ECON 671 International Economics

1
ECON 671 International Economics

• Exchange Rate Regimes and the
• IS-LM-BP Model

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IS-LM-BP under a Fixed Exchange Rate Regime
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Open Economy SR EquilibriumIS-LM-BP Model

• IS-LM-BP Model described by 3 equations
• (IS) Y C (Y-T, W) I(i) G NX(e, Y,
  YROW, W)
• (LM) Ms/P a(DR IR)/P f(Y, i, W, E(p))
• (BP) BOP0 NX(e, Y, YROW, W) j(i, i xa)
• IS-LM-BP with Fixed Exchange Rate Regime
• Endogenous Variables Y, i, M (BOPDIR)
• Exogenous Variables G, T, DR, W, P, e
• In a Fixed Exchange Rate Regime, adjustment to FX
  market equilibrium occurs through changes in
  Intl Reserves, IR.
• Changes in IR will shift LM Curve Only
• No Changes in IS or BP Curves to changes in IR.

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IS-LM-BP Model
Interest
Rate
Income, Output
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Types of Fixed EXR Regimes

• Traditional Fixed Exchange Rate Regime
• Govt sets a fixed level for the exchange rate.
• Central bank intervenes in FX market to maintain
  EXR fix.
• Requires Central bank to hold credible levl of
  Intl Reserves.
• Exchange Rate Bands
• Govt sets a band around a fixed level for
  exchange rate.
• Central bank intervenes if EXR moves outside
  bands.
• Requires Central bank to hold credible level of
  Intl Reserves.
• Currency Board
• Govt sets a fixed level for exchange rate.
• Currency Board issues domestic currency only to
  extent it can be backed 100 by Intl Reserves.
• Currency Board conducts no independent monetary
  policy.

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Fiscal Policy under a Fixed Exchange Rate Regime
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Fiscal Policy with Fixed EXR

• Look at effects of increase in govt spending, G.
• Direct Effect
• Increase in G will shift IS Curve outwards.
• No Direct effect on either BP or LM Curves.
• New internal equilibrium where LM and new IS
  intersect.
• Both Y and i increase at new intersection. This
  is not overall equilib.!!
• What is status of BoP at this point?
• Depends on capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• If capital is relatively immobile
• BOP lt 0, Intl Reserves fall as Central Bank
  tries to keep EXR fixed
• This shifts the LM Curve backwards until IS-BP-LM
  all intersect.
• If capital is relatively mobile
• BOP gt 0, Intl Reserves rise as Central Bank
  tries to keep EXR fixed
• This shifts the LM Curve outwards until IS-BP-LM
  all intersect.

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Fiscal Policy under Fixed EXR
Interest
Rate
LM0
BP(e0, i, Y)
i0
A
IS(e0, G0, T0)
Income, Output
Y0
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Fiscal Policy Capital Mobility
Capital Perfectly Mobile
Capital Completely Immobile
i
i
BP0
LM0
IS0
LM0
IS0
BP0
i0
i
Y0
Y
Y
Y0
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Fiscal Policy Capital Mobility
Capital Relatively Mobile
Capital Relatively Immobile
i
i
BP0
IS0
LM0
IS0
LM0
BP0
i0
i0
Y0
Y0
Y
Y
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Monetary Policy under a Fixed Exchange Rate
Regime
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Monetary Policy with Fixed EXR

• Look at effects of decrease in money supply
  through lower DR.
• Direct Effect
• Decrease in Ms shift LM Curve inwards.
• No Direct effect on either BP or IS Curves.
• New internal equilibrium where new LM and IS
  Curves intersect.
• Both Y and i increase at new intersection. This
  is not overall equilib.!!
• BoP at this point is always in surplus regardless
  of capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• BoP surplus means that IR will increase, results
  in increase in Ms.
• This shifts the LM Curve outwards until get back
  to original equilibrium.
• Monetary policy is ineffective under Fixed
  Exchange rate Regime
• Independent monetary policy is not possible as
  Central Bank must intervene to keep EXR at set
  level.

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Monetary Policy Capital Mobility
Capital Perfectly Mobile
Capital Completely Immobile
i
i
BP0
LM0
LM0
BP0
i0
i
i1
IS0
IS0
Y0
Y0
Y1
Y
Y
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Monetary Policy Capital Mobility
Capital Relatively Mobile
Capital Relatively Immobile
BP0
i
i
LM0
LM0
BP0
i0
i0
IS0
IS0
Y0
Y0
Y
Y
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Exchange Rate Policy
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EXR Policy with Fixed EXR

• Look at effects of devaluation in domestic
  currency, (rise in e).
• Direct Effects
• Depreciation raises NX which shifts IS and BP
  Curves outwards.
• No Direct effect on LM Curve.
• New internal equilibrium where LM and new IS
  Curves intersect.
• Both Y and i increase at new intersection. This
  is not overall equilib.!!
• BoP at this point is always in surplus regardless
  of capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• BoP surplus means that IR will increase, results
  in increase in Ms.
• This shifts the LM Curve outwards until get to
  IS-BP-LM equilibrium.
• Exchange Rate policy is effective.
• A Devaluation of the Exchange Rate is expected to
  increase the level of GDP in the country, i.e.
  its an expansionary policy.

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EXR Policy under Fixed EXR
Interest
Rate
LM0
BP(e0, i, Y)
i0
A
IS(e0, G0, T0)
Income, Output
Y0
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EXR Policy Capital Mobility
Capital Perfectly Mobile
Capital Completely Immobile
i
i
BP0
LM0
LM0
BP0
i0
i
BP1
IS0
IS0
Y0
Y0
Y
Y
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EXR Policy Capital Mobility
Capital Relatively Mobile
Capital Relatively Immobile
i
i
BP0
LM0
IS0
IS0
LM0
Degt0
i0
i0
BP0
Y0
Y0
Y
Y
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Summary of Policy Effects under a Fixed Exchange
Rate Regime
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Policy Effects with Fixed EXR

• Fiscal Policy
• Directly affects only the IS Curve.
• Adjustments to equilibrium depend on degree of
  capital mobility.
• Higher the degree of capital mobility, the more
  effective is fiscal policy.
• When capital immobile, IR adjustment shifts LM in
  increases i, Y fixed.
• When capital mobile, IR adjustment shifts LM out
  increases Y, i fixed.
• Monetary Policy
• Directly affects only the LM Curve.
• Adjustment to equilibrium does not depend on
  degree of capital mobility.
• Monetary policy is not effective in changing Y.
• Change in Domestic Reserves brings changes in i
  Y affecting FX market.
• FX market disequilibrium, requires Central Bank
  to change Intl Reserves by amount exactly
  offsetting original change in Domestic Reserves.
• Exchange Rate Policy
• Devaluation affects both IS BP curves,
  increasing Y.
• Central Bank intervention to achieve new fixed
  EXR brings about change.