EC202A Macroeconomics

1
EC202A Macroeconomics

• Handout 2
• Laura Povoledo
• The University of Reading

2
EC202A Macroeconomics

• The IS-LM-BP model
• Reading material that you may find useful
• Abel, Bernanke and McNabb, Chapters 5 and 14.
• Abel, Bernanke, 5th ed, Chapters 5 and 13.
• Dornbusch, Fisher and Startz, 9th ed, Chapter
  12.
• Begg, Fischer an Dornbusch, 7th ed, Chapters 28
  and 29.

3

• Outline
• The Goods Market Equilibrium in an Open Economy
• The open-economy IS curve
• The Balance of Payments and Capital Flows
• The BP curve
• The Mundell-Fleming model .

4
The Goods Market Equilibrium in an Open Economy

• Economies are linked internationally through two
  main channels
• trade in goods and services
• international financial markets.
• First, lets consider the effects of trade with
  the rest of the world on the goods market
  equilibrium and then well understand how to
  modify the IS curve.

5
The Goods Market Equilibrium in an Open Economy

• Previously, we have seen that the goods market
  equilibrium condition can be expressed in two
  ways
• 1) National saving equals investment

S I (1) Closed economy Equation
2) Aggregate supply equals aggregate demand
Y C I G (2) Closed economy Eq.
6
The Goods Market Equilibrium in an Open Economy

• What changes in an open economy?
• National saving now has two
  uses
• increase the nations capital stock by domestic
  investment
• increase the stock of net foreign assets by
  lending to foreigners.
• We capture this by re-writing the equilibrium
  condition (1) in the following way

Change no. 1
S I CA I NX NFP (1) Open economy Eq.
7
The Goods Market Equilibrium in an Open Economy

• Eq. (1) shows the uses of savings in an open
  economy. Investment I is accrued to the domestic
  capital stock. The current account balance CA
  indicates the amount of funds that the country
  has available for net foreign lending.

Hence, Eq. (1) states that in goods market
equilibrium in an open economy, the amount of
national saving S must equal the amount of
domestic investment I plus the amount lent abroad
CA.
8
The Goods Market Equilibrium in an Open Economy

• The closed economy equilibrium condition (1) is a
  special case of the open economy equilibrium
  condition (1), with CA 0.

• What else changes in an open economy?
• Domestic spending on goods
  and services is no longer equal to domestic
  output. This happens because
• Part of domestic output is sold to foreigners
  (exports)
• Part of spending by domestic residents purchases
  foreign goods (imports).

Change no. 2
9
The Goods Market Equilibrium in an Open Economy

• We can also re-write the equilibrium condition
  (2) - aggregate supply equals aggregate demand
  for an open economy.
• The main change is that domestic spending no
  longer determines domestic output. Instead,
  spending on domestic goods determines domestic
  output.
• Define
• A spending by domestic residents
• Then

A C I G
10
The Goods Market Equilibrium in an Open Economy

• Spending on domestic goods is total spending by
  domestic residents less their spending on imports
  plus foreign demand or exports.
• Therefore
• Where
• X exports
• Q imports.

Spending on domestic goods A NX
C I G X
Q
Domestic output
Note A is also called absorption.
11
The Goods Market Equilibrium in an Open Economy

• In order to obtain an equilibrium condition, we
  write

Y C I G NX (2) Open economy
Equation
Eq. (2) states that in goods market equilibrium
in an open economy, the supply of domestic goods
Y is equal to spending on domestic goods, A
NX.
12
The Goods Market Equilibrium in an Open Economy

• What affects net exports NX?
• Foreign output YF (higher foreign output
  increases X and NX)
• Domestic output Y (higher domestic output
  increases Q and decreases NX)
• The real exchange rate
  (higher means more exports and less imports)

13
The open-economy IS curve

• The IS curve shows the possible combinations of
  the interest rate r and domestic output Y, for
  which the goods market is in equilibrium.
• In the closed economy, the IS curve can be
  written as
• Meaning the goods market is in equilibrium when
  aggregate supply is equal to aggregate demand for
  goods. Consumption depends on Y, investment
  depends on r. We draw the IS line (goods market
  equilibrium condition) in the (r, Y) plane.

AS AD
Y C (Y) I(r) G
14
The open-economy IS curve

• In the open economy, the goods market equilibrium
  condition becomes
• Or simply

AS AD
Y C (Y) I(r) G NX(YF , Y, )
Y C (Y) I(r) G NX(Y)
r
The slope of the IS depends on size of multiplier
and the elasticity of investment to domestic
interest rate (which is negative, hence the
negative slope of the IS).
IS(r, Y)
Output, Y
15
The open-economy IS curve

• The IS curve is shifted by changes in G, YF and
  the real exchange rate (we are assuming that
  prices are fixed).

• If then
• If then
• If there is a real appreciation then

AD
G
r
YF
X
IS
NX
Y
16
The open-economy IS curve

• If then
• If then
• If there is a real depreciation then

AD
G
r
YF
X
IS
NX
Y
Note above the IS line AS gt AD (aggregate supply
gt aggregate demand). Below, AS lt AD.
17
LM - Money market equilibrium in the open economy
LM
LM is upward sloping because if income increases
money demand increases and the interest rate must
increase as well.
r
MD lt MS
MD gt MS
The money supply is affected by changes in eNOM
under fixed exchange rates, hence the LM shifts
if eNOM is different from the target level eNOM.
Under floating exchange rates, the LM is not
affected by eNOM.
Y
LM slope depends on elasticity of money demand
with respect to interest rates if the latter is
low then LM is steep.
18
The Balance of Payments and Capital Flows

• The Balance of Payments (from now on, BP) is the
  record of transactions between one country and
  the rest of the world.
• The two main accounts in the BP are the current
  account and the capital account
• The current account records trade in goods,
  services, and transfer payments.
• The capital account records the trade in assets.

Balance of Payments
Current Account
Capital Account
19
The Balance of Payments and Capital Flows

• Balance of payments accounts The record of a
  countrys international transactions.
• Any transaction that involves a flow of money
  into the UK is a credit item (enters with a plus
  sign).
• Any transaction involving a flow of money out of
  the UK is a debit item (enters with a minus sign).

20
The Balance of Payments and Capital Flows

• The overall BP surplus or deficit is the sum of
  the current and capital account surpluses or
  deficits
• Since residents of a country must pay for what
  they buy abroad, any current account deficit must
  be necessarily financed by an offsetting capital
  flow

BP CA KA
BP CA KA 0 Balance of Payments equilibrium
21
The Balance of Payments and Capital Flows

• But what are the economic forces that affect the
  BP? To answer this question we must look at each
  separate component of the BP.
• For convenience we divide the current account
  into 3 components

NX
Net exports of goods and services
CA
Investment income from abroad
NFP
NT
Net unilateral transfers
Note NFP (Net factor payments) is almost (but
not always) equal to Investment income from
abroad. Why?
22
The Balance of Payments and Capital Flows

• In general, NFP and NT are not much affected by
  current macroeconomic developments. From now on,
  we assume them to be equal to 0 for simplicity.
• We write CA X(YF, ) - Q(Y,
  )

What determines CA NX ?

• Net exports depend on
• real exchange rate
• the level of domestic income Y
• the level of foreign income YF

23
The Balance of Payments and Capital Flows

• A rise in foreign income increases
  exports
• A real depreciation improves net
  exports
• A rise in domestic income increases
  imports
• So the CA is a function of 3 variables
• The real exchange rate
  measures a country's competitiveness in foreign
  trade. If prices stay fixed then eR and eNOM
  (real and nominal exchange rate respectively)
  always move in the same direction.

YF
CA
CA
Y
CA
CA(YF , Y, )
24
The Balance of Payments and Capital Flows

• Again, we look first at the separate components.
• It is often useful to split the capital account
  into two separate components (1) the
  transactions of the countrys private sector and
  (2) official reserve transactions, which
  correspond to the central bank activities

What about the KA ?
KA
Net private capital inflows
NPKI
Official reserve transactions
ORT
25
The Balance of Payments and Capital Flows
Example a current account deficit (CA lt 0) can
be financed in two ways
Private residents selling off assets abroad or
borrowing abroad.
The central bank sells foreign currency and buys
home currency.
Exercise what are the implications of the two
options above for the capital account KA?
26
The Balance of Payments and Capital Flows
Answer
But what affects KA?

• NPKI depends on
• the interest rates differential (r rF)
• the expected depreciation of the currency E
  ?eNOM/eNOM

ORT depends on the choice of exchange rate
regime fixed and floating exchange rate system.
Since the role of ORT is better understood in
relation to the adjustment process, we write KA
as a function of (r rF) and E
?eNOM/eNOM KA(r rF, E ?eNOM/eNOM)
27
The Balance of Payments and Capital Flows

• The sensitivity of KA to changes in interest rate
  differentials is a crucial issue, since it
  depends on the degree of capital mobility.
• Three cases are possible (partial derivatives)

No capital mobility
Imperfect capital mobility
Perfect capital mobility
28
The Balance of Payments and Capital Flows

• Explanation
• If capital is assumed to be perfectly mobile,
  investors in one country can trade assets with
  investors in any other country without
  restrictions, that is, at low transaction costs
  and in unlimited amounts, in search of the
  highest yield or the lowest borrowing costs.

As a result, under perfect capital mobility
interest rates in one country cannot differ from
the interest rates in other countries without
infinite capital flows taking place.
In practice, capital controls and transaction
costs dampen the sensitivity of KA to changes in
interest rate differentials.
But as the world economies become more and more
integrated, perfect capital mobility becomes
increasingly the reality.
29
The BP curve

• We are now ready to write the BP equation
• This equation shows the BP equilibrium condition
  as a function of 6 macroeconomic variables.
• The next task is to obtain a diagram on the (r,
  Y) plane that represents all the possible
  combinations of the domestic real interest rate r
  and domestic output Y, for which the above
  equation BP CA KA 0. We call this line the
  BP curve/line.

BP CA(YF , Y, ) KA(r rF , E
?eNOM/eNOM) 0
30
The BP curve

• In the (r, Y) plane the balance of payments
  becomes a function of the domestic real interest
  rate r and domestic output Y only
• The slope of the BP line depends on the degree of
  capital mobility.

r
Changes in YF , rF, and E ?eNOM/eNOM
shift the BP curve.
BP(r, Y)
Output, Y
31
The BP curve
Case 1 No capital mobility
The level of r does not affect the BP since KA
0 always (only private KA). As a result, there is
only one level of Y such that CA 0 and the BP
is in equilibrium.
r
BP
Y
Note in the case of no capital mobility, the BP
line corresponds in practice to the condition
that the Current Account is in balance.
To the left of the BP line, BP gt 0 . To the right
, BP lt 0 .
32
The BP curve
Case 2 Imperfect capital mobility
BP is upward sloping because if Y rises, there
will be an increase in imports leading to a
deficit in the CA, and (to balance this with a
surplus in the KA) r must raise to attract more
capital.
r
BP
Y
Note in the case of imperfect capital mobility,
the BP line corresponds to the condition that the
Current Account surplus/deficit is exactly offset
by Net Private Capital Inflows.
Above the BP line BP gt 0 . Below, BP lt 0 .
33
The BP curve
Case 3 Perfect capital mobility
If capital can instantaneously move, the only
level of r that ensures the equilibrium in the KA
is rF . Y can be at any level because the KA
dominates over the CA .
r
BP
rF
Y
Above the BP line BP gt 0 . Below, BP lt 0 . The
different ways in which a BP imbalance is
corrected depend on the choice of exchange rate
regime, fixed or floating.
Note in the case of perfect capital mobility,
the BP line corresponds to the condition that Net
Private Capital Inflows (or outflows) not be
infinite.
34
The BP curve
Shifts in the BP curve

• If then
• If then
• If there is an expected nominal depreciation
  then

YF
X
r
rF
KA
BP
KA
Y
Note 1 changes in YF do not affect the BP curve
under perfect capital mobility. (Why?)
Changes in YF , rF, and E ?eNOM/eNOM
shift the BP curve.
35
The BP curve
Shifts in the BP curve

• If then
• If then
• If there is an expected nominal appreciation
  then

YF
X
r
rF
KA
BP
KA
Y
Note 2 changes in rF, and E ?eNOM/eNOM
do not affect the BP curve if there is no capital
mobility. (Why?)
Changes in YF , rF, and E ?eNOM/eNOM
shift the BP curve.
36
The Mundell-Fleming model
The graphical analysis that extends the IS-LM
model to the open economy under the assumption of
perfect capital mobility is called the
Mundell-Fleming model.
r
LM
BP
This model is used to explore the effects of
fiscal and monetary policies under both fixed and
flexible exchange rate systems
IS
Y
It can also be extended to cases other than
perfect capital mobility.
37
EC202A Macroeconomics

• Monetary Policy in the IS-LM-BP model
• Reading material that you may find useful
• Dornbusch, Fisher and Startz, Chapter 12 (9th
  ed).
• Begg, Fischer an Dornbusch, Chapter 29 (7th ed).

38

• Objective of the lectures
• While the IS-LM-BP model still works under the
  assumption that the price level is given, it
  nevertheless clearly establishes the key linkages
  among open economies trade, the exchange rate
  and capital flows.
• In this lecture, we want to understand how
• monetary policy operates in the open economy,
  under fixed or floating exchange rates.

39

• Outline
• Exchange rates and the equilibrium in the Balance
  of Payments
• The IS-LM-BP model (revision)
• Monetary Policy under imperfect capital mobility
  
• Monetary Policy under perfect capital mobility
• Monetary Policy without capital mobility .

40
Exchange rates and the equilibrium in the Balance
of Payments

• Choice of exchange rate regime

Fixed Monetary authority has to intervene in
foreign currency markets to maintain fixed
nominal exchange rate eNOM
Managed flexibility free float but interventions
to prevent excessive fluctuations
Floating no intervention in foreign exchange
market. Can be joint floating a group of
currencies are pegged to each other, but
fluctuate with respect to all the other
currencies.
ERM (before Euro) was joint float with adjustably
pegged exchange rate band.
41
Exchange rates and the equilibrium in the Balance
of Payments
The way in which the equilibrium in the balance
of payments is achieved depends on the choice of
the exchange rate regime and on the degree of
capital mobility.

• Lets consider 3 cases
• Fixed exchange rates, no capital mobility
• Fixed exchange rates, perfect capital mobility
• Floating exchange rates .

42
Exchange rates and the equilibrium in the Balance
of Payments
1. Fixed exchange rates
Suppose initially that there are no private
sector capital flows, perhaps because of capital
controls.
Without capital mobility, a current account
deficit (CA lt 0) can only be financed by the
Central Bank.
The Central Bank sells foreign exchange and buys
domestic currency. As a result, domestic money in
circulation falls, as pounds disappear back into
the Bank of England. This is called unsterilized
intervention. Forex reserves fall to restore the
equilibrium in the BP.
43
Exchange rates and the equilibrium in the Balance
of Payments
Another possibility is sterilized intervention.
This happens when the Central Bank (to offset the
fall in domestic money supply) buys domestic
bonds thereby restoring the domestic money
supply.
Both sterilized and unsterilized interventions
restore the BP equilibrium under fixed exchange
rates.
However, with no long term remedial action to
resolve the original reason for the CA deficit,
eventually the Central Bank will run out of
foreign reserves, and will be forced to adjust
exchange rates.
44
Exchange rates and the equilibrium in the Balance
of Payments
2. Fixed exchange rates
In the modern world, with capital mobility,
international investors have more money at their
disposal than Central banks, thus making the
defence of exchange rates in the manner just
explained futile.
The Central Bank no longer defends the exchange
rate by buying and selling foreign reserves.
Instead, it sets domestic interest rates to
provide the correct incentive for speculators.
45
Exchange rates and the equilibrium in the Balance
of Payments
The Central Bank must set the correct interest
rate, to eliminate one-way capital flows. This is
the only option open to the Central Bank if it
wishes to keep exchange rates fixed, yet faces
perfect capital mobility.
This interest rate, coupled with the level of
income, determines money demand. Sterilisation
options in this case do not work (as
international capital flows will nullify them).
Thus perfect capital mobility undermines monetary
sovereignty.
46
Exchange rates and the equilibrium in the Balance
of Payments
3. Floating exchange rates
Anything that tends to create a CA surplus
(resource discovery, increase in exports,),
induces an appreciation in the exchange rate.
Competi-tiveness decreases and net exports fall,
until the external balance (BP equilibrium) is
restored.
Anything that tends to create a CA deficit
induces a depreciation in the exchange rate.
Competitiveness increases and net exports rise,
until the external balance (BP equilibrium) is
restored.
47
Exchange rates and the equilibrium in the Balance
of Payments
When exchange rates float freely, there is no
official intervention in the forex market and no
net monetary transfers between countries since
the CA and the KA (and therefore the BP) are
always zero.
Thus under floating exchange rates monetary
sovereignty is restored.
48
The IS-LM-BP model (revision)

• Assumptions
• There is one general level of prices (P), and it
  is fixed
• Aggregate demand (AD) is
• Positively related to the level of government
  expenditure (G)
• Positively related to overseas output (YF),
  which is exogenous
• Positively related to the exchange rate (eNOM)
• Negatively related to the domestic interest rate
  (r) .

49
The IS-LM-BP model (revision)

• Assumptions
• Money demand (MD) is
• Positively related to domestic income level (Y)
• Negatively related to domestic interest rate
  (r).
• Money supply (MS) is under the control of the
  Central Bank .
• Capital account is affected by the differential
  between domestic and foreign interest rates (r
  rF) and expected depreciation E ?eNOM/eNOM .

50
The IS-LM-BP model (revision)

• Assumptions
• Trade (or current) account (i.e. balance of goods
  and services) is determined by the relationship
  between domestic income (Y) and foreign income
  (YF), and by the real exchange rate
  

51
The IS-LM-BP model (revision)

• goods market equilibrium
• Or simply

IS
AS ADd
Y C (Y) I(r) G NX(YF , Y, )
Y C (Y) I(r) G NX(Y)
r
Shifts occur with exogenous changes in aggregate
demand, that is G, Taxes, YF, and net exports NX
(which are positively influenced by eNOM and YF)
AS gt ADd
IS(r, Y)
AS lt ADd
Output, Y
52
The IS-LM-BP model (revision)
LM
Money market equilibrium
MD MS
MD(Y, r) MS
LM(r, Y)
r
MD lt MS
Shifts occur with exogenous changes in MS
MD gt MS
Y
53
The IS-LM-BP model (revision)
BP
External equilibrium
BP CA(YF , Y, ) KA(r rF , E
?eNOM/eNOM) 0
Or simply
BP(r, Y)
r
BP (r, Y) 0
BP gt 0
BP lt 0
Shifts occur with exogenous changes in YF, eNOM
and rF .
Y
54
The IS-LM-BP model (revision)
Overall model diagram
r
LM
Point E in the diagram represents internal and
external balance, and the six regions around it
are characterised by different kinds of
disequilibria .
MD lt MS AS gt ADd BP gt 0
MD gt MS AS gt ADd BP gt 0
MD lt MS AS lt ADd BP gt 0
BP
E
MD gt MS AS gt ADd BP lt 0
MD lt MS AS lt ADd BP lt 0
MD gt MS AS lt ADd BP lt 0
IS
Y
55
Monetary Policy under imperfect capital mobility
Under imperfect capital mobility, the BP is
upward sloping. Alternatively, we can justify the
positive slope of the BP by saying that this
country is a large open economy. Large open
economy an economy large enough to affect the
world interest rate. A good example of a large
open economy is the US.
r
BP
Y
56
Monetary Policy under imperfect capital mobility
Fixed exchange rates
M S
r
LM0
Overall money supply is completely ineffective in
stimulating output in a fixed exchange rate
regime. The initial equilibrium E0 cannot be
changed by changes in MS.
LM1
E0
BP
E1
IS
Y
57
Monetary Policy under imperfect capital mobility

• Explanation
• E0 to E1 Expansion of MS determines a decrease
  in the interest rate, which both stimulates
  investment and increases output (movement along
  the IS curve). As output increases imports
  increase and as interest rates fall capital
  outflows increase, so BP is in deficit at E1.

E1 back to E0 as the BP is in deficit, there is
excess supply of the domestic currency in the
international markets, and pressure to devalue,
but exchange rate is fixed, so monetary authority
has to intervene buying the excess (i.e. losing
foreign currency reserves), and money supply MS
contracts back to the original level.
58
Monetary Policy under imperfect capital mobility
Floating exchange rates
M S
r
LM0
Overall money supply is very effective in
stimulating output in a floating exchange rate
regime.
LM1
BP0
E0
BP1
E2
E1
IS1
IS0
Y
59
Monetary Policy under imperfect capital mobility

• Explanation
• E0 to E1 Expansion of MS determines a decrease
  in the interest rate, which both stimulates
  investment and increases output (movement along
  the IS curve). As output increases imports
  increase, and as interest rates fall capital
  outflows increase, so BP0 is in deficit at E1.

E1 to E2 as the BP is in deficit, there is
excess supply of the domestic currency in the
international markets, so exchange rate
depreciates, which stimulates exports and
increases output BP0 shifts to BP1 , and IS0
shifts to IS1
60
Monetary Policy under perfect capital mobility
Capital controls (regulations which prevent
private sector capital flows) were commonplace
between 1945 and 1973 but are very rare now.
Under perfect capital mobility, the BP is
horizontal as the domestic interest rate r must
be equal to the foreign rate rF. Alternatively Sm
all open economy an economy that is too small
to affect the world interest rate.
r
BP
rF
Y
61
Monetary Policy under perfect capital mobility
Example assume that the world consists of only
European countries (simplifying assumption, but
European countries are much more integrated
financially and in trade with each other than
with the rest of the world). During the
1990s France fixed exchange rate After
introduction of the UK floating exchange
rate /
r
BP
rF
Y
62
Monetary Policy under perfect capital mobility
Fixed exchange rates (France)
M S
r
LM0
Any attempt to change the money supply, and hence
interest rates, causes an immediate capital
inflow or outflow until the money supply and
interest rate are restored back to the original
level.
LM1
E0
rF
BP
IS
Y
63
Monetary Policy under perfect capital mobility
Thus money supply is ineffective under a fixed
exchange rate regime (both under imperfect and
perfect capital mobility).
But graphs are not enough, it is important also
to explain IN WORDS the effects of monetary
policy under perfect capital mobility and fixed
exchange rates. Explanation see next page.
Moreover, suppose you are Jean-Claude Trichet
(Governor of the Banque de France from 1993 to
2003). A famous columnist is blaming the Banque
de France for keeping interest rates too high in
spite of a severe recession. What is your answer
to this?
64
Monetary Policy under perfect capital mobility

• Explanation
• Expansion of MS determines a decrease in the
  interest rate, which both stimulates investment
  and increases output (movement along the IS
  curve). However, any fall in interest rates will
  generate a massive capital outflow. The central
  bank must reduce the domestic money supply, to
  prevent a change in interest rates. As a result,
  the economy stays at E0.

Reply to the columnist under fixed exchange
rates and perfect capital mobility, any attempt
to lower the interest rate below rF is
ineffective, it only depletes the foreign
reserves of the central bank.
65
Monetary Policy under perfect capital mobility
Floating exchange rates (UK)
M S
r
LM0
Under floating exchange rates, monetary policy is
highly effective in changing output.
LM1
E0
BP
rF
E2
E1
IS1
IS0
Y
66
Monetary Policy under perfect capital mobility

• Explanation
• E0 to E2 An increase in money supply shifts the
  LM curve to the right, so the interest rate falls
  while the level of output demanded increases
  (E1). At E1, the goods and money market are in
  equilibrium (at the initial exchange rate), but r
  has fallen below rF . The lower domestic
  interest rate causes an outflow of capital, which
  causes a currency depreciation. Because of the
  depreciation, competitiveness increases and the
  IS shifts to the right. At point E2, there is no
  further tendency for exchange rate to change.

67
Monetary Policy under perfect capital mobility

• We have shown that, under floating exchange
  rates, a monetary expansion in the home country
  leads to exchange rate depreciation, increased
  exports and a higher level of domestic output.
  But our depreciation shifts demand from foreign
  goods to home goods.

Such a policy is known as a beggar-thy-neighbour
policy, since an increase in domestic employment
has been created at the expense of other
countries, which now might experience higher
levels of unemployment.
68
Monetary Policy without capital mobility
Outlawing capital flows is a measure unlikely to
be taken these days. How can we explain the
effects of monetary policy under no capital
mobility (fixed versus floating exchange rates)?
r
BP
Y
69
Monetary Policy without capital mobility
The expansion of MS causes the movement from E0
to E1 . Output increases and imports increase.
Since the BP is in deficit in E1 , the Central
Bank has to buy the domestic currency to avert
the depreciation, hence MS contracts back to the
original level.
M S
Fixed exchange rates
r
BP
LM0
LM1
E0
E1
IS
Y
70
Monetary Policy without capital mobility
The expansion of MS causes the movement from E0
to E1 . Output increases and imports increase.
Since the BP is in deficit in E1 , the domestic
currency depreciates. Because of the
depreciation, competitiveness increases and both
the IS and the BP shift to the right.
M S
Floating exchange rates
r
BP1
BP0
LM0
LM1
E0
E2
E1
IS1
IS0
Y
71
EC202A Macroeconomics

• Fiscal Policy in the IS-LM-BP model
• Reading material that you may find useful
• Dornbusch, Fisher and Startz, Chapter 12 (9th
  ed).
• Begg, Fischer an Dornbusch, Chapter 29 (7th ed).

72

• Objective of the lecture
• To understand how fiscal policy operates in the
  open economy, under fixed or floating exchange
  rates.
• The IS-LM-BP model is our method of analysis.

73

• Outline
• The adjustment out of equilibrium
• Fiscal Policy under imperfect capital mobility
• Fiscal Policy under perfect capital mobility
• Fiscal Policy without capital mobility
• Stabilization policy .

74
The adjustment out of equilibrium
In lecture 2, we said that the way in which the
equilibrium in the balance of payments is
achieved depends on the choice of the exchange
rate regime and on the degree of capital mobility.
In fact, the balance of payments is always in
equilibrium, because in practice the capital
account KA finances the current account CA
imbalance BP CA KA 0
but the way in which a current account
imbalance is financed depends on the choice of
the exchange rate regime and on the degree of
capital mobility!
We now look at what this means for the adjustment
out of equilibrium.
75
The adjustment out of equilibrium
Assume that initially the economy is in E0
Because of a sudden fall in foreign output, the
IS and the BP shift and the economy moves to E1.
LM
r
BP
E0
E1
Because of the fall in exports, CA how is
this financed?
IS
Y
76
The adjustment out of equilibrium
1. Fixed exchange rates no capital mobility
BP
LM
r
Since CA is in deficit, there is excess supply of
domestic currency and excess demand for foreign
currency.
Because of the fixed exchange rate regime, the
Central Bank is committed to buy any excess
supply of domestic currency.
IS
Y
Y0
Foreign exchange reserves fall, generating a
positive number in the KA (see Abel et al. page
156). The LM shifts to the left.
77
The adjustment out of equilibrium
2. Fixed exchange rates perfect capital
mobility
LM
r
Since the interest rate is below the world level
rF , private capital flows out of the country.
BP
rF
Private residents buy assets abroad, so the KA is
in deficit too.
IS
Y
Y0
The Central Bank must set the correct interest
rate, to eliminate one-way capital flows.
Contractionary monetary policy, the LM shifts to
the left.
78
The adjustment out of equilibrium
3. Floating exchange rates
LM
r
Assume again that the CA is in deficit. Because
the interest rate has fallen, the KA is in
deficit too. There is excess supply of domestic
currency and excess demand for foreign currency.
As a result, the exchange rate depreciates.
BP
IS
Y
Y0
Because of the depreciation, competitiveness
increases and both the IS and the BP shift to the
right.
The BP goes back to 0.
79
Fiscal policy (foreword)
The actor of monetary policy is the Central
Bank. The actor of fiscal policy is the
government.

• The tools of fiscal policy are
• Government spending G
• Taxation T .

In the remainder of this lecture, G indicates
an expansionary fiscal policy (an increase in
government spending or a fall in taxes), while G
indicates a contractionary fiscal policy (a
fall in government spending or an increase in
taxes).
80
Fiscal policy (foreword)
We want to determine whether a policy to
stimulate output through an expansionary fiscal
policy will be successful and how it will work.
An expansionary fiscal policy has the effect of
increasing domestic aggregate demand. The amount
of the increase is determined by the multiplier
(which tells us how much of this injection will
be leaked out of the system in the form of
savings, taxation and demand for foreign goods
i.e. imports).
As money demand increases with income, the
increase in aggregate demand (i.e. income) will
also increase money demand, and equilibrium in
the money market (LM) will be restored at a
higher level of domestic interest rate.
What are the implications for the external (BP)
equilibrium?
81
Fiscal Policy under imperfect capital mobility
Fixed exchange rates
G
r
LM0
Fiscal policy in a fixed exchange rate regime
with imperfect capital mobility is effective in
expanding domestic output, with some rise in the
interest rate r.
LM1
E1
E2
E0
BP
IS1
IS0
Y
82
Fiscal Policy under imperfect capital mobility

• Explanation
• E0 to E1 due to the expansionary fiscal policy
  IS0 shifts to IS1 . As income increases, so does
  money demand, and equilibrium in the money market
  is maintained provided the domestic interest rate
  r rises. In E1 the BP is now in surplus as r has
  risen.

E1 to E2 as the BP is in surplus, there is
excess demand of the domestic currency in the
international markets, and pressure to revalue,
but exchange rate is fixed, so the central bank
has to intervene (i.e. buying foreign currency
reserves). As a result, the money supply
increases and the LM shifts until the BP
equilibrium is restored.
83
Fiscal Policy under imperfect capital mobility
G
Floating exchange rates
r
So fiscal policy in a floating exchange rate
regime with imperfect capital mobility is less
effective in expanding Y , and rises interest
rates r and exchange rates.
LM
E1
E2
BP1
E0
BP0
IS1
IS2
IS0
Y
84
Fiscal Policy under imperfect capital mobility

• Explanation
• E0 to E1 after the expansionary fiscal policy
  IS0 shifts to IS1 . As income increases, so does
  money demand, and equilibrium in the money market
  is maintained provided the domestic interest rate
  r rises. In E1 the BP is now in surplus as r has
  risen.

E1 to E2 Surplus in BP means excess demand for
domestic currency and the nominal exchange rate e
appreciates shift of BP0 to BP1. If prices
dont change, the nominal appreciation is also a
real appreciation, and exports will decrease (as
they become more expensive) reducing demand the
IS shifts to the left .
85
Fiscal Policy under perfect capital mobility
Example assume that the world consists of only
European countries (simplifying
assumption). During the 1990s France fixed
exchange rate After introduction of the UK
floating exchange rate /
r
BP
rF
Y
86
Fiscal Policy under perfect capital mobility
Fixed exchange rates (France)
G
r
LM0
Fiscal policy is strengthened by capital mobility
because, unlike in a closed economy , the money
supply must expand to keep the interest rate
constant at rF.
LM1
E0
E1
BP
rF
IS1
IS0
Y
87
Fiscal Policy under perfect capital mobility
Insight Fiscal policy affects the level of
aggregate demand, thus causing interest rates to
change. This causes a flow of capital across
borders, which affects exchange rates. Therefore
the central bank has to implement monetary policy
to keep interest rates constant. This policy
action by the central bank will reinforce the
effects of the fiscal policy on output.
88
Fiscal Policy under perfect capital mobility
Floating exchange rates (UK)
G
r
LM
Fiscal policy is completely ineffective in
stimulating output in a floating exchange rate
regime.
E0
BP
rF
IS1
IS0
Y
89
Fiscal Policy under perfect capital mobility

• Explanation
• After the expansionary fiscal policy, the IS
  shifts to the right and the domestic interest
  rate rises above the level of the world interest
  rate rF. A capital inflow occurs, leading to an
  appreciation of the domestic currency. The
  appreciation makes foreign goods cheaper for
  domestic citizens, and exported goods become
  relatively more expensive for foreigners.
  Therefore, net exports decrease and the IS shifts
  back to its original location.

In the end, the level of output Y does not
change, although its composition does (less
exports and more imports).
90
Fiscal Policy without capital mobility
As the IS shifts to the right, the economy moves
from E0 to E1 . Output increases and imports
increase. Since the BP is in deficit in E1 , the
Central Bank has to buy the domestic currency to
avert the depreciation, hence MS contracts and
output falls.
G
Fixed exchange rates
r
BP
LM1
LM0
E2
E1
E0
IS1
IS0
Y
91
Fiscal Policy without capital mobility
As the IS shifts to the right, the economy moves
from E0 to E1 . Output increases and imports
increase. Since the BP is in deficit in E1 , the
domestic currency depreciates. Because of the
depreciation, competitiveness increases and both
the IS and the BP shift to the right.
G
Floating exchange rates
BP0
r
BP1
LM
E1
E2
E0
IS2
IS1
IS0
Y
92
The effectiveness of monetary/fiscal policies on
output depends on the exchange rate regime and on
the degree of capital mobility (summary table)
93
Stabilization policy
In the IS-LM-BP model, exogenous changes in other
variables not under the direct control of the
monetary authority or the government are called
shocks.
r
LM
BP
For example, changes in YF , rF , and E
?eNOM/eNOM shift the BP.
IS
Y
Changes in YF shift the IS.
Changes in preferences for money demand shift the
LM.
94
Stabilization policy
For example, consider an economy initially at
full employment YF and external balance. Assume
that foreign output falls (war, restrictive
policies abroad, ). Both the IS and the BP
shift output falls below full potential and the
BP goes in disequilibrium.
r
LM
BP
IS
Y
YF
Y0
Notation YF domestic full employment
output YF foreign output
95
Stabilization policy

• Stabilization policy the use of fiscal/monetary
  policy to restore internal/external balance.

Internal balance exists when the economy is at
the full-employment level of output.
External balance exists when the Balance of
Payments is equal to 0.
Problem how to achieve 2 objectives (internal
external balance) simultaneously. Policy dilemma
caused by potential conflicts between the goals
of external and internal balance.
96
Stabilization policy

• Example 1 Fixed exchange rates

The economy is below full employment Y0 lt YF.
Cannot use monetary policy (fixed exchange
rates). In order to restore internal balance,
need expansionary fiscal policy. In order to
restore external balance, need contractionary
fiscal policy.
r
LM
BP
IS
YF
Y0
Y
In general, a combination of policies is needed
to establish internal and external balance
simultaneously.
97
Stabilization policy

• Example 2 Automatic adjustment of the BP

Under fixed exchange rates, the economy would
move to Y1. To restore internal balance, need for
an expansionary fiscal policy that shifts the IS
to the right. A depreciation or an import tariff
would also shift the IS to the right. Under
floating exchange rates, the economy would move
to Y2 need for a contractionary monetary policy.
r
LM
BP
IS
YF
Y1
Y2
Y
Policy measures are monetary and fiscal policy,
and also tariffs or devaluations.
98
EC202A Macroeconomics

• Exchange Rate Policy in the IS-LM-BP model
• Recommended reading
• Begg, Fischer an Dornbusch, Chapter 29
• Abel, Bernanke and McNabb, Chapter 14

99

• Objective of the lecture
• To understand exchange rate policy , as one of
  the tools available to policymakers to influence
  the level of economic activity in their country.
• Monetary and fiscal policy are not the only
  available tools.
• In this lecture we will see how exchange rate
  policy works.

100

• Outline
• Exchange rate policy in the Mundell-Fleming model
  
• Are devaluations effective in the long run?
• How to fix the exchange rate
• Fixed versus floating exchange rates
• Exchange rates monetary policy.

101
Exchange rate policy in the Mundell-Fleming model
Previously, we saw that monetary policy is
ineffective under fixed exchange rates. However,
monetary policy does have many attractions over
fiscal policy. Are there any other tools
available for stabilization?
The economy is below full employment Y0 lt YF,
and the BP is in deficit (internal and external
imbalances).
r
LM
BP
In general, a combination of policies is needed
to establish internal and external balance
simultaneously.
IS
YF
Y0
Y
102
Exchange rate policy in the Mundell-Fleming model

• Terminology

Under a system of floating exchange rates a
currency depreciates (appreciates) when it
becomes less (more) expensive in relation to
foreign currencies. This is caused by market
forces or, in some instances, by the intervention
of central banks.
However, under a system of fixed exchange rates,
currency devaluation (revaluation) takes place
when the price at which foreign currencies can be
bought is increased (decreased) by official
government action.
In other words, a devaluation or revaluation is a
change in the par value (the exchange rate that
the central bank agrees to defend).
103
Exchange rate policy in the Mundell-Fleming model

• In order to represent the effects of a
  devaluation in the Mundell-Fleming model, we must
  go back to its building blocks
• since the nominal exchange rate only
  enters the IS and the BP lines, devaluation does
  not affect the LM.

IS
Y C (Y) I(r) G NX(YF , Y, )
LM
MD(Y, r) MS
BP CA(YF , Y, ) KA(r rF ) 0
BP
104
Exchange rate policy in the Mundell-Fleming model

• In order to make precise statements about the
  effects of a devaluation in the IS-LM-BP model,
  we must clarify first
• The effect of changes in eNOM on the real
  exchange rate eR
• The effect of changes in eR on net exports (NX
  CA) .

If a devaluation increases NX then both the IS
and the BP shift to the right, and output
increases. But only if.
105
Exchange rate policy in the Mundell-Fleming model
Devaluation (pursued by a country in fixed
exchange rate regime) is effective in expanding
output if

1. Relative prices do not change, so that a decrease
   in nominal exchange rate will also mean a
   decrease in real exchange rate. This means that
   exports become cheaper in foreign currency and
   imports become more expensive in domestic
   currency

1. Net exports NX increase in value.

106
Exchange rate policy in the Mundell-Fleming model
Condition 1 is not satisfied in the long run,
but it may be quite realistic in the short run.
Condition 2 requires that the value of exports
increases more than value of imports. This
depends on the price elasticities of demand for
exports and imports, and is summarised in the
Marshall-Lerner condition (sum of price
elasticities of demand for exports and imports
exceeds 1).
In the rest of the analysis, we assume that the
Marshall-Lerner condition holds and relative
prices are fixed, so if there is a devaluation
then NX and both the IS and the BP shift to
the right.
107
Exchange rate policy in the Mundell-Fleming model
Devaluation under fixed exchange rates
LM0
r
LM1
A devaluation of the domestic currency improves
competitiveness and increases output in the short
run.
E1
BP0
E0
BP1
E2
IS1
IS0
YF
Y
108
Exchange rate policy in the Mundell-Fleming model

• Explanation
• E0 to E1 Devaluation means that the balance of
  payments equilibrium changes - shift from BP0 to
  BP1 -. Net exports increase shift of IS0 to IS1
  -. As output expands interest rates rise, so
  there will be a capital inflow. This will result
  in a balance of payments surplus (point E1), and
  excess demand of domestic currency.

E1 to E2 under fixed exchange rates, money
supply expands to accommodate the excess demand
of domestic currency. This will give a further
impulse to aggregate demand and the final
equilibrium will be for a higher level of output.
109
Are devaluations effective in the long run?

• Q In the long run can changes in a nominal
  variable (the nominal exchange rate) ever have
  any effect on real variables (output,
  competitiveness)?
• A No, unless there is real change in the economy
  at the same time. In the absence of this, the
  eventual effect of devaluation is a rise in all
  other nominal wages and prices in line with the
  higher import prices, leaving all real variables
  unchanged.

If there is a devaluation of the home currency,
the import price of raw materials increases.
Domestic firms want to pass on these costs
increases in higher prices. Workers realise that
that consumer prices are higher, and demand
higher wages.
110
Are devaluations effective in the long run?

• Eventually, devaluation has no real effects. Most
  empirical evidence suggests that the effect of
  devaluation is completely offset by a rise in
  domestic wages and prices after 4-5 years.
  Devaluation leads to a temporary, not a
  permanent, increase in competitiveness.
• In the long run, competitiveness is
  determined by real factors, and it goes back to
  its long-run equilibrium level.
• However, devaluation is the simplest way to
  change competitiveness quickly. It may thus be an
  appropriate response to a real shock which needs
  a quick change in the equilibrium real exchange
  rate.

111
Are devaluations effective in the long run?
For example, consider an economy initially at
full employment YF and external balance. Assume
that there is a permanent fall in export demand
both the IS and the BP shift to the left. At the
original exchange rate, this generates a slump
that reduces wages and prices, until the
resulting increase in competitiveness
restores the original equilibrium.
r
LM
BP
IS
Y
YF
TBA the full employment level of output YF is
not the foreign level of output YF !
112
Are devaluations effective in the long run?
Devaluation can deliver an overnight improvement
in competitiveness, shifting both the IS and the
BP back to their original positions. Devaluation
speeds up adjustment .
Devaluation may therefore be an appropriate
response to a real shock that requires a change
in the equilibrium real exchange rate.
Conversely, where no real change is required,
devaluation eventually generates rises in prices
and nominal wages.
113
Fixed exchange rates and macroeconomic policy
Thus, we have learned that the Mundell-Fleming
model is useful to analyse the effects of a
devaluation in the short run. However, since it
was not designed to explain how the exchange
rates are determined in the long run, it cannot
be used for this purpose.
We are now getting close to the question of how
to choose the nominal exchange rate in a fixed
exchange rate regimes. The above discussion has
taught us that governments cannot realistically
expect to fix the level of competitiveness
or real exchange rate (not in the long/medium
run), but what about the nominal exchange rate
eNOM?
114
Fixed exchange rates and macroeconomic policy
Fixed-exchange-rate systems are important
historically and are still used by many
countries. In this subsection, we will be
talking about fixed exchange rate systems
only. There are two key questions wed like to
answer

1. How should the official nominal exchange rate be
   fixed?
2. Which is the better system, flexible or fixed
   exchange rates?

115
How to fix the exchange rate
In a fixed exchange rate system, the government
sets the nominal exchange rate, in an agreement
with other countries. However, a potential
problem with fixed exchange rate systems is that
the official rate may not what the market wants
the currency may be overvalued or undervalued,
according to whether the official rate is above
or below the market value. Example Assume the
par value is 0.5 1 But the market value is
0.6 1 the euro is undervalued
the pound is overvalued
116
How to fix the exchange rate

• How can a country deal with a situation in which
  its official exchange rate is overvalued?

1. The country could devalue the currency, thus
   officially changing the par value

1. The country could restrict international
   transactions to reduce the supply of its currency
   to the foreign exchange market (if a country
   prohibits people from trading the currency at
   all, the currency is said to be inconvertible).

1. The central bank can buy its own currency, using
   its official reserves (the decline in official
   reserve assets is equal to a countrys current
   account deficit). Thus the market value changes.

117
How to fix the exchange rate
A country cant maintain an overvalued currency
forever, as it will run out of official reserve
assets. Moreover, a speculative run (or
speculative attack) may end the attempt to
support an overvalued currency. If investors
think a currency may soon be devalued, they may
sell assets denominated in the overvalued
currency, increasing the supply of that currency
on the foreign exchange market. This causes even
bigger losses of official reserves from the
central bank and speeds up the likelihood of
devaluation, as occurred in Mexico in 1994 and
Asia in 19971998.
118
How to fix the exchange rate
Thus an overvalued currency cant be maintained
for very long. Similarly, in the case of an
undervalued currency, the official rate is below
the fundamental value. In this case, a central
bank trying to maintain the official rate will
acquire official reserve assets. If the domestic
central bank is gaining official reserve assets,
foreign central banks must be losing them, so
again the undervalued currency cant be
maintained for long.
119
How to fix the exchange rate
The best way for a country to make the official
nominal exchange rate equal to the long run
market value is through the use of monetary
policy. In fact, Then

• calling
• eR , the real exchange rate, which is given in
  the long run
• P, the level of domestic prices
• PF , the level of foreign prices

eNOM eR P / PF
120
How to fix the exchange rate
So, provided eNOM eR P / PF is also used by
the currency traders as an anchor value in the
short run, given that eR and PF are beside the
control of the government, the central bank must
manage the money supply so that this equation is
satisfied (i.e. ensuring equality between the par
value and the market value). This is because the
money supply has an effect on the domestic price
level P. For example, if the currency is
overvalued a monetary contraction is needed. If
the currency is undervalued a monetary expansion
is needed.
121
How to fix the exchange rate
This implies that countries cant both maintain
the fixed exchange rate and use monetary policy
to affect output (as seen previously). Using
expansionary monetary policy to fight a recession
would lead to an overvalued currency. So under
fixed exchange rates, monetary policy cant be
used for macroeconomic stabilization. However, a
group of countries may be able to coordinate
their use of monetary policy.
122
Fixed versus floating exchange rates
Flexible-exchange-rate systems also have
problems, because the volatility of exchange
rates introduces uncertainty into international
transactions.

• There are two major benefits of fixed exchange
  rates
• Stable exchange rates make international trades
  easier and less costly certainty for exporters /
  importers/ investors
• Fixed exchange rates help discipline monetary
  policy, making it impossible for a country to
  engage in expansionary policy the result may be
  lower inflation in the long run.

123
Fixed versus floating exchange rates

• But there are also some disadvantages to fixed
  exchange rates
• They take away a countrys ability to use
  expansionary monetary policy to combat recessions
  
• Sudden real shocks that require a change in the
  equilibrium real exchange rate cannot be absorbed
  by nominal exchange rate adjustment, a new par
  value must be negotiated, via a lengthy political
  process
• Disagreement among countries about the conduct of
  monetary policy may lead to the breakdown of the
  system
• Speculators can cause financial political
  crises .

124
Fixed versus floating exchange rates

• Benefits of floating exchange rates are
• Government ignores exchange rate, no intervention
  needed
• No need to worry about the balance of payments
• Sudden real shocks that require a change in the
  equilibrium real exchange rate immediately
  absorbed by nominal exchange rate adjustment, the
  economy is thus insulated from shocks
• Government can concentrate on internal policy
  objectives (inflation, unemployment, income
  distribution) .

125
Fixed versus floating exchange rates

• Disadvantages of floating exchange rates are
• Exchange rate can be volatile in the short run,
  causing uncertainty (harmful to investment
  trade)
• Loss of external, balance of payments constraint
  on macro-policy may lead to inflationary bias.
• Large capital flows may get out of control,
  causing the nominal exchange rate to get out of
  line with its underlying (fundamental) value .

126
Fixed versus floating exchange rates

Which system is better may thus depend on the
circumstances
If large benefits can be gained from increased
trade and integration, and when countries can
coordinate their monetary policies closely, then
fixed exchange rates may be desirable. Countries
that value having independent monetary policies,
either because they face different macroeconomic
shocks or hold different views about the costs of
unemployment and inflation than other countries,
should have a floating exchange rate.
127
Exchange rates monetary policy

In conclusion, exchange rate policy and monetary
policy are not independent. The increased trade
financial integration will undoubtedly have an
effect on how monetary policy is conducted around
the world.

• Example. The Bank of England core purposes
• Monetary Stability
• Financial Stability .
• You can read them online
• http//www.bankofengland.co.uk/about/corepurposes/
  index.htm

128
Exchange rates monetary policy
Among other things, Monetary Stability means,
according to the Bank of England stable
prices and confidence in the currency. And,
under Price stability and monetary policy, we
can read The first objective of any central
bank is to safeguard the value of the currency in
terms of what it will purchase at home and in
terms of other currencies. Monetary policy is
directed to achieving this objective and to
providing a framework for non-inflationary
economic growth. As in most other developed
countries, monetary policy operates in the UK
mainly t