Macroeconomic Policy and Floating Exchange Rates

1. Macroeconomic Policy and Floating Exchange Rates

2. Introduction • What are fiscal and monetary policy? • Given floating exchange rates, what are the effects of fiscal and monetary policy on • The exchange rate • The current account • Interest rates and • Short run capital flows

3. Fiscal and Monetary Policy • Fiscal Policy – uses changes in government taxes and/or spending at the national level to affect economic activity • Monetary Policy – uses changes in money supply and/or interest rates to affect country’s GDP • What are the effects of fiscal and monetary policy on the exchange rate, the current account, and short run capital flows?

4. Fiscal and Monetary Policy • Past focus of monetary and fiscal policy targeted an external balance • Balancing of the inflows and outflows included in the current account • Currently, monetary and fiscal policy focus on a country’s internal balance • Levels of unemployment and inflation as preferences of citizens of the economy. Focus on managing growth rate of real GDP and the price level

5. Fiscal and Monetary Policy • In general, the focus on internal balance comes at the expense of the external balance • Policies designed to affect the internal balance, however, can have a significant affect on external balance

6. Changes in Fiscal Policy • Government spending in most countries is a significant portion of GDP • Changes in government spending can have a critical impact on an economy • Government spending usually financed through borrowing, thereby having a significant impact on country’s domestic financial markets

7. Changes in Fiscal Policy • Expansionary Fiscal Policy • Assume a balanced budget – government spending equals government taxes • Government adopts lower tax revenues and/or higher government spending • Leads to government budget deficit (or larger deficit) • Assume government borrows to finance – does not print money

8. Changes in Fiscal Policy • Expansionary Fiscal Policy • Can show graphically the effects of this policy on the economy • Demand for loanable funds - total demand for loans in the economy which is indirectly related to interest rate • Private sector – public’s consumption activities that must be financed (homes, cars, etc.) and business demand for investment • Public sector – government needs for funds

9. Changes in Fiscal Policy • Expansionary Fiscal Policy • Supply of loanable funds – total amount of money available to be borrowed • Represented as perfectly inelastic – amount of loanable funds not related to interest rate • In short run the amount the public want sot save determines supply of loanable funds • Balanced budget – demand of loanable funds equals supply at equilibrium interest rate ie.

10. Loanable Fund Market

11. Changes in Fiscal Policy • Expansionary Fiscal Policy • Government’s demand for loanable funds increases – D to D’ • In closed economy, interest rate increases • In open economy, rise in interest rates leads to inflow of foreign capital • Foreign capital augments supply of loanable funds (S to S+f) • Interest rate decreases back to ie • Expansionary policy puts less upward pressure on interest rates in an open economy

12. Changes in Loanable Funds

13. Changes in Fiscal Policy • Expansionary Fiscal Policy – Effects on exchange rate • Assume initial exchange rate with no inflows of capital – current account balanced • Inflow of capital required foreign investors to sell foreign currency to buy dollars • Supply of foreign exchange increases and nominal exchange rate appreciates • Capital account surplus – current account deficit

14. Exchange Rate Effects

15. Changes in Fiscal Policy • Expansionary Fiscal Policy - Effects on domestic economy? • Aggregate demand increases • Closed economy leads to increased output and price level • Open economy effects are less clear • Current account worsens as exports decline and imports increase • Effect is AD shifts back to the left

16. Changes in Domestic Market

17. Changes in Fiscal Policy • Expansionary Fiscal Policy - Conclusion • Net effect on AD, equilibrium output, and price level depends on magnitude of two effects • Expansionary fiscal policy in open economy is less effective at changing equilibrium output than in a closed economy

18. Changes in Fiscal Policy • Contractionary Fiscal Policy • Combination of higher taxes and/or lower government spending • Reduces government budget deficit (increases size of surplus)

19. Changes in Fiscal Policy • Contractionary Fiscal Policy – Effects on interest rates • Demand for loanable funds decreases • Interest rate initially lowers • Less investment by domestic and foreign investors in domestic economy – outflow of capital from domestic economy • Supply of loanable funds decreases lowering interest rates back toward ie

20. Loanable Funds Market

21. Changes in Fiscal Policy • Contractionary Fiscal Policy – Effects on foreign exchange • Demand for foreign exchange increases as capital is moved to foreign markets • Currency depreciates • Capital outflow causes a capital account deficit • Current account surplus – difference between imports (M) and exports (X)

22. Foreign Exchange Market

23. Changes in Fiscal Policy • Contractionary Fiscal Policy – Effects on domestic market • Aggregate demand decreases • Closed economy leads to both decrease in domestic output and price level • Open economy depreciating currency causes exports to increase and imports to fall • Aggregate demand increases toward original

24. Domestic Market

25. Changes in Fiscal Policy • Contractionary Fiscal Policy – Net Effect • Net effect on output and price level depends on magnitude of two effects • Contractionary fiscal policy in an open economy is less effective in changing equilibrium output than in a closed economy

26. Changes in Fiscal Policy • Conclusions • Given current global conditions with floating exchange rates and relatively large short run capital flows, fiscal policy is not as effective at controlling output and price level • Effects of fiscal policy are not irrelevant, however • Interest rate, exchange rate, capital flows and current account balance change noticably affecting business decisions

27. Changes in Monetary Policy • Central bank attempts to affect the short run performance of the economy by changing the growth rate of the money supply and/or interest rates • Discretionary monetary policy – using monetary policy in reaction to and/or to prevent unwanted changes in economy’s short run performance • Some increased interest in a monetary rule instead of discretionary policy

28. Changes in Monetary Policy • Expansionary Monetary Policy – Effects on interest rate • Central bank increases money supply or money supply growth rate • Increases in money supply increase the supply of loanable funds • Interest rate decreases initially • Capital outflow causes supply of loanable funds to decrease increasing interest rate

29. Loanable Funds Market

30. Changes in Monetary Policy • Expansionary Monetary Policy – Effects on exchange rate • Capital outflows cause demand for foreign exchange to increase • Currency depreciates worsening capital account - deficit • Current account surplus as exports increase and imports decrease – difference between M and X

31. Foreign Exchange Market

32. Changes in Monetary Policy • Expansionary Monetary Policy – Effects on domestic economy • Aggregate demand increases since both consumption and investment spending have increased • Closed economy - Output and price level increase • Open economy – increasing exports and decreasing imports increase AD again • Net result: Output and price level increase

33. Domestic Market

34. Changes in Monetary Policy • Contractionary Monetary Policy – Effects on Interest rate • Central bank decreases money supply or reduces money supply growth rate • Government bonds are sold • Decreases supply of loanable funds raising interest rates • Attraction of foreign capital shifts supply of loanable funds to the right decreasing interest rates

35. Loanable Funds Market

36. Changes in Monetary Policy • Contractionary Monetary Policy – Effects on exchange rate • Capital inflow increases supply of foreign exchange • Currency appreciates • Capital account surplus • Current account deficit – difference between X and M

37. Foreign Exchange Market

38. Changes in Monetary Policy • Contractionary Monetary Policy – Effects on domestic market • Reduction in growth rate of interest sensitive consumption and reducing in investment growth rate • AD decreases lowering output and price level in closed economy • Open economy – exports fall and imports rise • AD decreases further • Net effect lowers output and price level

39. Changes in Monetary Policy

40. Policy in Open Economy • Effects of policies described in terms of effects on external and internal balances • Current account balance – external balance • Equilibrium output and price level – internal balance • At any point, there is an optimal balance of output level and price level • Best implies full employment and stable prices

41. Policy in Open Economy • Full employment and stable prices are rarely met so policy used to achieve a balance between output level and price level • Fiscal and monetary policy can be used to influence internal or external balance • In general, government cannot balance both together so much choose to target one

42. Policy in Open Economy • In an open economy with floating exchange rates, macroeconomic policy tends to focus on internal balance • Although both fiscal and monetary policy affect current account and exchange rates, they are not the primary focus of policy • It is sometimes perceived that exchange rate and current account are the primary targets of macroeconomic policies

43. Policy in Open Economy • Following table summarizes effects of different policies on each of the macroeconomic variables • Output, price level, exchange rate and current account • Can use the table to show effects of a policy mix – various combinations of fiscal and monetary policy

44. Policy in Open Economy

45. Policy in Open Economy • Consistent Policy Mixes - Recession • Real GDP below full employment level • Government target to increase output • Expansionary monetary policy and/or expansionary fiscal policy • Combination of both would increase output and price level • Effect on exchange rate is unclear depending on magnitude of two policies on interest rates

46. Policy in Open Economy • Consistent Policy Mixes - Recession • Effect on exchange rate is unclear depending on magnitude of two policies on interest rates • Effects on current account are also unclear again depending on effect on interest rates • Given opposite effects on exchange rates and current account, neither is likely to change much in either direction • End result is improvement of economy by increasing output

47. Effects of Policy Mix - Expansionary

48. Policy in Open Economy • Consistent Policy Mixes – Inflation • Producing output greater than full employment levels • Combination of monetary and fiscal policies • Both equilibrium output and price level fall • Exchange rate and current account effects unclear since policies move in opposite directions

49. Effects of Policy Mix - Contractionary

50. Policy in Open Economy • Consistent Policy Mixes – Conclusion • When governments adopt similar consistent fiscal and monetary policy, the equilibrium level of output and price level can change without drastic changes in exchange rate or current account.