Macroeconomics

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Macroeconomics

• Lecture 16
• Capital controls and the EMS crisis

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Outline

• EMS crisis in 1992
• Capital controls

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The EMS Crisis of 1992

• 1990 Sterling joins the EMS.

• September 1992 Sterling forced out of EMS

Why?

• German unification

• The sleeping dragon

• Free capital flows

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The uncovered interest parity

• Risk premium

• expected depreciation

Return to Pound (domestic) asset
Expected return to Dollar (foreign) asset
Return in
Capital gain/loss due to (expected) depreciation
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Actual depreciation/ depreciation pressure
Expected depreciation
e
A
e0
e1
B
Y
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The EMS Crises

• German unification

• Expectations about future devaluation

Run down of Foreign Reserves
Speculative attack
Domestic recession

• Expectations about future devaluation

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Initial impact of German Unification
e
A
B
e0
e1
Y
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e
DCB
S0
D
High r
S1
Outflow capital
e0
Depreciation pressure
CB buys

• Run down
• of FR

The CB buys /sells

• Recession

Dynamic implications

• Run down
• of FR

Expectations about devaluation

• Recession

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Dynamic effects Expectations and speculation
e
C
e0
B
Y
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Speculation
e
CB intervention
time
t0
From time t0

• Government gives in and devaluates

• The exchange stays fixed

No appreciation risk!
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Restrictions on private capital movements

• Currency restrictions
• Risk attributes
• Exchange rate uncertainty.

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Imports increase when income increases, so
e
D
S0
S1
supply of up (demand of up)

D and S related to trade in goods
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Strict capital controls
The equilibrium in the FOREX market now requires
that the trade balance is in balance
Suppose NXgt0.
Demand for from exporters greater than supply
of from importers.
Appreciation pressure
e
r
D
S0
A
B

Y
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Economic policy and capital controls
With restrictions on private capital flows in
place, the domestic interest can deviate from
the foreign interest rate. Thus,

• monetary policy can potentially work through the
• the Keynesian transmission mechanism (via r)

(2) fiscal policy can potentially be crowded out
via increases in the domestic interest rate.
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Fixed exchange rate systemwith strict capital
controls
r
e
S0
S1
A
A
C
B
B
D1
D
Y

Can monetary autonomy be recouped?
Supply of up
depreciation pressure
central bank buy up
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Fixed exchange rate systemwith strict capital
controls
r
e
C
S0
S1
B
A
A
C
B
D1
D0
Y

Can fiscal policy affect output?
Supply of up
depreciation pressure
central bank buy up
Notice that r increases, and crowds out private
investments.
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Policy with fixed exchange rates
Fiscal
Monetary
first row perfect capital mobility second row
no capital mobility.
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Enjoy the Easter Break!
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Policy with floating exchange rates and strict
capital controls
Fiscal
Monetary
Verify by going through the graphical analysis
that this is correct.