International Political Economy

1
International Political Economy
2
International Imbalance

• Lesson 4
• Section 4.1

3

• Balance of payments surpluses and deficits mean
  the international sector of our economy is in
  disequilibrium.
• The importance of the balance of payments is that
  it measures imbalance in our international
  sector, thereby pointing to economic forces for
  change.
• So is necessary to identify these forces and how
  they bring about change.

4

• Monetary and fiscal policies are shocks to the
  economy that affect many economic variables, such
  as income, interest rates, and prices.
• Changes in these variables create imbalances in
  the international sector, which in turn set in
  motion forces that modify the impact of these
  policies on the economy
• Is necessary to examine how our earlier
  discussions of monetary and fiscal policies must
  be adjusted to recognize the influence of forces
  generated through the international sector of the
  economy
• The recent increase in the openness of the world
  requires that macroeconomic analysis pay more
  attention to these forces.

5
Interest rate
Fiscal policy
Monetary policy
Income
Price level
International imbalance
Deficit
Surplus
6

• Exactly what are the forces for change that an
  imbalance in the balance of payments engenders?
• This is a crucial question, the answer to which
  depends on whether the economy is operating on a
  flexible or a fixed exchange rate system

7
Fiscal policy Monetary policy
Flexible exchange rate Effective Effective
Flexible exchange rate Ineffective Ineffective
Fixed exchange rate Effective Effective
Fixed exchange rate Ineffective Ineffective
8
International Imbalance with flexible exchange
rate

• Lesson 4
• Session 4.2

9
Domestic currency Demand gt supply
Export gt Import
BoP surplus
Exchange rate increase
BoP balance
Exchange rate decrease
BoP deficit
Export lt Import
Domestic currency Demand lt supply
10
BoP surplus
Exchange rate
Domestic currency demand
Domestic currency supply
P
P1
Domestic currency
S1
D1
11
BoP deficit
Exchange rate
Domestic currency demand
Domestic currency supply
P2
P
Domestic currency
D2
S2
12

• Under a flexible exchange rate system, the
  government allows the forces of supply and demand
  to determine the exchange rate.
• If there is a balance of payments surplus, demand
  for our currency on the foreign exchange market
  exceeds its supply, so market forces cause a rise
  in the value of our currency.
• Those who want the extra, unavailable dollars try
  to obtain them by offering extra foreign currency
  for them, so our currency becomes more valuable
  in terms of foreign currency
• This process operates in reverse if there is a
  balance of payments deficit.
• In this case, the demand for our currency on the
  foreign exchange market is less than its supply,
  so market forces cause a fall in its value

13

• Note that under a flexible exchange rate system,
  any tendency toward a balance of payments surplus
  or deficit is automatically and instantaneously
  eliminated by a flexing of the exchange rate, so
  that our measure of the imbalance (the balance of
  payments) is always zero.
• The balance of payments measure is nonzero only
  if the government engages in some net buying or
  selling of foreign currency.
• In the context of a flexible exchange rate, the
  terminology "balance of payments surplus or
  deficit" must be interpreted as reflecting a
  surplus or deficit that would appear if the
  exchange rate were not permitted to adjust
  instantaneously.

14

• Under a flexible exchange rate, therefore, the
  initial reaction of the economy to an imbalance
  in the balance of payments is a change in the
  exchange rate, which in turn creates additional
  forces for change in the economy.
• If, with other variables constant, the exchange
  rate rises, demand for our exports falls because
  foreigners find our exports more expensive in
  terms of their currency.
• Furthermore, imports become cheaper to us
  (because our currency now buys more foreign
  exchange), so there is a fall in demand for
  domestically produced goods and services that
  compete with imports.
• Both phenomena imply that aggregate demand for
  domestically produced goods and services falls
• Similarly, if the exchange rate falls, demand for
  exports and import-competing goods and services
  should be stimulated, implying a rise in demand
  for domestically produced goods and services

15

• To summarize, if the economy has a flexible
  exchange rate, an imbalance in the international
  sector of the economy, measured by the balance of
  payments, automatically causes the exchange rate
  to change
• This change in turn causes the import-competing
  and export sectors of the economy to adjust, thus
  affecting aggregate demand for goods and services

16
Flexible Exchange Rate
Imbalance
BoP deficit
BoP surplus
Exchange rate increase
Exchange rate decrease
Import increase
Export decrease
Export increase
Import decrease
BoP0
17
International Imbalance With a Fixed Exchange Rate

• Lesson 4
• Section 4.3

18
BoP surplus
Exchange rate
Domestic currency demand
Domestic currency supply
Pcb
Domestic currency
D1
S1
19
BoP deficit
Exchange rate
Domestic currency demand
Domestic currency supply
Pcb
Domestic currency
S1
D1
20

• Under a fixed exchange rate system, the
  government does not allow the forces of supply
  and demand to determine the exchange rate.
• Instead, the government fixes the exchange rate
  at what it believes is the "right" rate, and the
  central bank, armed with a stockpile of foreign
  exchange reserves, stands ready to buy or sell
  foreign currency at that rate.
• If there is a balance of payments surplus, the
  demand for our currency by foreigners is greater
  than the supply, so some of these foreigners will
  seek extra, unavailable domestic currency.
• Under a flexible exchange rate, they would have
  to get our currency by offering more foreign
  exchange, but under a fixed exchange rate this
  higher cost can be avoided because the Central
  Bank will exchange their foreign currency for
  domestic currency at the fixed rate

21

• When the Central Bank does so, it takes the extra
  foreign exchange currency and in return provides
  domestic currency.
• The most important implication of this process is
  that the domestic money supply increases by the
  increase in domestic currency times the money
  multiplier
• When there is a balance of payments deficit, the
  opposite occurs.
• We are supplying more domestic currency on the
  foreign exchange market (seeking foreign currency
  to take vacations abroad, for example) than there
  is foreign demand for domestic currency, so those
  of us unable to obtain foreign currency from
  foreigners go to the Central Bank to buy foreign
  exchange at the fixed rate.
• To buy the foreign currency we give the Central
  Bank currency, removing them from public
  circulation and thereby decreasing the domestic
  money supply.

22

• To summarize, if the economy has a fixed exchange
  rate, an imbalance in the international sector of
  the economy, measured by the balance of payments,
  automatically causes the money supply to change,
  in turn affecting economic activity.

23

• Armed with these two general resultsthat
  international imbalance causes exchange-rate
  changes under a flexible exchange rate system and
  money-supply changes under a fixed exchange rate
  systemwe can examine how monetary and fiscal
  policy are affected by repercussions from the
  international sector.
• To maintain simplicity, all analysis ignores
  price-level changes and inflation. Incorporating
  them would not change the general results, only
  the breakdown of nominal income changes into real
  changes and price changes.

24
Fiscal Policy Under Flexible Exchange
Rates

• Lesson 4
• Section 4.4

25

• An increase in government spending leads to an
  increase in income and an accompanying increase
  in the interest rate, causing some crowding out.
• The increase in income increases imports,
  creating a balance of payments deficit, but the
  increase in the interest rate causes capital
  inflows, creating a balance of payments surplus.
• Which will dominate?
• The consensus among economists on this empirical
  question is that the latter will outweigh the
  former.
• Because of the high mobility of international
  capital, a slight increase in our interest rate
  causes a substantial capital inflow, outweighing
  the impact on the balance of payments of the
  accompanying rise in imports.

26

• Once this empirical question is settled, it is
  easy to see how international forces modify the
  impact of fiscal policy.
• Under a flexible exchange rate system, the
  balance of payments surplus created by a
  stimulating dose of fiscal policy causes the
  exchange rate to appreciate.
• This increase decreases exportsdirectly
  decreasing demand for domestically produced goods
  and services.
• It also in creases imports, thereby decreasing
  demand for domestically produced goods and
  services that compete against imports.
• The decrease in aggregate demand for domestically
  produced goods and services partially offsets the
  impact on the economy of the stimulating dose of
  fiscal policy, decreasing the strength of fiscal
  policy in affecting the income level

27
Fiscal Policy Under Fixed Exchange Rates

• Lesson 4
• Session 4.5

28

• When the exchange rate is fixed, the balance of
  payments surplus created by a stimulating dose of
  fiscal policy does not cause the exchange rate to
  rise.
• Instead, it causes an increase in the money
  supply as the central bank buys foreign currency
  (the balance of payments surplus) with domestic
  currency.
• This increase in the money supply augments the
  stimulating effect of the policy dose, making
  fiscal policy stronger in affecting the income
  level.

29
Reaction to Fiscal Policy This flowchart shows the
 reaction of the economy to an increase in governm
ent spending under both flexible and exchange rate
 systems (source Kennedy 1999).
30
Monetary Policy Under Flexible Exchange
Rates

• Lesson 4
• Section 4.6

31

• An increase in the money supply lowers the
  interest rate, and the lower interest rate
  stimulates aggregate demand and moves the economy
  to a higher level of income.
• This rise in income increases imports, creating a
  balance of payments deficit, and the fall in the
  interest rate reduces capital inflows, thus
  augmenting this balance of payments deficit.

32

• Under a flexible exchange rate system, the
  balance of payments deficit causes the exchange
  rate to depreciate.
• This lower exchange rate increases
  exportsdirectly increasing demand for
  domestically produced goods and services. It also
  decreases importsincreasing demand for
  domestically produced goods and services that
  compete against imports.
• The rise in aggregate demand for domestically
  produced goods and services augments the impact
  on the economy of the stimulating dose of
  monetary policy, thus giving greater strength to
  monetary policy in affecting the income level

33
Reaction to Monetary Policy This flowchart shows t
he reaction of the economy to an increase in money
 supply under both flexible and fixed exchange rat
e systems (source Kennedy 1999).
34
Monetary Policy Under Fixed Exchange
Rates

• Lesson 4
• Section 4.7

35

• When the exchange rate is fixed, the balance of
  payments deficit created by a stimulating dose of
  monetary policy does not cause the exchange rate
  to fall.
• Instead, it causes a decrease in the money supply
  as the Central Bank buys domestic currency with
  foreign exchange to prevent the balance of
  payments deficit from lowering the exchange rate.
  
• The decrease in the money supply diminishes the
  stimulating effect of the policy dose, making
  monetary policy weaker in affecting the income
  level

36

• There is more to this story however.
• An increase in the money supply created the
  balance of payments deficit, and an automatic
  decrease in the money supply is decreasing the
  deficit.
• Consequently, only when the original money supply
  increase has been completely wiped out will the
  deficit be eliminated.
• The economy will regain equilibrium back where it
  started, so the end result of this monetary
  policy is no change.
• This reflects an extremely important general
  result
• under a fixed exchange rate, monetary policy is
  completely ineffective as a policy tool.
• Monetary policy implicitly is being used to fix
  the exchange rate, so is not available for other
  purposes

37
Fiscal policy Monetary policy
Flexible exchange rate Effective Effective
Flexible exchange rate Ineffective Ineffective
Fixed exchange rate Effective Effective
Fixed exchange rate Ineffective Ineffective
38
Sterilization Policy

• Lesson 4
• Session 4.8

39

• Monetary policy in the context of a fixed
  exchange rate is ineffective because an
  expansionary monetary policy creates a balance of
  payments deficit, which automatically decreases
  the money supply, offsetting and eventually
  eliminating the original increase in the money
  supply.
• What if, however, the monetary authorities take
  monetary action to counteract the automatic
  change in the money supply, allowing the original
  monetary dose to be maintained?
• As the money supply decreases automatically in
  the preceding example, the monetary authorities
  could annually increase the money supply by
  exactly the same amount
• This policy is called a sterilization policy
  because it "sterilizes" the automatic
  money-supply change that results from an
  imbalance in international payments under fixed
  exchange rates.
• Pursuing this policy maintains the original
  monetary policy dose and allows monetary policy
  to retain its effectiveness

40

• Unfortunately, there is a catch
• the sterilization policy maintains the imbalance
  in international payments.
• In the example, the balance of payments deficit,
  which would normally disappear as it
  automatically decreased the money supply, now
  persists as this automatic mechanism is
  "sterilized."
• What are the implications of of a continuing
  balance of payments deficit?

41

• Consider how the government, through its agent
  the central bank, deals with the balance of
  payments deficit.
• The deficit means that the supply of dollars on
  the foreign exchange market exceeds the demand,
  so those unable to obtain foreign exchange for
  their currency go to the government to exchange
  them at the fixed rate.

42

• The government sells foreign currency to them at
  the fixed rate, as it has promised to do, and in
  return obtains domestic currency, which normally
  would thereby be removed from public circulation,
  thus decreasing the money supply.
• Under a policy of sterilization, of course, the
  central bank arranges to have these dollars put
  back into circulation.
• The key point here is that during this process
  the government is selling off its holdings of
  foreign exchange. As long as the balance of
  payments deficit continues, the government's
  stock of foreign exchangeits foreign exchange
  reservessteadily falls.

43

• The major problem with sterilization policy
  should now be evident.
• By maintaining the balance of payments deficit,
  the sterilization policy causes the government's
  foreign exchange reserves to run low, threatening
  its ability to continue this policy, and worse,
  alerting foreign exchange speculators that the
  dollar may soon have to be allowed to fall.
• The resulting foreign exchange crisis usually
  results in a devaluation (a substantive fall in
  the fixed exchange rate value), creating
  embarrassment for the government and profits for
  speculators.
• If a balance of payments surplus is being
  maintained by a sterilization policy, however,
  opposite results are obtained.
• Foreign exchange reserves cumulate to
  embarrassingly high levels, ultimately causing an
  upward revaluation of the currency and, once
  again, profits for speculators.

44
Government Influence on the Exchange
Rate

• Lesson 4
• Session 4.9

45

• It is rare to find an exchange rate system that
  is fully flexible.
• Usually, government intervenes in the operation
  of the foreign exchange market to "modify" the
  natural forces of supply and demand.
• Sometimes intervention is intended to prop up an
  exchange rate for reasons of prestige, and at
  other times it is intended to push down the
  exchange rate in order to produce jobs through
  stimulation of demand for exports and
  import-competing goods and services

46

• Neither of these interventions can be viewed with
  favor because they attempt to set the exchange
  rate at an unnatural level.
• A more convincing rationale for government
  interference in this market is that without such
  interference the exchange rate may be volatile,
  so volatile that it is disruptive to
  international business activity.
• Government action designed to cushion temporary
  shocks to the exchange rate, rather than to
  influence its long-run level, is thought to be a
  legitimate policy

47

• The government employs two main mechanisms to
  influence the exchange rate.
• First, it can intervene directly in the foreign
  exchange market, buying or selling dollars. This
  intervention is viable as long as the
  government's stock of foreign exchange reserves
  is not threatened, as it would be, for example,
  if it tried to keep the exchange rate above its
  long-run level through continual purchases of
  dollars with its foreign exchange reserves.
• Second, government can influence the exchange
  rate by using monetary policy to change the real
  interest rate changes in the interest rate in
  turn affect capital inflows and outflows and thus
  the exchange rate.
• Most governments, through their central banks,
  adopt a combination of these two policies.