game” require monetary
authorities to refrain from sterilizing payments imbalances. Instead,
they should actively push their domestic lending in the same
direction as the payments imbalance, so as to speed up the
elimination of payments imbalances, even if this requires sacrificing
the goal of internal balance in the short run.
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Sterilized/Unsterilized intervention: Under a fixed or managed exchange rate regime, the monetary
authorities have to intervene in the foreign exchange market to
satisfy any private excess demand for, or supply of, foreign
exchange. If the monetary authorities allow such operations to
affect the money supply, it is called unsterilized intervention. If,
instead, they undertake offsetting purchases or sales of
government bonds in the open market, so as to prevent a balance
of payments surplus or deficit from having any net effect on the
domestic money supply, it is called sterilized intervention.
Warm-up Questions
True or False? Explain.
1.
T/F
Easier monetary policy worsens the balance of payments in the short run.
2.
T/F
Contractionary monetary policy can correct a situation where a country has rapid
inflation and a payments deficit.
3.
T/F
Money is easy; economics is hard.
4.
T/F
Sterilized intervention is impossible under perfect capital mobility.
5.
T/F
If both import and export demand are perfectly inelastic, a country’s trade deficit could
be reduced by revaluing its currency.
Multiple Choice
1.
Expanding aggregate demand can achieve internal and external balance only if the economy is
experiencing
A. a payments surplus and unemployment.
B. a payments surplus and inflation.
C. a payments deficit and inflation.
D. a payments deficit and unemployment.
2.
A payments deficit can be sterilized if monetary authorities
A. sell government bonds in the open market.
B. purchase government bonds in the open market.
C. decrease their lending to commercial banks.
D. sell foreign exchange to match the private excess demand for foreign exchange.
3.
The appropriate monetary-fiscal mix in the case of a payments deficit and unemployment is
A. easier fiscal policy and easier monetary policy.
B. easier fiscal policy and tighter monetary policy.
C. tighter fiscal policy and easier monetary policy.
D. tighter fiscal policy and tighter monetary policy.
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4.
Under fixed exchange rates, if capital is perfectly mobile,
A. both monetary and fiscal policy are powerful.
B. neither monetary nor fiscal policy is powerful.
C. fiscal policy is powerful but monetary policy is not.
D. monetary policy is powerful but fiscal policy is not.
5.
A devaluation will improve the trade balance if
A. the country is small.
B. demand for both imports and exports is perfectly elastic.
C. we measure the trade balance a number of months after the devaluation.
D. all of the above.
Problems
1.
The Prime Minister of Saxony is up for re-election, and the electorate is angry about the high
inflation rate and Saxony’s payments deficit with Leinster.
a. If the Prime Minister has promised to defend the fixed exchange rate of Ss 100 / Ll, can he
use domestic monetary and fiscal policies to achieve both internal and external balance?
(You may assume that capital does not flow easily between the two countries.)
b. Suppose the Prime Minister decides to abandon the fixed exchange rate and allow the scudo
to devalue to Ss 150 / Ll. Can he count on a devaluation to reduce the Saxon trade deficit?
(Remember, Saxony is a small country.)
2.
If the development of new information technology were to make capital perfectly mobile
between Saxony and Leinster, what would this do to
a. the ability of Saxony’s fiscal authorities to increase the level of national income?
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b. the ability of Saxony’s monetary authorities to increase the level of national income?
3.
The Central Bank of Saxony (CBS) has decided that universal home ownership is a worthwhile
goal for the country. To encourage new home construction and purchase, it expands the Saxon
money supply significantly, pushing down interest rates on construction loans and mortgages.
Assuming that CBS is also committed to keeping the exchange rate between the scudo and the
lira fixed, how successful will this home ownership program be in a world of internationally
mobile capital?
4.
Demand for petroleum and petroleum fuels is relatively inelastic. Therefore, would you counsel
an OPEC leader to further improve his country’s trade balance by devaluing its currency?
5.
Consider a country that currently has full employment, a balanced current account, limited
capital mobility, and a fixed exchange rate. Which of the following disturbances can be remedied
with standard aggregate demand tools, and which might require surrendering the country’s fixed
exchange rate?
a. A loss of export markets.
b. A reduction in savings and a corresponding increase in home demand for domestic goods.
c. An increase in government spending.
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d.
A shift in residents’ spending from imports to domestic goods.
e.
A reduction in imports with an equal increase in savings.
f.
An increase in residents’ demand for the domestic currency.
Discussion Topics
1.
Since monetary policy and fiscal policy are not officially coordinated in the U.S., would the
assignment rule be applicable?
2.
Could a country change the level of capital mobility between it and other countries? How? Why
might it want to change that level?
3.
The OPEC shocks in the 1970s resulted in high unemployment, rapid inflation, and payments
deficits for many countries. What sorts of policy dilemmas did this combination of problems
cause?
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