Macroeconomic Policy and Floating Exchange Rates

1. Macroeconomic Policy and Floating Exchange Rates

2. CHAPTER ORGANIZATION • Introduction • Fiscal and Monetary Policy • Changes in Fiscal Policy • Changes in Monetary Policy • Monetary and Fiscal Policy in an Open Economy • Trade Flow Adjustment and Current Account Dynamics • Summary

3. INTRODUCTION • Fiscal and monetary policies are two macroeconomic policies that governments employ to affect domestic output • These polices have an effect on the exchange rate, the current account, interest rates, and short run capital flows within an environment of floating exchange rates

4. FISCAL AND MONETARY POLICY • Fiscal policy entails using changes in government taxation and/or spending to affect the level of economic activity GDP • Monetary policy uses changes in the money supply and/or interest rates to affect a county’s GDP • Changes in these policies have predictable effects on the exchange rate, the current account balance, and short-run capital flows

5. FISCAL AND MONETARY POLICY • The assumption is that the government does not employ fiscal and/or monetary policy in an attempt to generate a balanced current account, but to affect the output and price level • It used to be common practice for governments to focus fiscal and/or monetary policy on obtaining what is known as an external balance • This involves the balancing of the inflows and outflows included in the current account

6. FISCAL AND MONETARY POLICY • Governments now tend to use monetary and fiscal policy to focus on a country’s internal balance • Internal balance refers to the levels of unemployment and inflation that fit the preferences of the citizens of various economies • The focus on internal balance comes at the expense of external balance considerations • Policies designed to achieve a desired internal balance may have large consequences for a country’s external balance

7. CHANGES IN FISCAL POLICY • In most countries government spending is such a large part of the GDP that any changes can have a critical impact on an economy • Substantial amounts spent on transfer payments mean tax revenues add to this amount • A portion of total government spending is usually financed through borrowing, thereby having a significant impact on country’s domestic financial markets and interest rates

8. CHANGES IN FISCAL POLICY • Expansionary Fiscal Policy • The government adopts an expansionary fiscal policy by choosing to lower tax revenues and/or have higher government spending • This leads to a government budget deficit (or larger deficit) • Assume government borrows to finance and does not print money • This will have a predicable effect on interest rates

9. CHANGES IN FISCAL POLICY • The result of an expansionary fiscal policy in an open economy is that less upward pressure is put on interest rates than would be the case in a closed economy • A larger federal government budget deficit tends to increase domestic interest rates which causes an inflow of foreign capital into the country • The capital flows have an effect on the equilibrium exchange rate

10. S Exchange Rate (XR) S’ XRe E X XR’ M D Foreign Exchange (FX) CHANGES IN FISCAL POLICY Figure 18.2 Effects of Expansionary Fiscal Policy on the Exchange Rate

11. CHANGES IN FISCAL POLICY • In an economy with a balanced current account, if the government adopts an expansionary fiscal policy and domestic interest rates rise, the inflow of foreign capital requires foreign investors to sell foreign currency to buy dollars • The supply of foreign exchange increases and the nominal exchange rate appreciates • This means the domestic currency has appreciated in nominal terms • There will be a capital account surplus and a current account deficit

12. CHANGES IN FISCAL POLICY • An expansionary fiscal policy puts upward price pressure on domestic interest rates which leads to an increase in the flow of capital from abroad into the domestic financial markets • We need to consider the effect of an expansionary fiscal policy on the domestic economy • In a closed economy this would lead to an increase in domestic output and price level

13. CHANGES IN FISCAL POLICY • In an open economy the effects are less clear as an expansionary fiscal policy has two conflicting effects • The policy increases aggregate demand as the government reduces taxes and/or increases spending, the direct effect • The policy reduces aggregate demand as the exchange rate appreciates and the current account balance deteriorates, the indirect effect

14. CHANGES IN FISCAL POLICY • The net effect depends on the magnitude of the two effects • Expansionary fiscal policy in an open economy is less effective at changing equilibrium output than in a closed economy

15. Price Level (P) AS P’ F Pe E AD’ AD Ye Y’ Real GDP (Y) CHANGES IN FISCAL POLICY Figure 18.3 Effects of Fiscal Policy on Equilibrium Output and Price Level

16. CHANGES IN FISCAL POLICY • Contractionary Fiscal Policy • A contractionary fiscal policy would entail some combination of higher taxes and/or lower government spending • This reduces a government budget deficit or increases size of a surplus • Adopting a contractionary fiscal policy causes the overall demand for loanable funds to shrink and lowers the interest rate

17. CHANGES IN FISCAL POLICY • The lower domestic interest rate affects capital flow into the country as domestic and foreign investors would tend to invest less and domestic investors would tend to invest more capital abroad • The net result would be an outflow of capital from domestic economy and the supply of loanable funds would decrease lowering interest rates • A contractionary fiscal policy puts less downward pressure in domestic interest rates in an open economy than in a closed economy

18. Exchange Rate (XR) S M XR’ X XRe E D’ D Foreign Exchange (FX) CHANGES IN FISCAL POLICY Figure 18.5 Effects of Contractionary Fiscal Policy on the Exchange Rate

19. CHANGES IN FISCAL POLICY • A contractionary fiscal policy lowers the federal government budget deficit which decreases domestic interest rates and causes an outflow of capital • This increases the demand for foreign exchange and the exchange rate rises or the domestic currency depreciates • This causes the capital account to become negative which causes the current account to become positive

20. CHANGES IN FISCAL POLICY • In an open economy, a contractionary fiscal policy causes aggregate demand to decrease and the domestic currency to depreciate as the government increases taxes and/or reduces spending—the direct effect • The contractionary fiscal policy increases aggregate demand as the currency depreciates and the current account balance to improve—the indirect effect • A contractionary fiscal policy in an open economy is less effective in changing equilibrium output than it is in a closed economy

21. CHANGES IN FISCAL POLICY • In open economies with international capital mobility, fiscal policy is not as particularly effective in changing the equilibrium level of output or the price level • The effects of fiscal policy are not irrelevant, however • Fiscal policy can affect interest rates, exchange rates, capital flows and current account balances and the effects are noticeable in the economy and have an effect on business decision making

22. CHANGES IN MONETARY POLICY • Most central banks in developed countries use discretionary monetary policy in an attempt to affect the short run performance of the economy by changing the growth rate of the money supply and/or interest rates • Recently there has been some increased interest in the substitution of some form of monetary rule for discretionary monetary policy • The central bank would focus on controlling a more limited variable such as the price level

23. CHANGES IN MONETARY POLICY • New Zealand and the EU are currently operating with a price stabilization rule • But few countries use a nondiscretionary (monetary rule) monetary policy • In most cases, changes in monetary policy are the result of discretionary policy decisions • Even with a monetary rule, there are periodic changes in the money supply and interests rates

24. CHANGES IN MONETARY POLICY • Expansionary Monetary Policy • An expansionary monetary policy results when a central bank increases the money supply or money supply growth rate • Increases in the money supply increase the supply of loanable funds initially causing a decrease in the interest rate • The decrease in interest rates causes a capital outflow

25. Interest Rate (i) S S’ E ie F i’ D Loanable Funds (L) CHANGES IN MONETARY POLICY Figure 18.7 Supply and Demand for Loanable Funds and Expansionary Monetary Policy

26. CHANGES IN MONETARY POLICY • Capital outflow causes supply of loanable funds to decrease which increase the interest rate • Capital outflows cause demand for foreign exchange to increase and the currency depreciates which worsens the capital account causing a deficit • This translates into a current account surplus as exports increase and imports decrease • An expansionary monetary policy indirectly leads to a current account surplus when capital is mobile between countries

27. Exchange Rate (XR) S M XR’ X XRe E D’ D Foreign Exchange (FX) CHANGES IN MONETARY POLICY Figure 18.8 Effects of Expansionary Monetary Policy on the Exchange Rate

28. CHANGES IN MONETARY POLICY • In a closed economy, monetary policy is generally effective because lower interest rates increase both consumption and investment spending—the direct effect • Aggregate demand increases • In an open economy, the fall in interest rates induces depreciation of the domestic currency and capital outflow improving the current account as exports increase and imports decrease—the indirect effect

29. CHANGES IN MONETARY POLICY • The aggregate demand curve shifts even further to the right • The net result is that in an open economy with capital mobility, monetary policy is effective in increasing the level of economic activity

30. Price Level (P) AS P” G P’ F Pe E AD” AD’ AD Ye Y’ Y” Real GDP (Y) CHANGES IN MONETARY POLICY Figure 18.9 Effects of Monetary Policy on Equilibrium Output and Price Level

31. CHANGES IN MONETARY POLICY • Contractionary Monetary Policy • In contractionary monetary policy, the central bank decreases the money supply or reduces the money supply growth rate • The most notable effect is an increase in domestic interest rates • In developed countries selling government bonds decreases the supply of loanable funds causing a rise in interest rates

32. Interest Rate (i) S’ S F i’ E ie D Loanable Funds (L) CHANGES IN MONETARY POLICY Figure 18.10 Supply and Demand for Loanable Funds and Contractionary Monetary Policy

33. CHANGES IN MONETARY POLICY • The resulting attraction of foreign capital and increase in supply causes a decrease in the exchange rate • This creates a capital account surplus and a current account deficit • A contractionary monetary policy is effective in a closed economy because the increased interest rate reduces the growth rate of consumption and/or investment

34. Exchange Rate (XR) S S’ XRe E X XR’ M D Foreign Currency (FX) CHANGES IN MONETARY POLICY Figure 18.11 Effects of Contractionary Monetary Policy on the Exchange Rate

35. CHANGES IN MONETARY POLICY • The reduction in total spending causes a decease in aggregate demand lowering output and the price level • In an open economy, the effects are larger • The increase in interest rate induces capital flows into the country and an appreciation of the currency • The current account deteriorates as exports fall and imports rise—the indirect effect • In an open economy, monetary policy is highly effective in changing equilibrium levels of output and price

36. Price Level (P) AS Pe E P’ F P” G AD AD’ AD” Y” Y’ Ye Real GDP (Y) CHANGES IN MONETARY POLICY Figure 18.12 Effects of Monetary Policy on Equilibrium Output and Price Level

37. Interest Rate (i) S G F i’ E ie D’ D L’ L Loanable Funds (L) CHANGES IN MONETARY POLICY Figure 18.13 Crowding Out in a Closed Economy

38. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • The effects of government policies are often described in terms of effects on a country’s external and internal balances • The current account balance represents the external balance while the equilibrium level of output and price level is the internal balance • At any point in time, there is an optimal balance of output level and price level implying full employment and stable prices • This is rarely observed

39. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • Governments frequently use fiscal and monetary policy to achieve an acceptable balance between output and price level • Fiscal and/or monetary policy can be used to influence internal or external balance • In many cases, governments cannot balance both and have to choose which is more important • Typically internal balance is seen as most important and fiscal and/or monetary policy is focused on achieving an optimal internal balance

40. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • Although both fiscal and monetary policy affect the current account and exchange rates, they are usually not the primary focus of policy • The public and the press tend to think the exchange rate and the current account are the primary targets of macroeconomic policies • While this may be the case, macroeconomic policy is often focused on a country’s internal balance • The policy mix of a country is the effects of various combinations of fiscal and monetary policy

41. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY Table 18.1 Effects of Different Fiscal and Monetary Policies Under Flexible Exchange Rates and Capital Mobility

42. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • Consistent Policy Mixes • In a recession the real GDP is below the full employment level • The government want to increase output by adopting an expansionary monetary policy and/or expansionary fiscal policy • A combination of both would tend to increase output and price level • The potential for rising prices may be deemed an acceptable risk

43. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • The effect on the exchange rate is unclear depending on magnitude of change in the two policies on domestic interest rates • The effect on the current account is also unclear depending on the effect on interest rates • From a policy perspective, battling a recession and letting the external balance adjust as needed is a safe option • The domestic economy would improve and the external balance is unlikely to change by a large amount in either direction

44. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • A similar scenario emerges if the problem is inflation • The economy is temporarily producing output at greater than full employment levels • The government would employ a combination of contractionary monetary and fiscal policies • The effects are clear, both equilibrium output and the price level would fall • The effects on the exchange rate and current account are unclear since policies move in opposite directions

45. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • This policy mix does not appear to be a problem as the internal balance moves in the desired direction without dramatic changes in the external balance • When governments adopt similar fiscal and monetary policies, the equilibrium level of output and the price level can be changed without making drastic changes in the exchange rate or current account balance

46. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • Inconsistent Policy Mixes • Mixtures of fiscal and monetary policies that are inconsistent with one another are inconsistent with internal balance objectives • Why would a government adopt such a mixture when the effects are unclear? • Often different policy makers are in control of fiscal and monetary policy • In the U.S., elected officials control the fiscal policy while the independent Federal Reserve determines the monetary policy

47. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • The effect of inconsistent policies can be ambiguous on the domestic economy • The effect on the external balance is explicit • An expansionary fiscal policy and contractionary monetary policy leads to an appreciation of the currency and decreased current account • The policies reinforce one another and the effect on the external balance can be significant

48. MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY • A contractionary fiscal policy coupled with an expansionary monetary policy leads to a depreciation of the domestic currency and an improvement in the current account balance • The effect of changes in the country’s exchange rate can have a dramatic impact on the competitiveness of individual firms with tradable goods

49. 50 – 0 – –50 – –100 – –150 – –200 – –250 – –300 – In Billions of Dollars 1980 1985 1990 1995 Year Federal Deficit Current Account MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY Figure 18.14 Federal Budget Deficit and the Balance on Current Account for the U.S., 1980-1996

50. 9 – 6 – 3– 0 – –3 – Long-Run Real Interest Rate 1980 1985 1990 1995 Year Real Interest Rate MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY Figure 18.15a U.S. Real Exchange Rate and Long-Run Interest Rate, 1980-1996