26-1 Economic Policy in the Open Economy Under Flexible Exchange Rates Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter 26

26-2 Learning Objectives Analyze the impact of fiscal policy on income, trade, and exchange rates under flexible exchange rates. Analyze the impact of monetary policy on income, trade, and exchange rates under flexible exchange rates. Show how external economic shocks affect the domestic economy under flexible exchange rates.

26-3 Introduction The effectiveness of monetary and fiscal policies at influencing national income differ dramatically under fixed and flexible exchange rate systems. Do flexible exchange rate systems make countries more vulnerable to external shocks such as the recent global recession?

26-4 The Effects of Fiscal and Monetary Policy Under Flexible Exchange Rates Under a flexible exchange rate system, combinations of income and interest rates not on the BP curve will cause disequilibrium in foreign exchange markets, and force an adjustment in the exchange rate. This will cause the BP curve to shift.

26-5 The Effects of a Currency Depreciation on the BP Curve Y i BP 0 A depreciation expands exports and contracts imports. For any given level of Y, a lower i is required to balance the BOP. BP 1

26-6 The Effects of a Currency Appreciation on the BP Curve Y i BP 0 An appreciation contracts exports and expands imports. For any given level of Y, a higher i is required to balance the BOP. BP 1

26-7 Fiscal Policy Under Flexible Exchange Rates – W ith perfect capital immobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP deficit, causing a depreciation and a rightward shift of the BP curve. – The depreciation increases exports, decreases imports, and shifts IS even farther rightwards. – This continues until IS, LM, and BP intersect at a common point.

26-8 Fiscal Policy Under Flexible Exchange Rates income i BP 0 IS LM i0i0 Y0Y0 IS' Perfect capital immobility BP 1 IS '' i3i3 Y2Y2

26-9 Fiscal Policy Under Flexible Exchange Rates – W ith perfect capital mobility, any fiscal stimulus increases Y and i. – This creates an incipient BOP surplus, causing an appreciation of the currency. – The appreciation decreases exports, increases imports, and shifts IS back to the left.

26-10 Fiscal Policy Under Flexible Exchange Rates income i BP IS LM iEiE Y0Y0 IS' Perfect capital mobility

26-11 Fiscal Policy Under Flexible Exchange Rates – The bottom line: When capital is relatively immobile, fiscal policy is more effective at increasing national income. When capital is relatively mobile, fiscal policy is less effective at increasing national income. Between these two extremes, the effect on the exchange rate depends on the relative slopes of LM and BP. – BP steeper than LM: depreciation – LM steeper than BP: appreciation

26-12 Monetary Policy Under Flexible Exchange Rates – W ith perfect capital immobility, a monetary stimulus increases Y, and the increase in imports causes an incipient BOP deficit to emerge. – As currency depreciates, BP shifts rightward. – Depreciation also shifts IS rightwards.

26-13 Monetary Policy Under Flexible Exchange Rates income i BP IS LM Ei0i0 Y0Y0 LM' Perfect capital immobility BP' IS' i2i2 Y2Y2

26-14 Monetary Policy Under Flexible Exchange Rates – W ith perfect capital mobility, any monetary stimulus increases Y. – This generates a large capital outflow and a depreciation of the home currency. – The depreciation causes IS to shift outwards.

26-15 Monetary Policy Under Flexible Exchange Rates income i BP IS LM iEiE Y0Y0 LM' Perfect capital mobility IS' Y2Y2

26-16 Monetary Policy Under Flexible Exchange Rates – The bottom line: When capital is relatively immobile, monetary policy is effective at increasing national income. When capital is relatively mobile, monetary policy is particularly effective at increasing national income.

26-17 Policy Coordination Under Flexible Exchange Rates – Coordination of fiscal and monetary policy may make the attainment of other targets besides income possible. – Examples of alternative targets include interest rates and exchange rates. – Consider an income and interest rate target of Y* and i*as an example.

26-18 Policy Coordination Under Flexible Exchange Rates – If fiscal policy alone is used to reach Y*, it is likely that the interest rate will overshoot the target of i*. – In addition, the fiscal policy creates an incipient BOP surplus, appreciating the currency, and shifting BP back to the left. – The depreciation also shifts IS part of the way back to the left. – In the end, neither target is reached.

26-19 Policy Coordination: Fiscal Policy Alone LM BP 0 IS Y0Y0 i0i0 IS FP Y*Y* i*i* i Y* BP FP IS' FP Y FP i FP

26-20 Policy Coordination Under Flexible Exchange Rates – If monetary policy alone is used to reach Y*, the increase in Ms will cause a currency depreciation, and a rightward shift in BP. – In addition, the monetary policy shifts IS rightwards. – In the end, neither target is reached.

26-21 Policy Coordination: Monetary Policy Alone LM BP' IS Y0Y0 Y*Y* BP IS' Y' LM' i' i Y i0i0 i*

26-22 Policy Coordination Under Flexible Exchange Rates – If monetary and fiscal policies are used, both i* and Y* can be attained. – Expansionary fiscal policy allows Y to increase without the expenditure switching effects.

26-23 Policy Coordination: Monetary Policy Alone LM IS Y0Y0 Y*Y* BP IS' LM' i0i0 i Y i*

26-24 Effects of Shocks in the IS/LM/BP Model (Imperfect K-Mobility) – So far, we’ve examined the effects of fiscal and monetary policy holding a number of factors constant, including domestic and foreign prices, foreign interest rate, and expected exchange rate changes. – How are changes in such variables (“shocks”) transmitted through the economy?

26-25 Effects of Shocks: A Foreign Price Shock – If the foreign price level were to increase, the home economy would expand due to increases in exports and decreases in imports (IS shifts right). – The BP also shifts right due to expenditure switching effects of higher foreign prices. – Both effects cause i to rise, and the currency to appreciate. – These shift IS and BP back to where they started.

26-26 Foreign Price Shock LM IS Y0Y0 BP IS' i0i0 i Y BP'

26-27 Foreign Price Shock LM IS Y0Y0 BP IS' i0i0 i Y BP'

26-28 Foreign Price Shock LM IS Y0Y0 BP i0i0 i Y

26-29 Effects of Shocks: A Domestic Price Shock – If the domestic price level were to increase, the real money supply would fall, shifting LM leftwards. – Exports will fall and imports rise, so IS shifts leftwards. – The BP curve will also shift left in order to bring the BOP back into equilibrium.

26-30 Domestic Price Shock LM IS Y0Y0 BP i0i0 i Y LM' IS' BP' i1i1 Y1Y1

26-31 Effects of Shocks: A Foreign Interest Rate Shock – If the foreign interest rate were to increase, the home country should experience an outflow of short-term capita; BP shifts leftwards. – The home currency depreciates. – This shifts the IS curve rightward, and the BP curve back toward the right.

26-32 Foreign Interest Rate Shock LM IS Y0Y0 BP i0i0 i Y IS' BP'

26-33 Foreign Interest Rate Shock LM IS Y0Y0 BP i0i0 i Y IS' BP' BP'' Y1Y1 i1i1