macroeconomic policy and floating exchange rates

Macroeconomic Policy and Floating Exchange Rates

Introduction What are fiscal and monetary

policy? Given floating exchange rates, what

are the effects of fiscal and monetary policy on The exchange rate The current account Interest rates and Short run capital flows

Fiscal and Monetary Policy Fiscal Policy – uses changes in government

taxes and/or spending at the national level to affect economic activity

Monetary Policy – uses changes in money supply and/or interest rates to affect country’s GDP

What are the effects of fiscal and monetary policy on the exchange rate, the current account, and short run capital flows?

Fiscal and Monetary Policy Past focus of monetary and fiscal policy

targeted an external balance Balancing of the inflows and outflows

included in the current account Currently, monetary and fiscal policy

focus on a country’s internal balance Levels of unemployment and inflation as

preferences of citizens of the economy. Focus on managing growth rate of real GDP and the price level

Fiscal and Monetary Policy In general, the focus on internal

balance comes at the expense of the external balance

Policies designed to affect the internal balance, however, can have a significant affect on external balance

Changes in Fiscal Policy Government spending in most countries

is a significant portion of GDP Changes in government spending can

have a critical impact on an economy Government spending usually financed

through borrowing, thereby having a significant impact on country’s domestic financial markets

Changes in Fiscal PolicyI. Expansionary Fiscal Policy

Assume a balanced budget – government spending equals government taxes

Government adopts lower tax revenues and/or higher government spending

Leads to government budget deficit (or larger deficit)

Assume government borrows to finance – does not print money


Can show graphically the effects of this policy on the economy

A. Demand for loanable funds - total demand for loans in the economy which is indirectly related to interest rate

1. Private sector – public’s consumption activities that must be financed (homes, cars, etc.) and business demand for investment

2. Public sector – government needs for funds


B. Supply of loanable funds – total amount of money available to be borrowed

Represented as perfectly inelastic – amount of loanable funds not related to interest rate

In short run the amount the public want sot save determines supply of loanable funds

C. Balanced budget – demand of loanable funds equals supply at equilibrium interest rate ie.

Loanable Fund Market


Government’s demand for loanable funds increases – D to D’

In closed economy, interest rate increases In open economy, rise in interest rates leads

to inflow of foreign capital Foreign capital augments supply of loanable

funds (S to S+f) Interest rate decreases back to ie Expansionary policy puts less upward

pressure on interest rates in an open economy

Changes in Loanable Funds

Changes in Fiscal PolicyI. Expansionary Fiscal Policy – Effects on

exchange rate Assume initial exchange rate with no inflows

of capital – current account balanced Inflow of capital required foreign investors to

sell foreign currency to buy dollars Supply of foreign exchange increases and

nominal exchange rate appreciates Capital account surplus – current account

deficit

Exchange Rate Effects

Changes in Fiscal PolicyI. Expansionary Fiscal Policy -

Effects on domestic economy? Aggregate demand increases Closed economy leads to increased

output and price level Open economy effects are less clear

Current account worsens as exports decline and imports increase

Effect is AD shifts back to the left

Changes in Domestic Market

Changes in Fiscal PolicyI. Expansionary Fiscal Policy -

Conclusion Net effect on AD, equilibrium

output, and price level depends on magnitude of two effects

Expansionary fiscal policy in open economy is less effective at changing equilibrium output than in a closed economy

Changes in Fiscal PolicyII. Contractionary Fiscal Policy

Combination of higher taxes and/or lower government spending

Reduces government budget deficit (increases size of surplus)

Changes in Fiscal PolicyII. Contractionary Fiscal Policy –

Effects on interest rates Demand for loanable funds decreases Interest rate initially lowers Less investment by domestic and

foreign investors in domestic economy – outflow of capital from domestic economy

Supply of loanable funds decreases lowering interest rates back toward ie

Loanable Funds Market

Changes in Fiscal PolicyII. Contractionary Fiscal Policy –

Effects on foreign exchange Demand for foreign exchange

increases as capital is moved to foreign markets

Currency depreciates Capital outflow causes a capital

account deficit Current account surplus – difference

between imports (M) and exports (X)

Foreign Exchange Market

Changes in Fiscal PolicyII. Contractionary Fiscal Policy – Effects

on domestic market Aggregate demand decreases Closed economy leads to both decrease in

domestic output and price level Open economy depreciating currency

causes exports to increase and imports to fall

Aggregate demand increases toward original

Domestic Market

Changes in Fiscal PolicyII. Contractionary Fiscal Policy – Net

Effect Net effect on output and price level

depends on magnitude of two effects Contractionary fiscal policy in an

open economy is less effective in changing equilibrium output than in a closed economy

Changes in Fiscal PolicyIII. Conclusions

Given current global conditions with floating exchange rates and relatively large short run capital flows, fiscal policy is not as effective at controlling output and price level

Effects of fiscal policy are not irrelevant, however

Interest rate, exchange rate, capital flows and current account balance change noticably affecting business decisions

Changes in Monetary Policy Central bank attempts to affect the

short run performance of the economy by changing the growth rate of the money supply and/or interest rates

Discretionary monetary policy – using monetary policy in reaction to and/or to prevent unwanted changes in economy’s short run performance

Some increased interest in a monetary rule instead of discretionary policy

Changes in Monetary PolicyI. Expansionary Monetary Policy –

Effects on interest rate Central bank increases money supply or

money supply growth rate Increases in money supply increase the

supply of loanable funds Interest rate decreases initially Capital outflow causes supply of loanable

funds to decrease increasing interest rate

Changes in Monetary PolicyI. Expansionary Monetary Policy –

Effects on exchange rate Capital outflows cause demand for

foreign exchange to increase Currency depreciates worsening

capital account - deficit Current account surplus as exports

increase and imports decrease – difference between M and X

Changes in Monetary PolicyI. Expansionary Monetary Policy – Effects

on domestic economy Aggregate demand increases since both

consumption and investment spending have increased

Closed economy - Output and price level increase

Open economy – increasing exports and decreasing imports increase AD again

Net result: Output and price level increase

Domestic Market

Changes in Monetary PolicyII. Contractionary Monetary Policy –

Effects on Interest rate Central bank decreases money supply or

reduces money supply growth rate Government bonds are sold Decreases supply of loanable funds

raising interest rates Attraction of foreign capital shifts supply

of loanable funds to the right decreasing interest rates


Effects on exchange rate Capital inflow increases supply of

foreign exchange Currency appreciates Capital account surplus Current account deficit – difference

between X and M


Effects on domestic market Reduction in growth rate of interest

sensitive consumption and reducing in investment growth rate

AD decreases lowering output and price level in closed economy

Open economy – exports fall and imports rise

AD decreases further Net effect lowers output and price level

Changes in Monetary Policy

Policy in Open Economy Effects of policies described in terms of

effects on external and internal balances Current account balance – external

balance Equilibrium output and price level –

internal balance At any point, there is an optimal balance

of output level and price level Best implies full employment and stable prices

Policy in Open Economy Full employment and stable prices are

rarely met so policy used to achieve a balance between output level and price level

Fiscal and monetary policy can be used to influence internal or external balance

In general, government cannot balance both together so much choose to target one

Policy in Open Economy In an open economy with floating exchange

rates, macroeconomic policy tends to focus on internal balance

Although both fiscal and monetary policy affect current account and exchange rates, they are not the primary focus of policy

It is sometimes perceived that exchange rate and current account are the primary targets of macroeconomic policies

Policy in Open Economy Following table summarizes effects

of different policies on each of the macroeconomic variables Output, price level, exchange rate and

current account Can use the table to show effects of

a policy mix – various combinations of fiscal and monetary policy

Policy in Open Economy

Policy in Open EconomyII. Consistent Policy Mixes - Recession

Real GDP below full employment level Government target to increase output Expansionary monetary policy and/or

expansionary fiscal policy Combination of both would increase output

and price level Effect on exchange rate is unclear

depending on magnitude of two policies on interest rates

Policy in Open EconomyI. Consistent Policy Mixes - Recession

Effect on exchange rate is unclear depending on magnitude of two policies on interest rates

Effects on current account are also unclear again depending on effect on interest rates

Given opposite effects on exchange rates and current account, neither is likely to change much in either direction

End result is improvement of economy by increasing output

Effects of Policy Mix - Expansionary

Yd P XR CAExpansionaryFiscal – Direct

IndirectExpansionaryMonetary – Direct

IndirectNet Effect

Policy in Open EconomyI. Consistent Policy Mixes – Inflation

Producing output greater than full employment levels

Combination of monetary and fiscal policies

Both equilibrium output and price level fall

Exchange rate and current account effects unclear since policies move in opposite directions

Effects of Policy Mix - Contractionary

Yd P XR CAContractionaryFiscal – Direct

IndirectContractionaryMonetary – Direct

IndirectNet Effect

Policy in Open EconomyII. Consistent Policy Mixes –

Conclusion When governments adopt similar

consistent fiscal and monetary policy, the equilibrium level of output and price level can change without drastic changes in exchange rate or current account.

Policy in Open EconomyII. Inconsistent Policy Mixes

Why adopt opposing fiscal and monetary policy when conclusions for internal balance is unknown?

Different policy makers in control of fiscal and monetary policy – Federal Reserve and Federal Government

Known effects on the country’s external balances Effects on external balance is extreme

strong, affecting economy’s tradable goods sector

Policy in Open EconomyII. Inconsistent Policy Mixes

Expansionary fiscal policy and contractionary monetary policy lead to

Appreciated currency and decreased current account

Contractionary fiscal policy with expansionary monetary policy lead to

Depreciated currency and improved current account

Trade Flow Adjustment & Current Account DynamicsII. We have assumed no lags in effects

on macroeconomic variables from monetary and fiscal policy

Financial markets are relatively efficient so interest rates affected quickly

High capital mobility allows exchange rate to change relatively quickly

Trade Flow Adjustment & Current Account Dynamics

II. Could be lags when the macroeconomic variables change in response to policy

Price of imports and exports may not change instantly as exchange rate changes

International trade may respond slowly to changes in prices compared to response of financial markets

Time to affect current account balance could be six months to a year

Trade Flow Adjustment & Current Account Dynamics In long run, as country’s currency

depreciates, its export expand and imports contract (and vice versa)

In short run, as country’s currency exchange rate changes, response of exports and imports and current account balance could be easily in opposite direction

Trade Flow Adjustment & Current Account Dynamics International trade is often conducted

between parties on a contract basis Imported agreed to purchase certain

amount of a good at an agreed upon price If currency depreciates, cost of goods in

domestic currency rises Value of imports rises but value of exports

n domestic currency does not change Current account may initially worsen

Trade Flow Adjustment & Current Account Dynamics J-Curve

Effect on country’s current account balance

If currency depreciates Current account balance initially worsens After contracts are renewed reflecting new

exchange rate, current account begins to improve

Important for policy makers to take the lag effect into account

Short run versus long run

J-Curve

macroeconomic policy and floating exchange rates

Documents

fiscal policy focus

effects of fiscal

monetary policyfiscal

ieexpansionary policy

macroeconomic policy

loanable fundschanges

loanable funds total

government budget deficit