EC 340

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

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.

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 to rise.

Monetary policy is more effective than fiscal policy when exchange rates are flexible.

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

Flexible exchange rates stabilize external shocks but magnify internal shocks.

Fixed or Flexible Exchange Rates?

  1. types of macroeconomic shocks
  2. policy tool preferences
  3. policy goals
  4. controlling inflation
  5. variability

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917