Impact of Fiscal and Monetary Policy in Economies with Fixed Exchange Rates - Prof. Akila | Study notes Economics

Spring Semester ’03-’04

Akila Weerapana

Lecture 12: Short-Run Macro Policy: Fixed Exchange Rates

I. OVERVIEW

•In the last lecture we looked at the short-run impact of monetary and fiscal policy in small

and large economies under a flexible exchange rate system. We showed that fiscal policy

tends to be relatively less effective in an open economy under flexible exchange rates, while

monetary policy tended to be more effective.

•We also showed that the large open economy case was in-between the small open economy

case and the closed economy case.

•Today, we will focus on analyzing the impacts of fiscal and monetary policy in the case of an

economy with fixed exchange rates; the impact of policy differs dramatically from the case of

flexible exchange rates.

II. THE KEY FEATURE OF POLICY ANALYSIS UNDER FIXED

EXCHANGE RATES

•The basic gist of the analysis is identical. In moving from a closed economy to a small open

economy, we need to worry about an additional complication: the change in interest rate will

lead to either an inflow or an outflow of money.

•In the case of floating exchange rates, the inflow/outflow of money leads to a change in the

exchange rate. Changes in the exchange rate, in turn, affect the value of the real exchange

rate and net exports as well as affecting the expected depreciation of the domestic currency.

The IS curve and the BP curve both shift until UIRP is restored.

•In the case of fixed exchange rates, the mechanism has to be different. After all we cannot

have appreciation or depreciation of the currency if its value is fixed. In this case, changes

in the money supply that come from buying and selling foreign currency is the mechanism

through which UIRP is restored

•When domestic interest rates are higher than world interest rates there is an inflow of foreign

money. Since the central bank fixes the exchange rate, it stands prepared to sell domestic

currency in exchange for foreign currency to individuals who want to deposit their money

in the domestic economy. When the central bank sells domestic currency it increases the

domestic money supply, thus lowering interest rates.

•Conversely, when domestic interest rates are lower than world interest rates there is an outflow

of foreign money. Since the central bank fixes the exchange rate, it stands prepared to buy

domestic currency in exchange for foreign currency from individuals who want to deposit

their money abroad. When the central bank buys domestic currency it decreases the domestic

money supply, thus raising interest rates.

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Spring Semester ’03-’

Akila Weerapana

Lecture 12: Short-Run Macro Policy: Fixed Exchange Rates

I. OVERVIEW

In the last lecture we looked at the short-run impact of monetary and fiscal policy in small

and large economies under a flexible exchange rate system. We showed that fiscal policy

tends to be relatively less effective in an open economy under flexible exchange rates, while

monetary policy tended to be more effective.

We also showed that the large open economy case was in-between the small open economy

case and the closed economy case.

Today, we will focus on analyzing the impacts of fiscal and monetary policy in the case of an

economy with fixed exchange rates; the impact of policy differs dramatically from the case of

flexible exchange rates.

II. THE KEY FEATURE OF POLICY ANALYSIS UNDER FIXED

EXCHANGE RATES

The basic gist of the analysis is identical. In moving from a closed economy to a small open

economy, we need to worry about an additional complication: the change in interest rate will

lead to either an inflow or an outflow of money.

In the case of floating exchange rates, the inflow/outflow of money leads to a change in the

exchange rate. Changes in the exchange rate, in turn, affect the value of the real exchange

rate and net exports as well as affecting the expected depreciation of the domestic currency.

The IS curve and the BP curve both shift until UIRP is restored.

In the case of fixed exchange rates, the mechanism has to be different. After all we cannot

have appreciation or depreciation of the currency if its value is fixed. In this case, changes

in the money supply that come from buying and selling foreign currency is the mechanism

through which UIRP is restored

When domestic interest rates are higher than world interest rates there is an inflow of foreign

money. Since the central bank fixes the exchange rate, it stands prepared to sell domestic

currency in exchange for foreign currency to individuals who want to deposit their money

in the domestic economy. When the central bank sells domestic currency it increases the

domestic money supply, thus lowering interest rates.

Conversely, when domestic interest rates are lower than world interest rates there is an outflow

of foreign money. Since the central bank fixes the exchange rate, it stands prepared to buy

domestic currency in exchange for foreign currency from individuals who want to deposit

their money abroad. When the central bank buys domestic currency it decreases the domestic

money supply, thus raising interest rates.

The case of fixed exchange rates is in many ways easier to analyze than the case of flexible

exchange rates. This is because a credible fixed exchange rate system will have eE^ = e

always, thus reducing UIRP to simply i = i∗^ (where i∗^ is the interest rate of the country

whose currency you fix to and e is the exchange rate denoted in terms of domestic currency

per unit of that country’s currency). As a result, the BP curve is also just a horizontal line

at the foreign interest rate.

III. POLICY IN A SMALL OPEN ECONOMY

Fiscal Policy

We first focus on the small open economy case as before. Suppose the small open economy

was initially in equilibrium with the interest rate of i 0 (which also happens to be the foreign

interest rate i∗) and an output level of Y 0. We will consider an expansionary fiscal policy, an

increase in G.

The increase in G increases the expenditure on goods and services and raises production.

This shifts the IS curve out to IS’ and causes the interest rate to increase above i∗, to i 1 and

Y to increase to Y 1.

When the domestic interest rate increases above the foreign interest rate UIRP is violated

since i 1 > i∗. Domestic returns are higher so there is an inflow of money into the country;

the central bank hands out domestic currency in exchange for foreign currency.

The exchanging of domestic currency for foreign currency by the central bank increases the

domestic money supply. This shifts the LM curve out. Unlike in the flexible exchange rate

case there is no appreciation of the domestic currency and hence no impact on NX and the

IS curve - the additional effects here are all on the LM side.

Furthermore, since foreign interest rates are unaffected, the BP curve remains at i∗. Thus the

inflow will continue until the LM curve has shifted out enough for i to return to i∗^ restoring

UIRP at i = i∗

As can be seen in the figure below, the overall effect is that, under fixed exchange rates,

expansionary fiscal policy increases output in a small open economy by more than in a closed

economy.

Unlike in the flexible exchange rate case there is no depreciation of the domestic currency

and hence no impact on NX and the IS curve - once again, the additional effects here are all

on the LM side.

Furthermore, since foreign interest rates are unaffected, the BP curve remains at i∗. Thus

the outflow will continue until the LM curve has shifted back enough for i to return to i∗

restoring UIRP at i = i∗^ - in other words, until LM returns to the original state.

Interest rates and output are exactly the same as it was before: expansionary monetary policy

has NO short-run effect in a small open economy under fixed exchange rates.

So even though expansionary fiscal policy has extremely powerful short-run effects in a small

open economy under fixed exchange rates, expansionary monetary policy has no effect at all.

The general intuition is that expansionary fiscal policy tends to raise interest rates, which

results in a monetary inflow that expands the money supply, which adds to the increase in

domestic output. On the other hand, expansionary monetary policy tends to lower interest

rates, resulting in a monetary outflow that reduces the money supply, which raises interest

rates and therefore reduces output.

Increase in M s: Small Open Economy (Fixed)

i

Y

IS

LM

BP

LM′

Y 0 = Y 2 Y 1

i 2 = i∗^ = i 0

i 1

The process works in reverse for contractionary policy. Interest rates and output are exactly

the same as it was before: contractionary monetary policy has NO short-run effect in a small

open economy under fixed exchange rates.

Decrease in M s: Small Open Economy (Fixed)

i

Y

IS

LM

BP

LM′

Y 1 Y 0 = Y 2

i 2 = i∗^ = i 0

i 1

the contraction would have continued until the interest returned to the original world interest

rate level.

Decrease in G: Large Open Economy (Fixed)

i

Y

IS

LM

BP

IS′

LM′

BP′

i 0 = i∗

i 1

i 2 = i∗ 1

Y 2 Y 1 Y 0

Monetary Policy

Again suppose the large open economy was initially in equilibrium with the interest rate at

the world interest rate and an output level of Y 0 and first consider an expansionary policy.

The increase in money supply brings about a fall in interest rates and an increase in output

to i 1 and Y 1 respectively.

Since this is a large open economy, the increase in money supply also lowers the world interest

rate, by a lesser degree, to i∗ 1.

When the domestic interest rate decreases below the foreign interest rate UIRP is violated

since i 1 < i∗ 1 : there is an outflow of money from the country; the central bank hands out

foreign currency reserves in exchange for domestic currency. This reduces the domestic money

supply and shifts the LM curve back.

The outflow will continue until the LM curve has shifted back enough to intersect with the

IS curve and the BP curve at the new foreign interest rate i∗ 1 restoring UIRP at i 2 = i∗ 1 , with

an output level of Y 2.

Under fixed exchange rates, expansionary monetary policy in a large open economy increases

output by more than in a small open economy but by less than in a closed economy.

Increase in M s: Large Open Economy (Fixed)

i

Y

IS

LM

BP

LM′′^ LM′

BP′

Y 0 Y 2 Y 1

i∗^ = i 0

i 1

i∗ 1 = i 2

Under fixed exchange rates, contractionary monetary policy in a large open economy decreases

Impact of Fiscal and Monetary Policy in Economies with Fixed Exchange Rates - Prof. Akila , Study notes of Economics

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Download Impact of Fiscal and Monetary Policy in Economies with Fixed Exchange Rates - Prof. Akila and more Study notes Economics in PDF only on Docsity!

Spring Semester ’03-’

Akila Weerapana

Lecture 12: Short-Run Macro Policy: Fixed Exchange Rates

I. OVERVIEW

and large economies under a flexible exchange rate system. We showed that fiscal policy

tends to be relatively less effective in an open economy under flexible exchange rates, while

monetary policy tended to be more effective.

case and the closed economy case.

economy with fixed exchange rates; the impact of policy differs dramatically from the case of

flexible exchange rates.

II. THE KEY FEATURE OF POLICY ANALYSIS UNDER FIXED

EXCHANGE RATES

economy, we need to worry about an additional complication: the change in interest rate will

lead to either an inflow or an outflow of money.

exchange rate. Changes in the exchange rate, in turn, affect the value of the real exchange

rate and net exports as well as affecting the expected depreciation of the domestic currency.

The IS curve and the BP curve both shift until UIRP is restored.

have appreciation or depreciation of the currency if its value is fixed. In this case, changes

in the money supply that come from buying and selling foreign currency is the mechanism

through which UIRP is restored

money. Since the central bank fixes the exchange rate, it stands prepared to sell domestic

currency in exchange for foreign currency to individuals who want to deposit their money

in the domestic economy. When the central bank sells domestic currency it increases the

domestic money supply, thus lowering interest rates.

of foreign money. Since the central bank fixes the exchange rate, it stands prepared to buy

domestic currency in exchange for foreign currency from individuals who want to deposit

their money abroad. When the central bank buys domestic currency it decreases the domestic

money supply, thus raising interest rates.

exchange rates. This is because a credible fixed exchange rate system will have eE^ = e

always, thus reducing UIRP to simply i = i∗^ (where i∗^ is the interest rate of the country

whose currency you fix to and e is the exchange rate denoted in terms of domestic currency

per unit of that country’s currency). As a result, the BP curve is also just a horizontal line

at the foreign interest rate.

Fiscal Policy

was initially in equilibrium with the interest rate of i 0 (which also happens to be the foreign

interest rate i∗) and an output level of Y 0. We will consider an expansionary fiscal policy, an

increase in G.

This shifts the IS curve out to IS’ and causes the interest rate to increase above i∗, to i 1 and

Y to increase to Y 1.

since i 1 > i∗. Domestic returns are higher so there is an inflow of money into the country;

the central bank hands out domestic currency in exchange for foreign currency.

domestic money supply. This shifts the LM curve out. Unlike in the flexible exchange rate

case there is no appreciation of the domestic currency and hence no impact on NX and the

IS curve - the additional effects here are all on the LM side.

inflow will continue until the LM curve has shifted out enough for i to return to i∗^ restoring

UIRP at i = i∗

expansionary fiscal policy increases output in a small open economy by more than in a closed

economy.

and hence no impact on NX and the IS curve - once again, the additional effects here are all

on the LM side.

the outflow will continue until the LM curve has shifted back enough for i to return to i∗

restoring UIRP at i = i∗^ - in other words, until LM returns to the original state.

has NO short-run effect in a small open economy under fixed exchange rates.

open economy under fixed exchange rates, expansionary monetary policy has no effect at all.

results in a monetary inflow that expands the money supply, which adds to the increase in

domestic output. On the other hand, expansionary monetary policy tends to lower interest

rates, resulting in a monetary outflow that reduces the money supply, which raises interest

rates and therefore reduces output.

i

Y

IS

LM

BP

LM′

Y 0 = Y 2 Y 1

the same as it was before: contractionary monetary policy has NO short-run effect in a small

open economy under fixed exchange rates.

i

Y

IS

LM

BP

LM′

Y 1 Y 0 = Y 2

the contraction would have continued until the interest returned to the original world interest

rate level.