ECON3315 International Economic Issues Instructor: Patrick M. Crowley Issue 17: The Macroeconomics of Exchange rates

Overview Intro Intro Flexible exchange rates Flexible exchange rates Fixed exchange rates Fixed exchange rates Which is better? Which is better?

Intro: macro effects  Exchange rate regimes have implications for macroeconomic policy  To see these implications we look at implications for flexible exchange rates on macro variables and then for fixed exchange rates on macro variables  Then we can deduce what will happen if we use fiscal or monetary policy under each of these “extreme” cases of exchange rate policy  This is sometimes known as the “Mundell-Fleming model”  Basic result is that monetary policy is more effective with flexible exchange rates, but fiscal policy less effective, and monetary policy is less effective but fiscal policy more effective under fixed exchange rates

Aside: the J-curve Exports and imports can be thought of as a combination of prices and quantities, just like any revenue stream X = p X q X and M = p M q M But when exchange rates change, p X changes for foreigners immediately – but does q X ? Answer is no, takes time. Similar logic for M – here prices change immediately, but quantities change over time. Result is that when US$ depreciates, TB worsens before it improves….

Aside: the J-curve When US$ depreciates, in short run TB and CA will worsen, but in the medium and long run TB will improve, so GDP will increase…. When US$ depreciates, in short run TB and CA will worsen, but in the medium and long run TB will improve, so GDP will increase…. Q: How long does this take to occur? Q: How long does this take to occur? A: Depends on i) long term contracts and ii) how sensitive quantities are to price changes A: Depends on i) long term contracts and ii) how sensitive quantities are to price changes Most economists think about 6 to 12 months…. Most economists think about 6 to 12 months….

Flexible exchange rates Monetary policy If money supply goes up, nominal interest rates fall If money supply goes up, nominal interest rates fall Through interest parity this causes exchange rate to depreciate. Through interest parity this causes exchange rate to depreciate. This causes the trade balance to improve, increasing real GDP, so Y goes up. This causes the trade balance to improve, increasing real GDP, so Y goes up. Obviously vice-versa if money supply falls. Obviously vice-versa if money supply falls. Fiscal policy If G goes up then Y goes up. If G goes up then Y goes up. But through crowding out(?) interest rates increase. But through crowding out(?) interest rates increase. As interest rates increases this causes the exchange rate to appreciate As interest rates increases this causes the exchange rate to appreciate This causes the trade balance to deteriorate, reducing Y. This causes the trade balance to deteriorate, reducing Y. Could potentially completely offset original increase in G. Could potentially completely offset original increase in G.

Fixed exchange rates Monetary policy If money supply goes up, nominal interest rates fall If money supply goes up, nominal interest rates fall But interest rates cannot fall otherwise exchange rate will depreciate. But interest rates cannot fall otherwise exchange rate will depreciate. So if so, central bank has to buy up domestic currency which automatically reduces money supply! So if so, central bank has to buy up domestic currency which automatically reduces money supply! No effect on Y No effect on Y Fiscal policy If G goes up then Y goes up. If G goes up then Y goes up. But through crowding out(?) interest rates increase. But through crowding out(?) interest rates increase. As interest rates increase currency will start to appreciate As interest rates increase currency will start to appreciate But this can’t happen – so government sells domestic currency to increase supply But this can’t happen – so government sells domestic currency to increase supply This causes the money supply to increase. This causes the money supply to increase. This increases Y. This increases Y.

Fixed or flexible: which is better? From Mundell-Fleming model, flexible exchange rates are better for monetary policy, but fixed exchange rates are better for fiscal policy. Many developing countries have problems in making their central bank monetary policy credible, so that is why many of them choose more fixity in their exchange rates. Just recently IMF told CEECs to fix to the euro to avoid further collapse in their exchange rates – and that way to “import credibility” from the euro area….good example of how fixed exchange rates can help!!!