Lecture 11- Open Economy Macroeconomics with Flexible Exchange Rates
from last time
monetary policy with flexible exchange rates
fiscal policy with flexible exchange rates
shocks to the economy
fixed or flexible exchange rates?
From Last Time
- Is our paper supposed to be co-written: 1 group, 1 paper or 1 group, 3 papers? 1 group, 1 paper
- Expansionary fiscal policy is more effective than expansionary monetary policy under fixed exchange rates because, in the short run, expansionary fiscal policy can lead to a balance of payments surplus. The BOP surplus causes the money supply to
increase which reinforces the expansionary nature of your economic policy.
- Why are exports not considered in the calculation for the multiplier in a small open economy? Such an economy is too small to have an impact on other national economies. So, the multiplier is equal to 1 divided by the sum of the nation's
marginal propensity to save and its marginal propensity to import.
- Do countries base their exchange rate policy solely on the cause of economic shocks? No, the decision may be based on any combination of economic and political considerations.
Monetary Policy with Flexible Rates
Assume full-employment and suppose that the supply of dollars in the foreign exchange market increases as the
U.S. runs a balance of payments deficit. The exchange rate drops (the dollar falls in value) so that prices
in the U.S. fall relative to those in the rest of the world. Imports will fall and exports will rise causing
the trade balance to improve. The rise in net exports causes aggregate demand to increase and real GDP to
increase by a multiplied amount.
Consider an expansionary monetary policy. The rise in the money supply causes the interest rate to fall.
The lower interest rate has two effects: (1) it stimulates AD which results in a rise in real GDP; higher
income worsens the balance of trade, and (2) the fall in the interest rate causes capital to flow out of the
country, thereby worsening the balance of payments. The result of these two forces is a worsening of the BOP
which causes the dollar to depreciate which causes real GDP to rise. What's going on is that the currency
depreciation caused by the increase in the money supply expands the economy even more.
- a BOP deficit causes the dollar to depreciate which causes real GDP to rise
- a BOP surplus causes the dollar to appreciate which causes real GDP to fall
Fiscal Policy with Flexible Rates
Consider an expansionary fiscal policy. This has two effects as well: (1) AD and real GDP rise, worsening
the trade balance, and (2) the higher interest rates caused by the bigger budget deficit attract capital
inflows which improve the balance of payments (this is a short run phenomenon). These two effects work in
opposite directions but the net result is probably a fall in the value of the dollar which causes real GDP
Monetary policy is more effective than fiscal policy when exchange rates are flexible.
Shocks to the Economy
- domestic monetary shock - e.g. increase in money demand
- domestic spending shock - flexible rates are procyclical
- international capital flow shocks - e.g. capital outflow
- export demand shock
- import supply shock
Flexible exchange rates stabilize external shocks but magnify internal shocks.
Fixed or Flexible Exchange Rates?
- types of macroeconomic shocks
- policy tool preferences
- policy goals
- controlling inflation