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 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

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 – public’s consumption activities that must be financed (homes, cars, etc.) and business demand for investment Public sector – government needs for funds

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.

Loanable Fund Market

Changes in Fiscal Policy Expansionary Fiscal Policy 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 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

Exchange Rate Effects

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

Changes in Domestic Market

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

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

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

Loanable Funds Market

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)

Foreign Exchange Market

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

Domestic Market

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

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

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 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

Loanable Funds Market

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

Foreign Exchange Market

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

Domestic Market

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

Loanable Funds Market

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

Foreign Exchange Market

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

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 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

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

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

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

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

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.

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 country’s external balances Effects on external balance is extreme strong, affecting economy’s tradable goods sector

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

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

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

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