Macroeconomic Policy and Floating Exchange Rates

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Macroeconomic Policy and Floating Exchange Rates
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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

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

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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
  countrys 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

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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

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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
  countrys domestic financial markets

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Changes in Fiscal Policy

• 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

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Changes in Fiscal Policy

• Expansionary Fiscal Policy
• Can show graphically the effects of this policy
  on the economy
• Demand for loanable funds - total demand for
  loans in the economy which is indirectly related
  to interest rate
• Private sector publics consumption activities
  that must be financed (homes, cars, etc.) and
  business demand for investment
• Public sector government needs for funds

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Changes in Fiscal Policy

• Expansionary Fiscal Policy
• 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
• Balanced budget demand of loanable funds equals
  supply at equilibrium interest rate ie.

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Loanable Fund Market
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Changes in Fiscal Policy

• Expansionary Fiscal Policy
• Governments 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 Sf)
• Interest rate decreases back to ie
• Expansionary policy puts less upward pressure on
  interest rates in an open economy

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Changes in Loanable Funds
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Changes in Fiscal Policy

• 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

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Exchange Rate Effects
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Changes in Fiscal Policy

• 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

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Changes in Domestic Market
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Changes in Fiscal Policy

• 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

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Changes in Fiscal Policy

• Contractionary Fiscal Policy
• Combination of higher taxes and/or lower
  government spending
• Reduces government budget deficit (increases size
  of surplus)

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Changes in Fiscal Policy

• 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

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Loanable Funds Market
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Changes in Fiscal Policy

• 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)

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Foreign Exchange Market
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Changes in Fiscal Policy

• 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

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Domestic Market
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Changes in Fiscal Policy

• 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

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Changes in Fiscal Policy

• 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

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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 economys short run performance
• Some increased interest in a monetary rule
  instead of discretionary policy

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Changes in Monetary Policy

• 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

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Loanable Funds Market
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Changes in Monetary Policy

• 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

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Foreign Exchange Market
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Changes in Monetary Policy

• 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

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Domestic Market
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Changes in Monetary Policy

• 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

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Loanable Funds Market
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Changes in Monetary Policy

• Contractionary Monetary Policy Effects on
  exchange rate
• Capital inflow increases supply of foreign
  exchange
• Currency appreciates
• Capital account surplus
• Current account deficit difference between X
  and M

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Foreign Exchange Market
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Changes in Monetary Policy

• Contractionary Monetary Policy 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

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Changes in Monetary Policy
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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

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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

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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

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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

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Policy in Open Economy
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Policy in Open Economy

• 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

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Policy in Open Economy

• 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

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Effects of Policy Mix - Expansionary
Yd P XR CA
Expansionary Fiscal Direct
Indirect
Expansionary Monetary Direct
Indirect
Net Effect
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Policy in Open Economy

• 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

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Effects of Policy Mix - Contractionary
Yd P XR CA
Contractionary Fiscal Direct
Indirect
Contractionary Monetary Direct
Indirect
Net Effect
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Policy in Open Economy

• 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.

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Policy in Open Economy

• 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 countrys external balances
• Effects on external balance is extreme strong,
  affecting economys tradable goods sector

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Policy in Open Economy

• 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

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Trade Flow Adjustment Current Account Dynamics

• 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

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Trade Flow Adjustment Current Account Dynamics

• 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

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Trade Flow Adjustment Current Account Dynamics

• In long run, as countrys currency depreciates,
  its export expand and imports contract (and vice
  versa)
• In short run, as countrys currency exchange rate
  changes, response of exports and imports and
  current account balance could be easily in
  opposite direction

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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

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Trade Flow Adjustment Current Account Dynamics

• J-Curve
• Effect on countrys 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

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J-Curve