Session 23 Internal and External Balance with Fixed Exchange Rates

Benefits of Fixed Rate Helps reduce Inflation Helps reduce uncertainty For example, if a firm is exporting to the US, a rapid appreciation in the domestic currency would make its exports uncompetitive and therefore may go out of business.

Defending against Depreciation S1 $ D$D$ Excess Demand Dollars need to be sold New Spot Rate

Defending against Appreciation S1 $ D$D$ Excess Supply Dollars need to be bought New Spot Rate

Money Supply & the Balance of Payment with Fixed Rate Government sell domestic currency There are a lot of competitions among the banks Capital flows out to other countries offering higher interest rate When income rise, people tend to buy more importing products. When price level increase, foreign customers will buy less domestic products. For a decrease in the money supply, reverse the direction of all changes.

Payments Adjustments for a Surplus Country with Fixed Rates When the domestic money is supplied, people do not need to hold money.

Expansionary Fiscal Policy & the Balance of Payment with Fixed Rate For contractionary fiscal policy, reverse the direction of all changes.

Foreigners buy more domestic currency than its need (Less domestic currency in the system) Government have to sell its own currency Foreigners buy less domestic currency than its need (More domestic currency still in the system) Government have to buy its own currency.

Employment & Fixed Exchange Rate What would happen if the scenario is different from this ? Easy fiscal policy (The government spends more budgets) Tight monetary policy by buying the domestic currency back. ( As the domestic currency is less, the interest is higher; the need to hold the money is greater.) The government achieve both full level of employment and the balance of payments

Perfect Capital Mobility This happens to a small country that cannot influence global financial markets by itself. The interest rate depends on the global interest. For FE curve, any interest rate above or below 6% will impact on the capital inflows to this country, but will not influence the domestic product. For LM curve, any interest rate above or below 6% will impact the need to hold the currency of this country, but will not influence the domestic product. The defense of fixed exchange rate will not impact on the interest and the domestic production. For IS curve, the shift of the curve has an effect on the domestic product, but no effect on the interest rate.