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EC111 MACROECONOMICS Spring Term 2012

Lecturer: Jonathan Halket

Week 23

Topic 8: OPEN ECONOMY MACROECONOMICS (continued)

We looked at the case where the exchange rate was fixed and there was zero

international capital mobility. We saw that both fiscal and monetary policy were

ineffective. Now we look at three other cases.

Case 2: A fixed exchange rate (e = ē) and perfect international capital mobility (α = ∞)

Recall that here the BP curve is horizontal, even a small deviation from the ruling

international interest rates causes huge capital flows, and eliminates any gap between

home and foreign interest rates. Thus the BP curve is fixed at the international interest

rate rF.

Fiscal Policy

Initially we have BP = 0. The government increases its expenditure, shifting the IS curve

to the right. The tendency for the interest rate to deviate above rF causes a massive

inflow of financial capital from abroad. The inflow of capital increases the demand for

LM2

IS1

BP (α = ∞)

LM1

Y

r

rF

IS2

2

pounds, which more than offsets the current account deficit. This puts upward pressure

on the exchange rate so the Bank sells pounds in exchange for foreign currency. This

increases the money supply and shifts the LM curve to the right, until the interest rate is

back at rF.

National income has increased and the interest rate is unchanged. Fiscal policy is

powerful because, with perfect international capital mobility, it does not drive up the

interest rate.

Monetary Policy

Starting again from BP = 0, the Bank expands the money supply, shifting the LM curve

to the right. But this tends to reduce interest rate below the world rate. Massive capital

outflows create a balance of payments deficit. The Bank has to buy pounds to support

the exchange rate which is tending to fall as investors sell pounds. This shifts the LM

curve back to the left—and back to its original position.

So monetary policy is still ineffective as income is not changed and neither is the interest

rate. In case 1 and case 2, by fixing the exchange rate, the Bank gives up its control over

monetary policy.

LM1

IS1

BP (α = ∞)

LM2

Y

r

rF

3

Case 3: A floating exchange rate (e = e*) and no international capital mobility (α = 0)

Here the Bank does not intervene in the foreign exchange market (a free float) so the

exchange rate settles to its equilibrium where supply of pounds is equal to the demand

for pounds. Note that central banks often allow the exchange rate to vary but intervene

to smooth out extreme fluctuations. This is sometimes called a „managed float‟ or a

„dirty float‟. Here we assume a „clean float‟ where the Bank does not intervene at all.

Fiscal Policy

Initially we have BP = 0. The government increases its expenditure, shifting the IS curve

to the right, from IS1 to IS2. This increases national income and increases the demand

for imports. This in turn shifts the supply of pounds to the right and causes a

depreciation of the exchange rate from e1 to e2.

BP2 (α = 0)

LM

IS2

BP1 (α = 0)

IS1

Y

r

IS3

4

Recall that the IS curve is:

The fall in the exchange rate adds a further rightward shift to the IS curve (to IS3

above). The original expansionary effect of government expenditure is magnified by the

fact that it has driven down the exchange rate, increasing competitiveness. Note also

that as a result of the exchange rate depreciation, the balance of payments is still zero

but the vertical BP curve is displaced to the right.

Monetary Policy

Starting again at BP = 0. The Bank increases the money supply, shifting the LM curve

to the right (next page). The rise in income increases the demand for imports, which as

before, causes the exchange rate to depreciate (as above). This in turn shifts the IS curve

to the right. Note also that, because of the depreciation, the BP curve has also shifted to

the right.

Thus monetary is also powerful because the initial LM shift is enhanced by a rightward

shift in the IS curve as the economy gains competitiveness. Because the Bank does not

intervene in the foreign exchange market, the expansion of the money supply is not

reversed by the monetary effects of a balance of payments deficit.

£

£S

1

e

e*1

e*2

£S

2

£D

1

5

Case 4: A floating exchange rate (e = e*) and perfect international capital mobility (α =

∞)

Now (as in Case 2) the PB curve is horizontal at the world interest rate rF.

Fiscal Policy

Starting at BP = 0, an increase in government spending shifts the IS curve to the right,

but this tends to raise the domestic interest rate The high interest rate attracts capital

from the rest of the world. We assume here that the increased demand for pounds

arising from international capital inflows outweighs the increased supply of pounds that

results from the increase in import demand. Therefore the exchange rate appreciates

making British goods less competitive and shifting the IS curve back to the left.

Thus the original expansion due to government spending is offset by the effects of the

increase in the exchange rate: imports have risen and exports have fallen. So fiscal

policy is ineffective. Once income has moved back to the original level, the interest rate

is also back at rF so there is no further incentive for capital flows.

BP2 (α = 0)

LM1

BP1 (α = 0)

IS1

Y

r

LM2

IS2

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Monetary Policy

Starting from BP = 0, the Bank increases the money supply, shifting the LM curve to

the right. This tends to push down the interest rate below the world rate, causing

investors to move their financial capital abroad. The exchange rate depreciates because

LM2

IS1

BP (α = ∞)

LM1

Y

r

rF

IS2

LM1

IS1

BP (α = ∞)

LM2

Y

r

rF

IS2

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of an increase in the supply of pounds both on the current account and on the capital

account. The depreciation shifts the IS curve to the right until the interest rate is back

at rF.

Monetary policy is powerful because its effects are magnified by the exchange rate

depreciation.

Exchange rate dynamics

In case 4 we compare the initial position before the policy intervention with the final

outcome. But along the way, adjustments take place that may cause the exchange rate to

initially “overshoot” and then gradually return to the new long run level.

Consider a foreign investor buying a British bond, holding it for a year, and then selling

it and converting the proceeds back into Euros. The overall return on the bond for the

foreign investor will be the rate of interest plus any appreciation of the exchange rate

that that occurs over the period, which makes the bond worth more in foreign currency-

(here we ignore changes in the price of the bond).

So the return on the bond will be: where is the rate of change of the exchange

rate (e.g ten percent, or 0.1). Competition among investors for the highest returns

ensures that British bonds will yield the same as the rest of the world (ignoring

differences in risk). So we have:

, and thus if

Now consider again monetary policy with a floating exchange rate and perfect capital

mobility (case 4). The exchange rate falls in the short run as r < rF. This means that to

be willing to invest foreign investors must expect the exchange rate to rise, .

time

e

e1

e2

e3

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The initial response to monetary expansion will be for the exchange rate to „jump‟ down

below the long run equilibrium and then rise gradually. This helps to explain why

exchange rates are so volatile and why they sometimes seem to over-react to policy

announcements.

Summary of policy effectiveness

We have now examined the effectiveness of policy in different situations—fixed and

floating exchange rate and perfect and zero international capital mobility. The effects of

policy can be summarised as follows:

Fiscal Policy Monetary Policy

Case 1 Fixed exchange rate; no

international capital mobility

Weak Weak

Case 2 Fixed exchange rate; perfect

international capital mobility

Strong Weak

Case 3 Floating exchange rate; no

international capital mobility

Strong Strong

Case 4 Floating exchange rate; perfect

international capital mobility.

Weak Strong

Note that:

Here we have assumed that prices are fixed and there is excess supply of labour.

So we are in a Keynesian world. In a classical world national income is at the full

employment level and so no policy can be effective.

We have taken the extreme cases of where international capital mobility is either

perfect or non-existent. If the BP curve is upward sloping then all policies will be

effective to some degree. The precise degree depends on how large is α.

We have not considered other „shocks‟ such as changes in foreign income YF or

domestic investment (shifts in h). But these could be analysed using the same

framework.

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Exchange rates and economic policy

In 1944 a fixed exchange rate system was set up involving all the major economies. It

was overseen by the IMF. Under the so called Bretton Woods system the UK exchange

rate relative to the US dollar was £1 = $2.80. The value of the dollar in turn was linked

to a fixed quantity of gold ($35 an ounce).

In the early phase up to 1958 international capital mobility was limited. This is a little

like case 1. The scope for policy was limited—attempts to stimulate the economy using

fiscal and monetary policy were limited by periodic balance of payments crises. This

was the origin of so-called stop-go policies. But in any case unemployment was low so

there was less need for expansionary policy.

In 1967 the UK devalued to $2.40. At the same time international capital flows were

becoming freer and so in principle there was more scope for the use of fiscal policy (case

2). The US ran large deficits which increased the money supplies of other countries and

eventually the fixed exchange rate system was abandoned in 1972.

With floating exchange rates and international capital mobility monetary policy should

be powerful (case 4, but it was a managed float). Unemployment was rising and the UK

government engaged in a massive expansion of the money supply. But it generated

inflation not employment. Why? Because the NAIRU had increased. And inflation was

given a further twist by the oil price increases in 1974 and 1978.

It took a long time to get inflation under control—even with the deflationary monetary

and fiscal policies adopted by the Thatcher government from 1979. These new policies

also represented the triumph of the Monetarists over the Keynesians.

By the late 1980s inflation was falling and the exchange rate was rising. The government

cut interest rates and the pound fell. Wide swings in the exchange rate were seen as

creating uncertainty and so in 1990 the UK joined the European exchange rate

mechanism (ERM) which was the precursor to the Euro. One reason was to limit

speculation. Investors who believed that the pound would depreciate would sell now and

hope to buy pounds again later at a lower exchange rate.

It did not work. The UK entered the ERM at a rate of £1 = 2.95DM. People expected

inflation in Germany to increase the relative competitiveness of the UK (why?) but it

did not happen and the pound was somewhat overvalued. Policy to counter this began

to create doubts that the UK could maintain the exchange rate—speculators sold

pounds.

The UK was forced out of the ERM and the pound depreciated—leading to a strong

economic recovery. An alternative approach to policy was adopted: Inflation Targeting.

As the boom proceeded inflation pressures caused the Bank to keep interest rates high

relative for foreign rates, so the exchange rate rose.

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Fixed versus floating exchange rates

There has been a long debate about fixed versus floating exchange rates. There are

advantages and disadvantages to each

One of the main advantages of a fixed exchange rate is certainty. Trade and can take

place without the risk that a change in the exchange rate will suddenly raise the cost of a

transaction. Uncertainty about the exchange rate may make people less willing to trade.

But it is possible (although not costless) to insure against this by using the forward

market (i.e. buying or selling currency in advance).

Fixed exchange rates are sometimes thought to reduce speculation. If foreign exchange

dealers make „bets‟ on an exchange rate going up or down in the future then there may

be mass buying or selling, which destabilises the exchange rate. A fixed exchange rate

would not have this problem. But on the other hand if there is doubt whether the

central bank has enough resources to maintain a too-high exchange rate this may result

in a speculative attack on the currency—as happened in the UK in 1992.

Some people argue that a fixed exchange rate enforces monetary discipline. It

constrains the central bank from adopting inflationary monetary policies and it ensures

the domestic price level does not get too out of line with price abroad. But on the other

hand it can create balance of payments crises, e.g. if there is a slump in foreign

countries the central bank may have to tighten its monetary policy even though there is

unemployment at home. The key issue here is whether the major shocks that give rise to

economic fluctuations originate in the domestic economy or abroad.

Should Britain join the Euro?

Joining the Euro is an extreme case of fixed exchange rates. It involves giving up

national currencies and adopting a common currency. Having a common currency

means having a common central bank; in the case of the Euro area the ECB.

Britain had planned to join the Euro. One reason was to reap the gains in trade that

would stem from having a common European market with no exchange rate barriers.

(Also fears that the financial centre of Europe would switch from London to Frankfurt).

Some people have pointed out that this does not mean no exchange rate instability—the

exchange rate against third currencies (the dollar) may become more volatile.

Some economists argued that that Britain had suffered from irresponsible monetary

policies in the 1970s and 1980s. The best way to constrain this was to link to a „strong‟

central bank (the Bundesbank, later the ECB).

The prelude to the Euro was the ERM. As we have seen, when Britain left the ERM a

new monetary policy was adopted (inflation targeting). This has worked pretty well.

From the monetary policy point of view there is now less reason to join the Euro.

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One problem for the Euro area is that the common monetary policy does not suit every

country. Before the GFC policy was too expansionary for some countries, such as

Ireland, which had a very strong economic boom. This was made worse (as in the case

of Greece) by expansionary fiscal policy. So while monetary policy may be stabilising

for the Euro area as a whole it may not be stabilising for an individual country. That

depends how closely the country‟s business cycle is correlated with the Euro area

average.

Britain suffered badly from the GFC. It adopted more aggressive policies than the

ECB—at least in the first year. Having an independent monetary policy seems to have

been an advantage. And having a floating exchange rate has allowed the pound to

depreciate, which ought to improve competitiveness and revive the economy.

I used to think that Britain would join the Euro sometime in the next decade or so. Now

I think it will not happen in my lifetime.