Home Page EC 340, International Trade and Finance Files EC 340 Lecture Notes Lecture 10: Open Economy Macroeconomics with Fixed Exchange Rates

|  Search

from last time
macroeconomic equilibrium
the multiplier
effects of AD and AS on the trade balance
effect of devaluation on national income
fixed exchange rates and economic policy
perfect capital mobility
shocks to the economy
assignment rule

From Last Time

• What was Nixon's explanation for our gold shortage? By the 1960's, the U.S. had begun to run large balance of payments deficits. More and more dollars ended up in the hands of foreign central banks. With so many dollars out there, foreign central banks became concerned about whether the dollar was really worth $35 = 1 ounce of gold. So, they began to redeem their dollars. The U.S. gold supply shrunk. Nixon could have contracted the American economy to reduce imports. This would have reversed the gold flow. He could have devalued the dollar, say by changing the price to $50 = 1 ounce of gold. He could have imposed restrictions on international transactions. The easiest thing to do, however, was just to break the link between gold and the dollar.
• PPP is not good in the short run but how does it do in the long run? Studies have found that it takes at least 5 years for PPP to reestablish itself after a disturbance to the exchange rate.
• Does/Should PPP work across states in the U.S.? Yes it should. There are profit opportunities if goods are priced differently across the country. It doesn't primarily because of transportation costs.
• Suppose a currency is expected to appreciate in value over the coming year. Assets denominated in that currency will rise in value, making them more attractive to investors. The demand for the currency will increase now so the current spot exchange rate appreciates.
• Exchange Rate Overshooting: A rise in the money supply will cause domestic interest rates to fall, making foreign investment more attractive. In order to keep people invested in the U.S. at the lower interest rate, the dollar must be expected to rise in value. This can only happen if the value of the dollar is bid below its ultimate equilibrium value. Then, the dollar will rise in value to reach its new equilibrium.
• Under the Bretton Woods system, exchange rate were fixed. Countries were supposed to maintain exchange rates within a 1% band around the par value. If the deviation from the par value was due to something permanent, the exchange rate could be change d.

Macroeconomic Equilibrium

AD = C + I + G + X

Equilibrium is a situation in which there is no tendency for change. The economy will be in equilibrium when there is no reason for the level of income to change. Unplanned changes in inventory, equal to the difference between real GDP (Y) and aggregate demand will cause firms to alter the level of production:

• When AD > Y, firms see that their inventories have dropped below the desired level, so production increases to bring inventories up to desired levels. Real GDP rises so that economy cannot have been in equilibrium.
• When AD < Y, firms are unable to find buyers for all the goods they have produced. These unsold goods pile up in firms' inventories. Firms will cut back on production in order to sell off the excess inventories. Real GDP falls, so this cannot be the equilibrium either.
• When AD = Y, firms are able to sell all of the goods they have produced. Inventories are at the desired levels. Firms have no reason to increase or decrease production. Real GDP will not change. The economy is in equilibrium.

1. Y = AD
2. no unplanned changes in inventories
3. leakages = injections

The Multiplier

Suppose m is the marginal propensity to import. Then the spending multiplier in a small, open economy equal 1/(s + m).

This formula assumes that our imports have no effect on foreign economies. For a large open economy this is unlikely to be the case. The spending multiplier with foreign repercussions is

---

Effects of AD and AS on the Trade Balance

1. an increase in C + I + G will likely worsen the trade balance as imports will rise more than exports
2. an increase in exports will improve the trade balance
3. an increase in AS will lower prices and improve the trade balance as we export more and import less

---

Effects of Devaluation on National Income

Suppose the U.S. exports aircraft and imports shoes. U.S. net exports would be equal to
Price in $_aircraft x Quantity of Aircraft Exported - Price in $_shoes x Quantity of Shoes Imported

Suppose the dollar depreciates. The dollar price of shoes rises for American buyers while the price of aircraft falls for foreign buyers. Shoe imports fall and aircraft exports rise.

However, since imports have become more expansive, their real value may rise even though the quantity of imports falls. If the change in the exchange rate causes a large change in the quantity of imports and exports, then net exports will rise. Typically, in the short run the quantity of imports and exports does not change much. So, net exports fall. After consumers and firms have had time to adjust their spending patterns, net exports will rise.

Generally, the exchange rate and the trade balance move in opposite directions.

So, a devaluation will cause national income to rise if

1. devaluation actually improve the trade balance
2. the terms of trade do not worsen so that import prices rise while export prices fall

---

The IS/LM/BP Model

The IS curve tells us what value of the real interest rate clears the goods market for any given value of real income. It shows combinations of Y and r for which the goods market is in equilibrium. S equals I at all points along the IS curve. The IS curve is downward sloping because higher Y leads to higher S which requires a lower r to bring the goods market into equilibrium.

The LM curve traces out those combinations of r and Y for which the asset market is in equilibrium, holding everything else constant.

Assume a fixed exchange rate regime. There are two policy problems under fixed exchange rates:

1. external balance - maintaining the BOP so the exchange rate can remain fixed because a BOP deficit puts downward pressure on the value of the dollar while a BOP surplus puts upward pressure
2. internal balance - control AD to maintain full-employment without inflation

With fixed exchange rates, the BOP reflects private trading between the domestic and foreign currency. A BOP surplus causes a net inflow of money from abroad while a BOP deficit causes a net outflow.

influences on BOP

1. current account balance = NX(Y, R)
2. financial capital flows = F(r)

The BP line shows combinations of Y and r that allow equilibrium in the foreign exchange market. Point to the left of the BP line represent a BOP surplus while points to the right of the line represent a BOP deficit.

In the short run the economy is in equilibrium at the intersection of the IS and LM curves. Equilibrium can be at any BOP position: surplus, deficit, or balanced.

---

Fixed Exchange Rates and Economic Policy

monetary policy

An expansionary monetary policy worsens the balance of payments. An increase in the money supply has three effects: the real interest rate falls causing an outflow of capital, so the BOP worsens real income rises, so imports go up and the BOP worsens the price level rises causing imports to rise and exports to fall, so the BOP worsens

fiscal policy

Expansionary fiscal policy worsens the balance of payments in the long run. A rise in government spending, for example, causes Y to rise so imports go up, worsening the BOP r to rise, leading to an inflow of money which improves the BOP, but only in the short run

Fiscal policy is more effective than monetary policy when exchange rates are fixed.

---

Perfect Capital Mobility

Perfect capital mobility means that money is free to move between countries in search of the highest interest rate. So, the interest rate all over the world is fixed at r_w.

monetary policy

An increase in the money supply pushes the domestic interest rate below rw. This causes an outflow of money and the money supply shrinks. A contractionary monetary policy has the opposite effect. So, the LM curve is horizontal at rw and monetary policy has no effect on the LM curve. Monetary policy is ineffective under fixed exchange rates and perfect capital mobility.

fiscal policy

A rise in government spending causes the interest rate to rise. With r above rw, money flows into the economy from abroad. The inflow causes the money supply to rise until r falls back to rw. Fiscal policy is effective under fixed exchange rates and perfect capital mobility.

---

Shocks to the Economy

1. domestic monetary shock - e.g. increase in money demand
2. domestic spending shock - flexible rates are procyclical
3. international capital flow shocks - e.g. capital outflow
4. export demand shock
5. import supply shock

Fixed exchange rates stabilize internal shocks but magnify external shocks.

---

Assignment Rule

In the long run, both expansionary fiscal and monetary policy worsen the BOP through their effects on income. Which means that in some cases, it is impossible to improve both the level of domestic demand and the BOP.

options:

1. abandon fixed exchange rates (our subject for next week)
2. abandon controlling the domestic economy
3. develop new policy tools
4. use both monetary and fiscal policy

An increase in the money supply lowers the interest rate while expansionary fiscal policy raises the interest rate. So, a combination of expansionary monetary policy and contractionary fiscal policy that kept AD unchanged would decrease the interest rate and worsen the BOP. Monetary and fiscal policy can be mixed to achieve any combination of AD and BOP position.

The assignment rule suggests using fiscal policy to control the domestic economy and monetary policy to influence the BOP.

---

---

David A. Latzko 318 COB Department of Business and Economics Wilkes University Wilkes-Barre, PA 18766 phone: (717) 408-4718 fax: (717) 408-4917 dlatzko@wilkes.edu wilkes1.wilkes.edu/~dlatzko