Chapter Seventeen

Chapter Seventeen Short-Run Macroeconomic Policy under Flexible Exchange Rates

Introduction Macroeconomic Policy with Immobile Capital Macroeconomic Policy with Perfectly Mobile Capital Macroeconomic Policy with Imperfectly Mobile Capital The Policy Mix Summary of Short-Run Policy Effectiveness under a Flexible Exchange Rate Chapter Seventeen Outline

Introduction • From 1946 until 1973, the world economy operated under the Bretton Woods system of fixed exchange rates. • By the late 1960s, the system came under pressure: • Governments of major industrial economies faced increasing domestic political pressure to pursue short-run macroeconomic policies that maintained full employment; and • Policies of the U.S., the reserve-currency country, generated inflation which was transmitted to other countries. • System collapsed in 1973 – several countries allowed their currencies to float against the dollar.

Introduction • It is important to understand how a flexible exchange rate system works and its implications for macroeconomic policy.

Macroeconomic Policy with Immobile Capital • Fiscal Policy • The short-run effects of fiscal policy with immobile capital is shown in Figure 17.1: • An expansionary fiscal policy shifts IS from IS0 to IS1, raising income and the interest rate. • CAB moves into deficit, and domestic currency depreciates. • Depreciation raises the income consistent with external balance (shifting BOP line to right) and lowers relative prices of domestic goods (shifting IS from IS1 to IS2). • At new equilibrium, income, the interest rate, and the exchange rate are higher.

Figure 17.1: Short-Run Effect of Fiscal Policy with Immobile Capital i 0 1 BOP BOP 0 LM 2 IS 1 IS 0 IS 0 1 2 0 Q Q = Q Q Q EB IB EB EB

Macroeconomic Policy with Immobile Capital • Monetary Policy • The short-run effects of monetary policy with immobile capital are shown in Figure 17.2: • An increase in money stock causes income to rise and interest rates to fall to equalize the quantity of money demanded with the new, higher stock. • As income rises, the current account moves toward a deficit and the currency depreciates. • The depreciation lowers the relative price of domestic goods, shifts spending toward domestic and away from foreign goods, and raises the income consistent with external balance.

Figure 17.2: Short-Run Effect of Monetary Policy with Immobile Capital i 0 1 BOP BOP 0 LM 1 LM 1 IS 0 IS 0 0 1 Q Q = Q Q EB IB EB

Macroeconomic Policy with Perfectly Mobile Capital • Fiscal Policy • Higher mobile capital reduces fiscal policy’s effectiveness under flexible exchange rates. • With highly mobile capital, expansionary fiscal policy no longer causes a depreciation of the domestic currency, but an appreciation. • The appreciation causes a second form of crowding-out. • As domestic currency appreciates (e falls), the relative price of domestic goods rises because R = P/eP*, and individuals shift their expenditures toward the now relatively cheaper foreign goods.

Macroeconomic Policy with Perfectly Mobile Capital • Fiscal Policy (cont.) • Policy expected to be temporary, as shown in Fig. 17.3 (a): • In panel (a), the initial direct effect of an expansionary fiscal policy is to raise income and interest rates. • Higher domestic interest rate (point 2) generates a capital inflow and appreciation of domestic currency. • If the fiscal policy is perceived as temporary, BOP shifts to BOP1. • As exchange rate falls, domestic goods become more expensive relative to foreign ones.

Macroeconomic Policy with Perfectly Mobile Capital • Fiscal Policy (cont.) • Policy expected to be permanent, as shown in Fig. 17.3 (b): • The fall in private expenditure shifts IS back to IS2, at point three. • If policy is seen as permanent, the appreciation does not shift BOP line, but shifts IS all the way back to IS3, and equilibrium is restored at the original income level at point four. • Panel (b) traces the corresponding events in the foreign exchange market.

Figure 17.3a: Short-Run Effect on Fiscal Policy with Perfectly Mobile Capital i 0 LM 2 1 i BOP 1 3 0 i BOP 0 1 = 4 1 IS 2 IS 0 3 IS = IS 0 1 0 Q Q Q Q EB EB IB (a)

Figure 17.3b: Short-Run Effect on Fiscal Policy with Perfectly Mobile Capital $ e = / FX S FX e 1 0 e 3 1 4 e DFX(i0, i *, e ) 2 DFX(i1, i *, e ) DFX(i0, i *, e ) 0 Quantity of FX-denominated

Macroeconomic Policy with Perfectly Mobile Capital • Monetary Policy • The short-run effects of monetary policy with perfectly mobile capital is shown in Figure 17.4: • Policy expected to be temporary: panel (a) • An open market purchase of government bonds by central bank moves LM from LM0 to LM1. • Income rises and interest rates fall to make individuals willing to hold the new, larger stock of money. Capital flows are very sensitive to interest rate changes, so the fall in domestic interest rate causes a large capital outflow at point 2. • Resulting BOP deficit cause domestic currency to depreciate.

Macroeconomic Policy with Perfectly Mobile Capital • Monetary Policy (cont.) • As the exchange rate rises, domestic goods become relatively less expensive compared to foreign ones and spending shifts in favor of domestic goods. • IS moves to right. • If monetary policy is perceived as temporary, ee does not change and the depreciation shifts the BOP line down to BOP1. • New equilibrium is at point 3.

Macroeconomic Policy with Perfectly Mobile Capital • Monetary Policy (cont.) • If policy is perceived as permanent,ee rises along with e and the BOP line does not shift in response to the (now larger) depreciation, but the IS curve shifts further to IS2, restoring equilibrium at point 4. • Panel (b) illustrates the corresponding adjustment in the foreign exchange market.

Figure 17.4a: Short-Run Effect of Monetary Policy with Perfectly Mobile Capital i 0 LM 1 LM 1 4 0 i BOP 0 3 1 i BOP 1 2 2 IS IS 1 0 IS 0 1 0 Q Q = Q Q EB IB EB

Figure 17.4b: Short-Run Effect of Monetary Policy with Perfectly Mobile Capital $ e = / FX S FX 4 e 2 e 3 1 1 e 0 FX e D (i , i*, e ) 0 2 FX e D (i , i*, e ) 1 0 FX e D (i , i*, e ) 0 0 0 Quantity of FX-denominated Deposits

Macroeconomic Policy with Imperfectly Mobile Capital See Figure 17.5 • Fiscal Policy may raise income with imperfectly mobile capital, but the expansionary effect is at least partially offset by an appreciating currency that induces a shift toward foreign goods and away from domestic ones. • Figure 17.5: a rise in government purchases shifts IS to right and raises income and interest rates. • Capital flows into the economy and currency appreciates. As exchange rate falls, relative price of domestic goods rises. • Perceptions that policy is permanent makes policy less effective in raising income.

Figure 17.5: Short-Run Effects of Fiscal Policy with Imperfectly Mobile Capital 0 LM i 1 BOP 0 BOP 1 IS 2 IS 0 IS 0 Q Q Q EB IB

Macroeconomic Policy with Imperfectly Mobile Capital • Monetary Policy • Figure 17.6 shows that an increase in money stock raises income and lowers the interest rate. • Capital outflow depreciates currency, lowering relative price of domestic goods. • Spending switches to domestic goods, and IS shifts right. • Depreciation of currency makes monetary policy an effective instrument for reaching internal balance. • Perceptions that the policy is permanent (resulting in smaller BOP shift and larger IS shift) make it more effective in raising income.

Figure 17.6: Short-Run Effect of Monetary Policy with Imperfectly Mobile Capital i 0 LM 1 LM 0 BOP 1 BOP 1 IS 0 IS 0 0 1 Q Q = Q Q EB IB EB

The Policy Mix • Which combination of fiscal and monetary policies should policy makers use, or does it matter? • Choice of fiscal and monetary policy mix does matter: each combination will result in a different domestic interest rate/exchange rate. • Can dramatically affect distribution in different sectors of domestic economy. • Examples of policy mixes: • Fiscal policy alone • Monetary policy alone • Mix of fiscal and monetary policies

The Policy Mix • The use of various policy mixes to achieve internal balance is shown in Figure 17.7: • Policy makers can use many combinations to increase income to QIB. • Each combination results in different values of the interest rate and the exchange rate. • Expansionary fiscal policy alone produces highest interest rate, monetary policy alone the lowest, and a policy mix an intermediate value. • Expansionary fiscal policy appreciates the domestic currency; monetary policy alone depreciates it; and the policy mix in panel (c) leaves the exchange rate unchanged.

Figure 17.7a: Use of Various Policy Mixes to Achieve Internal Balance i 0 LM 1 BOP (a) Fiscal Policy Alone 0 BOP 1 IS 2 IS 0 IS 0 1 0 Q Q = Q Q EB IB EB

Figure 17.7b: Use of Various Policy Mixes to Achieve Internal Balance 0 LM i 1 LM 0 BOP 1 BOP 1 IS 0 IS 0 1 0 Q Q Q = Q EB IB EB (b) Monetary Policy Alone

Figure 17.7c: Use of Various Policy Mixes to Achieve Internal Balance 0 LM i 1 LM 0 BOP 1 IS 0 IS 0 1 0 Q Q = Q Q EB IB EB (c) Mix of Fiscal and Monetary policies

The Policy Mix • Responding to disturbances • The policy mix with which policy makers choose to pursue internal balance depends on, among other things, the nature of the disturbance that pushed the economy below full employment. • Such disturbances fall into two categories: • Shifts in tastes away from domestically produced goods; and • Increases in the demand for real money balances.

The Policy Mix • Responding to disturbances (cont.) • Policy responses to a spending disturbance are represented graphically in Figure 17.8: • Policy makers can respond to a contractionary spending disturbance with an expansionary fiscal or monetary policy. • A fiscal policy restores full employment at original interest rate and exchange rate (point 3). • A monetary policy restores full employment, but magnifies the disturbance’s effect on the interest rate and exchange rate (point 4).

Figure 17.8: Policy Responses to a Spending Disturbance i 0 1 LM LM 1 = 3 0 BOP 4 1 BOP 2 0 2 IS = IS 3 IS 1 IS 0 Q Q IB

The Policy Mix • A second type of disturbance consists of a rise in demand for real money balances • Possible policy responses to a contractionary monetary disturbance include expansionary fiscal or monetary policy. • An expansionary fiscal policy restores full employment, but exacerbates the rise in the interest rate and currency appreciation (point 4). • Monetary policy restores full employment at the pre-disturbance interest rate and exchange rate (point 3).

Figure 17.9: Policy Response to a Money-Demand Disturbance i 1 LM 2 = LM 0 LM 1 BOP 4 0 BOP 2 1 IS 1 = 3 2 IS 0 IS 0 Q Q IB

The Policy Mix • Constraints on the policy mix. • Defining the full-employment level of output for an economy is a complex task. • Is the current level of output consistent with, above, or below full employment? • Nature and source of disturbances may be difficult to discern. • Appropriate policy responses are dependent on correctly judging the disturbance’s time horizon. • Policy makers also face political pressures that constrain their ability to use some macroeconomic tools.

The Policy Mix • Transmission and the policy mix • Different domestic macroeconomic policy mixes have different effects on trading-partner economies, a phenomenon known as transmission. • Governments of the trading-partner economies often attempt to influence the course of domestic macroeconomic policy. • How trading partners feel about these transmitted policy effects depends on the state of their economies.

Note on Case One: Japan in the 1990s • Figure 17.10: the Japanese output gap, 1982 – 1999. • Output gap equals the percentage difference between actual real GDP and potential, or full employment, real GDP. • Figure 17.11: the Japanese stock market and land prices, 1985 – 1997. • By 1997, the Japanese Nikkei stock index and commercial land prices had fallen to their 1985 levels. • Figure 17.12: Japanese Stimulus Packages implemented in response to the economic slump. • These stimulus packages were implemented in periods when the output gap was particularly large See Figures 17.10 - 17.12

Figure 17.10: Japanese Output Gap, 1982-1999

Figure 17.11: Japanese Stock Market and Land Prices, 1990-2001 (1990 = 100)

Figure 17.12: Japanese Fiscal Stimulus Packages, 1992-1999 (Trillion ¥)

Note on Case Three: Floating the Pound, Part I • Figure 17.13 shows the real GDP growth for Britain and France, 1992 – 1997. • Following the September 1992 floating of the pound, British real GDP grew faster than did French GDP.

Figure 17.13: Real GDP, Britain and France, 1992-1997 5 Real GDP Growth (%) 4 United Kingdom France 3 2 1 0 1993 1994 1995 1996 1997 1992 Year 21

Note for Case Four: The Budget and the Dollar • Figure 17.14 (a) and (b) show the U.S. government budget and the exchange rate, 1973 – 1997. • The basic open economy macroeconomic model predicts that a government budget deficit would be associated with a domestic currency appreciation and a budget surplus with a depreciation. • Major trends during the 1973-97 period in the United States conformed to the expected pattern.

Figure 17.14a: The U.S. Government Budget and the Exchange Rate, 1973-2000

Figure 17.14b: The U.S. Government Budget and the Exchange Rate, 1973-2000

Key Terms in Chapter 17 • Bretton Woods system • Crowding out • Policy mix • Transmission

Chapter Seventeen