Economic Policy with Floating Exchange Rates Economic Policy with Floating Exchange Rates

Daniels and VanHooseEconoic Policy2 Main Topics in the Chapter: How do monetary and fiscal policy actions affect a nation’s real income under floating exchange rate? How does perfect capital mobility influence the relative effectiveness of monetary and fiscal policy actions in a small open country that permits its exchange rates to float? In a two-country setting with a floating exchange rate, to what extent can policy actions in one nation influence economic activity in the other nation?

Daniels and VanHooseEconoic Policy3 What is the basic economic efficiency trade-off faced in choosing between fixed and floating exchange rates? How does the choice between fixed and floating exchange rates depend in part on its implications for economic stability and monetary policy autonomy?

Daniels and VanHooseEconoic Policy4 What is the effect of monetary and fiscal policy on a nation under floating exchange rate. What are the advantages and disadvantages of a floating exchange rate for a nation?

Daniels and VanHooseEconoic Policy5 Ⅰ.Floating Exchange Rates and Imperfect Capital Mobility If choosing fixed ex. Rate, (1)central bank has to intervene the foreign market with exchange reserves, and (2)it has to decide to sterilize the intervention. By permitting the ex. Rate to float, central bank relieves itself from these burdens. But it will increase the potential for monetary policy actions. And the fiscal policy will lose some its potency.

Daniels and VanHooseEconoic Policy6 The Effect of Exchange-Rate Variations in the IS-LM-BP Exchange-Rate Variation and its Effect on the IS Schedule When domestic currency depreciates, the import will contract, and the export expend. This generate a rise in the nation’s autonomous expenditures at any given nominal interest rate. Thus, real income y will increase.

Daniels and VanHooseEconoic Policy7 Exchange-Rate Variations and its Effect on the BP Schedule The nation’s currency depreciates, the export will increase. It will generate an improvement in the trade balance that results in a balance-of-payments surplus at point A. This means that for the balance of payments to return to equilibrium, the nation’s real income must increase to a level such as y2, at which sufficient import spending takes place to return the trade balance to its previous level. So, we may conclude that a currency depreciation causes the BP schedule so shift to the right.

Daniels and VanHooseEconoic Policy8 The Effects of a Currency Depreciation on the IS and BP Schedules

Daniels and VanHooseEconoic Policy9 Monetary Policy under Floating Exchange Rates Interest-rate results in the increase of money stock. It causes LM to shift rightward in (a) and (b). It also causes increase of import and capital outflow and decrease of export and capital inflow. It causes domestic currency to depreciate. As a result, the IS and BP shift rightward. Finally, balance-of-payment equilibrium is reattained in (a) and (b) at point C.

Daniels and VanHooseEconoic Policy10 Fiscal Policy under Floating Exchange Rate Increase in fiscal expenditure causes initial rightward shift in the IS, which leads to increase in the nominal interest rate and real income. In (a) (low capital mobility), greater import spending more than offsets small capital inflow in causing BOP deficit. This induces domestic currency depreciate which shifts IS and BP to the right, leading to final equilibrium. In (b) (high capital mobility) larger inflows more than offsets greater imports in causing BOP surplus, which leads to appreciation of domestic currency. Appreciation of doc. currency shifts IS and BP leftward, leading to a final equilibrium.

Daniels and VanHooseEconoic Policy11 Ⅱ.Floating Ex. Rates and Perfect Capital Mibility In (a), amount of money increasing leads to rightward shift of LM, which induces a decline in the interest rate. That causes capital outflows. The resulting BOP deficit causes domestic currency to depreciate. This leads to higher export and less import. So, IS shift rightward. In (b), Increasing fiscal expenditure shift IS to rightward. The resulting rise in the interest rate induces inflows that lead to BOP surplus. This leads to doc. currency to appreciate. That leads to export decline and import increase, causing IS to return back.

Daniels and VanHooseEconoic Policy12 Real-Income Effects with Perfect Capital Mobility and Fixed Versus Flexible Exchange Rates Exchange-Rate Setting Monetary Policy Effect Fiscal Policy Effect Fixed Exchange Rate Minimum EffectMaximum Effect Flexible Exchange Rate Maximum EffectMinimum Effect

Daniels and VanHooseEconoic Policy13 Economic Policies with Perfect Capital Mobility and a Floating Exchange Rate: A Two-Country Example In Chapter 11, we talked about that one nation’s central bank intervened in the foreign exchange market to keep the rate of exchange for the two nation’s currencies fixed. Now, let’s apply that two-country example to a setting with a floating exchange rate.

Daniels and VanHooseEconoic Policy14 The Effects of a Domestic Monetary Expansion 1.The central bank increase the amount of domestic money in circulation (Fig.12-7). 2.LM’s rightward leads to the decline of domestic interest rate, which causes capital-outflows. 3.As a result, the value of domestic currency depreciates, and the value of foreign currency appreciates. 4.Domestic currency depreciation induces the nation’s IS to shift rightward. At the same time, the corresponding foreign currency appreciation induces its IS to shift leftward. 5.The resulting lower foreign real income causes domestic exports to decline, which shifts the domestic IS to the left. 6.Finally, higher domestic real income induces increased foreign exports, which shifts its IS to the right.

Daniels and VanHooseEconoic Policy15 7. The BP lines for both nations shift downward because of the simultaneous decline in nominal interest rates in both nations [In (a) and (b) ]. So. we conclude that under a floating ex. rate and perfect capital mobility, a domestic monetary expansion can have a begger-thy-neighbor effect on the foreign country. And, in Chapter 11, if the domestic monetary authority intervenes in the foreign ex. market to fix the ex. rate, then domestic monetary policy actions have no ultimate effect on either domestic or foreign real income levels or nominal interest rates in the two nation.

Daniels and VanHooseEconoic Policy16 The Effects of a Foreign Monetary Expansion The example in Figure 12-7 produces a mirror image for the foreign monetary expansion. The increase in the foreign money stock generates a decline in equilibrium nominal interest rates in both nations, a rise in equilibrium foreign real income, and a decline in equilibrium domestic real income.

Daniels and VanHooseEconoic Policy17 The Effects of a Domestic Fiscal Expansion The direct effect of a rise in domestic government expenditures shift the domestic IS in (a) to the right and the equilibrium domestic nominal interest rate rises (Fig. 12-8). This causes an inflow of financial resources. The domestic currency appreciates, and the foreign currency depreciates. This leads to the leftward of the domestic IS and the rightward of the foreign IS. R 2 =R 2 *. Conclusion: An increase in domestic fiscal expenditure results in expansions of real income levels in both nations.

Daniels and VanHooseEconoic Policy18 The Effects of a Foreign Fiscal Expansion The example in Figure 12-8 provides an mirror image for the effects of foreign fiscal expansion. The increase in foreign fiscal expansion generates the increase in equilibrium nominal interest rates and real income levels in both nations.

Daniels and VanHooseEconoic Policy19 Cross-Country Effects In Two-Country Model With Perfect Capital Mobility Exchange-Rate Setting Monetary Policy Effect Fiscal Policy Effect Fixed Exchange Rate Locomotive Effect Beggar-Thy- Neighbor Effect Flexible Exchange Rate Beggar-Thy- Neighbor Effect Locomotive Effect

Daniels and VanHooseEconoic Policy20 Ⅲ.Fixed versus Floating Ex. Rates Which is preferable: a fixed exchange rate, or a floating exchange rate? The fundamental trade-offs between fixed versus floating exchange rates cut across two dimensions: economic efficiency and economic stability.

Daniels and VanHooseEconoic Policy21 Efficiency Arguments for Fixed versus Floating Exchange Rates To evaluate whether a fixed exchange rate or a floating exchange rate may better contribute to economic efficiency, we need to contemplate the costs that a nation’s residents face. (1)Social Costs Stemming from Foreign Exchange Risks When the ex. rates float, the derivative securities have to be used to hedge against foreign exchange risks. Such hedging

Daniels and VanHooseEconoic Policy22 Activities entail expenditures of resources. For instance, banks must pay salaries to traders who possess the expertise. In addition, holding and trading derivatives exposes banks and other firms to risks, which include credit risks, market risks, operating risks, and systematic risks. All the risks are need to hedge with costs.

Daniels and VanHooseEconoic Policy23 (2) Efficiency via a Fixed Exchange Rate? If rates of exchange among currencies are fixed, then exchange-rate volatility and the related risks by definition should be significantly muted. But even in the fixed ex. rate system, people have to face the possibility of exchange-rate realignments, or changes in official target values for currency values. Consequently, there can be substantial risks arising from political instability or other factors.

Daniels and VanHooseEconoic Policy24 (3) The Pain of Realigning Between Feb. and Dec. of 1994, the peso’s value declined by more than 10 percent relative to the dollar. Then, on Dec. 21, the Mexican government unexpectedly devalued the peso. During the week following the devaluation, the peso’s value fell by a total of more than 35 percent. The U.S. investors in the peso-denominated financial assets lost one-third of the dollar value of their holdings.

Daniels and VanHooseEconoic Policy25 So, we reach the following conclusion on the efficiency merits of fixed versus floating exchange rates: There is a trade-off between the social costs incurred in hedging against foreign exchange risks in a system of floating exchange rates and the risk of experiencing unhedged losses as a result of unexpected devaluations in a system of fixed exchange rates.

Daniels and VanHooseEconoic Policy26 Stability Arguments for Fixed versus Floating Exchange Rates One potentially important consideration in choosing between fixed and floating exchange rates is economic stability, which include the stability of real income, inflation rate, and the unemployment rate. (1)Autonomous Expenditure Volatility and Fixed versus Floating Ex. Rates One possible source of real income instability is variability in aggregate autonomous expenditure, which causes changes in the equilibrium real income level, thereby resulting in changes in the position of the IS schedule.

Daniels and VanHooseEconoic Policy27 Suppose the real income in the rest of the world decline dramatically, which leads to the declines of domestic export (Fig ); This causes aggregate autonomous expenditures on domestic goods and services to decline, so IS line shifts leftward; As a result, equilibrium domestic real income declines from y1 to y2. Conclusion: Conclusion: Volatility in real income in the rest of the world results in domestic income instability.

Daniels and VanHooseEconoic Policy28 Does the choice between fixed and floating ex. rates have any bearing on domestic real income stability in the face of a decline in real income abroad? The answer is yes. Figure (a) shows that a fall in foreign real income with a fixed exchange rate causes the domestic IS schedule to shift leftward. The lower interest rate causes capital outflow, which leads to BOP deficit. The BOP deficit places downward pressure on the value of the nation’s currency. To keep ex. rate fixed, the central bank must reduce the money stock and shift the LM leftward. And the real income stay at y2.

Daniels and VanHooseEconoic Policy29 Figure (b) indicates that under a floating exchange rate, the fall in foreign real income causes domestic IS to shift leftward, which leads to the declines of interest rate, resulting in the capital outflow and depreciation of domestic currency. The domestic export increases, and the IS shift rightward and turn back again. Conclusion Conclusion: real income is more stable under a floating ex. Rate as compared with a fixed ex. Rate.

Daniels and VanHooseEconoic Policy30 (2) Financial Volatility and Fixed versus Floating Exchange Rates Consider another possible source of real income instability, which is volatility in the financial sector. Suppose people lose confidence in the bond market, and transfer bonds into money. The demand for money causes increase of equilibrium nominal interest rate, from R1 to R’ at point B (Fig (a)). At the initial level of real income, new real income-interest rate combination, at B in (b)

Daniels and VanHooseEconoic Policy31 lies above the Point A. Thus, an increase in the demand for money not stemming from a rise in real income generates an upward and leftward shift in the LM schedule. This causes equilibrium real income to decline y2 in (b). The decrease of real income induces a leftward shift in the money demand schedule in (a). The net effect is a rise in the equilibrium interest rate and a decline in equilibrium real income.

Daniels and VanHooseEconoic Policy32 The Figure provides a comparison between the real income effects of money demand variations for the two exchange-rate systems. In (a), a rise in demand for money under fixed ex. rate causes LM to shift leftward. The resulting rise in the domestic interest rate causes capital inflow. To keep the exchange rate fixed, the domestic central bank must purchase foreign assets, which leads to a rise in the domestic money stock and causes LM to shift back to the right. Real income stay at original level y1.

Daniels and VanHooseEconoic Policy33 In panel (b), the movement to B caused by demand for money under floating ex. rate, causes appreciation of domestic currency, which leads to decline in net export. Export’s decline causes IS to shift leftward. And at point C, the real income stay at a new real income level y2, which is obviously less than the original level y1. So, real income is less stable in the face of money demand variations under a floating exchange rate.

Daniels and VanHooseEconoic Policy34 (3) The Stability Trade-off 1. Variations in aggregate desired expenditures lead to real-income instability under a fixed- exchange-rate system. Permitting the exchange rate to float reduces the real-income effects of volatility in desired expenditures. 2. Variations in the demand for money contributes to real-income instability under a floating-exchange-rate system. Fixing the exchange rate reduces the real-income effects of volatility in money demand.

Daniels and VanHooseEconoic Policy35 Monetary Policy Autonomy and Fixed versus Floating Exchange Rates Monetary Policy Autonomy means the capability of a central bank to engage in monetary policy actions independent of the actions of other central banks.

Daniels and VanHooseEconoic Policy36 The Effects of an Increase in Government Spending with a Floating Exchange Rate

Daniels and VanHooseEconoic Policy37 The Effect of a Fall in the Demand for Real Money Balances on the Position of the LM Schedule