1. Fiscal and Monetary Policy Under Modern Financial Market Conditions
IMQF course in International Finance
Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson

2. Introduction
Key macroeconomic aspects of modern international financial markets:
Market determination of FX rate and capital mobility
BP disequilibrium (e.g. deficit) triggers decline in international reserves, scaling down money supply, rising interest rates with negative effects on income, which brings BP back to balance
Alternative: instead of reducing money supply, central bank can abandon fixed FX rate
Depreciation/devaluation should boost exports and discourage imports, thus bringing BP back to balance
Main topic in this chapter: role of monetary and fiscal policy in attaining external and internal equilibrium, under floating FX regime and capital mobility

3. Outline Fiscal Policy Under Floating FX regime
Monetary Policy Under Floating FX regime
Policy Under Perfect Capital Mobility
Monetary expansion
Fiscal expansion
Impossible Trinity

4. Fiscal Policy Under Floating FX regime
No capital mobility and floating FX regime
Fiscal expansion – shift of IS curve – rise in income (and imports) – trade deficit (from E to A) - …
…currency depreciation – rise in net exports (shifting BP curve to the right) and the IS curve to the right (from A to B)
BP will be shifted to the right until it reaches the IS-LM equilibrium (point B), which implies BP=0
Fiscal expansion raises income by a greater amount under floating regime than under fixed (Yb>Ya)
due to depreciation, there is a rise in net exports

5. Fiscal Policy Under Floating FX regime
Low capital mobility and floating FX regime
Fiscal expansion
shift of IS curve – rise in income (and imports) – trade deficit
shift of IS curve – rise in income – rise in money demand – increase in interest rate – inflow of capital…(from E to A)
…trade deficit smalle than under zero capital mobility, but without deprecation, BP will still be negative – making depreciation preassure – shifting IS and BP curve to the right (from A to B)
depreciation – rise in net exports – shiftin the IS and BP curves further to the right, until BP=0 is reached
When capital mobility is introduced, the BP deficit caused by fiscal expansion, before depreciation, is smaller (due to inflow of capital), which means that depreciation required to restore BP balance is smaller than under no capital mobility
shift from A to B, at Figure (b) is smaller than shift from A to B under Figure (a)

6. Fiscal Policy Under Floating
High capital mobility and floating FX regime
Fiscal expansion
shift of IS curve – rise in income (and imports) – trade deficit …- depreciation – rise in net exports…
shift of IS curve – rise in income – rise in money demand – increase in interest rate – inflow of capital…(from E to A)
Country is in BP surplus position, causing appreciation, decline in net exports and income

7. Fiscal Policy Under Floating
Effects of the US Budget Deficit
In Reagan introduced fiscal stimulus program (tax cuts and rise in defense spending)
Increase in structural fiscal deficit by 3 pp
No accomodating monetary policy
Fed was running restrictive monetary policy, to combat inflation
Rise in interest rates by 2-5 percent ( )
From 1982 Fed started to ease monetary policy, causing decline in nominal interest rates, but as inflation expectations declined fast, which is why the real interest rates remained high
High interest rates cause large inflow of capital
…triggering strong appreciation of USD to basket of currencies, by 58% ( )
Strong rise in trade deficit (imports) – peaked in 1987 (J-curve effect)
Summary of effects of fiscal expansion under floating:
Crowding out investment and spending via higher interest rates
Crowding out net exports, via currency appreciation

8. Fiscal Policy Under Floating
Effects of US Budget Deficit
National saving identity:
Fiscal expansion implies decline in government saving, which needs to be reflected, either into decline in investments or decline in the current account balance
In the US in 1980s, national savings declined by 5% of GDP reflecting in decline in investments by 3% of GDP and CA by 2% of GDP
Twin deficit: current account and budget deficit
If fiscal expansion triggers rise in imports, it means that part of the local budget deficit is financed from abroad
In 1990s government tackled the budget deficit, but current account deficit reached new highs
Due to strong boom of the economy, fueled by private demand (shift of IS curve to the right: financed by soaring wealth in the stock market and the boom of IT industry)
As investments rose more rapidly than national savings, CA has widened (US was borrowing from abroad to finance private sector deficit)
If there was no capital mobility, trade deficit would not deteriorate so much, but interest rates would rise more, thus crowding out investments (the effect would be redistributed from net exports to investments)

9. Monetary Policy Under Floating: Effect Enhanced by Capital Mobility
MONETARY EXPANSION UNDER ZERO CAPITAL MOBILITY
Monetary expansion (LM-LM’) – rise in money supply – rise in income (imports) – trade deficit – depreciation – rise in net exports (shift in IS and BP line to the right) – rise in income
Effects: rise in income larger than under fixed FX

10. Monetary Policy Under Floating: Effect Enhanced by Capital Mobility
MONETARY EXPANSION UNDER LOW CAPITAL MOBILITY
Monetary expansion (LM-LM’) – rise in money supply – rise in income (imports) – trade deficit – fall in interest rates (capital outflow) – larger deficit of the BP – larger depreciation to restore BP=0 – larger rise in net exports (shift in IS and BP line to the right)
Effects: rise in income larger than under zero capital mobility (capital mobility enhances effectivennes of monetary policy: both domestic and foreign demand rise, due to fall in i.r. and depreciation)

11. Monetary Policy Under Floating: Effect Enhanced by Capital Mobility
MONETARY EXPANSION UNDER HIGH CAPITAL MOBILITY
Monetary expansion (LM-LM’) – rise in money supply – rise in income (imports) – trade deficit – fall in interest rates (capital outflow) – even larger deficit of the BP – even larger depreciation to restore BP=0 – even larger rise in net exports (shift in IS and BP line to the right)
Effects: rise in income larger than under low capital mobility (more of a stimulus comes from net export than from domestic demand, due to capital mobility)

12. Monetary Policy Under Floating: Effect Enhanced by Capital Mobility
General result: effectiveness of monetary policy at changing output is enhanced the greater the degree of capital mobility
Under monetary approach to the BP with fixed FX rate, credit expansion flows out through the BP much faster (via TB and decline in reserves)
Capital mobility (outflow) due to decline in interest rates, makes required depreciation large, thus making significant stimulus for net exports and rise in income
Result for monetary policy different from the result for fiscal policy
Monetary policy lowers the interest rate causing capital outflow. Under fixed FX rate capital outflow would be contractionary for output, but under floating FX rate it triggers depreciation and rise in income
Fiscal expansion raises interest rate and causes capital inflow. Under fixed FX rate capital inflow would be further expansionary for output, but under floating FX rate it triggers appreciation and decline in income

13. Monetary Policy Under Floating: Effect Enhanced by Capital Mobility
EXAMPLES OF POWERFUL MONETARY CONTRACTIONS
USA 1980s: high inflation at the end of 70s curbed by tightening monetary policy
Rise in interest rates – drop in investments and employment – decline in inflation – recession
Decline in inflation and recession were deeper than expected due to strong appreciation of USD, caused by inflow of capital due high interest rates: recession born by FX-sensitive industries and interest-rate-sensitive industries
Expansion began in 1983, based on fiscal stimuli (interest rates remained high) – net plicy change in 1985 vs 1980 was neither contraction nor expansion – only the mix changed – in 1985 interest rates and value of dollar were high, which is why GDP growth was driven by C and G, at the expense of I and NX
UK in the 1980s: tightened monetary policy (and increase in North Sea oil wealth) triggered strong appreciation of GBP, thus harming competetivennes of exports oriented sector (rise in unemployment and deindustrialization)
Floating FX rate enhanced the effects of monetary policy, as inflow of capital made the appreciation larger (in this case – for worse, as it was a monetary contraction)
Japan in the end of 1980s: monetary expansion and strong intervention at the FX market (purchase of USD) created a financial bubble (strong growth and soaring prices of assets and real estate)
In 1990s central bank reverted to monetary contraction (rise in interest rates) – financial bubble was bursted, but higher interest rates attracted capital, causing appreciation of Yen and recession

14. Policy Under Perfect Capital Mobility
In industrialized countris capital mobility is very high – infinitely high?
Free flow of capital in the EU
If k is infinitely high, the BP curve has zero slope (m/k), at the level equal to the home country interest rate i
If i was higher than i*, a bunch of capital would flow in, thus pushing i down, and restoring zero differential of the interest rates

15. Policy Under Perfect Capital Mobility
FISCAL EXPANSION
FIXED FX: Fiscal expansion (shifting IS to the right) – rise in demand for money – rise in interest rates – rise in spending – rise in income (point A)
Rise in interest rates causes huge inflow of capital
If central bank wants to keep fixed FX regime, it must abandon money supply target: inflow of capital makes money supply swelling – shifting the LM curve to the right
It must be shifted sufficiently to the right – causing large decline in interest rates, to restore BP=0 (point B)

16. Policy Under Perfect Capital Mobility
MONETARY EXPANSION
FIXED FX: Monetary expansion (shifting LM to the right) – rise in money supply – decline interest rates – rise in spending/investments – rise in income (point A)
Decline in interest rates causes huge outflow of capital
If central bank wants to keep fixed FX regime, it must abandon money supply target: outflow of capital makes money supply sinking – shifting the LM curve back to the left
As outflow of capital is unlimited, central bank cannot sterilize

17. Policy Under Perfect Capital Mobility
IMPOSSIBLE TRINITY AND THE EMU
Impossible trinity of economic integration:
fixed FX rate, financial openness and monetary independence
In 1979 EEC member states started coordinating their FX rates in order to stabilize it, at the same time removing capital controls
This has put the EEC countries to category (c) – monetary policy becoming powerless
In 1991 an EC summit meeting in Maastricht, affirmed the creation of EEMU, that should lead to adoption of the single currency (by 1999)
German Bundesbank kept the interest rate high, in order to curb inflation (caused by fiscal expansion after reunification) – which was not preferred choice of other slow growing economies
Strong opposition to high interest rates in some countries – in Denmark adoption of Euro was rejected at the referendum, the same outcome becoming possible in France
Italy and UK left Exchange Rate Mechanism – shift to floating FX regime, while France widened its bands to 15%
Illustration of impossible trinity: only the Netherlands was ready to give up monetary sovereignity, Italy and UK gave up the fixed FX rates, while Spain reinforced capital conrols…

18. Policy Under Perfect Capital Mobility
FLOATING FX: Fiscal expansion (shifting IS to the right) – rise in demand for money – rise in interest rates – rise in spending – rise in income (point A)
Rise in interest rates causes huge inflow of capital – appreciation – decline in net exports – return to initial equlibrium
Fiscal expansion with perfect capital mobility is more effective under fixed FX regime at boosting income, than under floating FX
GDP does not rise due to fiscal expansion, but its componsition is changed: decline in the share of net export and rise in the share of C and/or G (depending whether fiscal expansion was in the form of tax cuts or rise in spending)

19. Policy Under Perfect Capital Mobility
FLOATING FX: Monetary expansion (shifting LM to the right) – rise in money supply – decline in interest rates – rise in spending/investments – rise in income (point A)
Decline in interest rates causes huge outflow of capital – depreciation – rise in net exports (shift IS curve to the right) – return to BP=0 at higher level of income
Monetary expansion with perfect capital mobility is more effective under floating FX regime at boosting income, than under fixed FX
Its more poweful compare to partial capital mobility, too
Perfect capital mobility prevents interest rate differential (IS curve alone determines the level of income)

20. Policy Under Perfect Capital Mobility
Under perfect capital mobility, change in FX rate must be very large, to generate the necessary increase in income, especially in the short run when the trade elasticities are low
Monetary expansion works entirely via international sector (decline in interest rate triggers outflow of capital, rising net exports)…no effect on domestic investment
To sum up the effects of fiscal and monetary policy under perfect capital mobility:
Fixed FX rate: fiscal policy efficient, monetary policy powerless
Floating FX: fiscal policy powerless, monetary policy efficient
Investors account for interest rate in local currency, considering also the expected changes in the FX rate
This is why the interest rate differential still existis (e.g. between EMU and USA)
Some stimulus to output can come from domestic demand
FX rate does not have to move quite as far as previously thought