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Chapter 8

Economic Policy in the Open Economy Under Flexible Exchange Rates

Learning ObjectivesAnalyze the impact of fiscal policy on

income, trade, and exchange rates under flexible exchange rates.

Analyze the impact of monetary policy on income, trade, and exchange rates under flexible exchange rates.

Show how external economic shocks affect the domestic economy under flexible exchange rates.

Introduction

The effectiveness

of monetary and

fiscal policies at

influencing

national income

differ dramatically

under fixed and

flexible exchange

rate systems.

Do flexible

exchange rate

systems make

countries more

vulnerable to

external shocks

such as the recent

global recession?

The Effects of Fiscal and Monetary Policy Under

Flexible Exchange Rates

Under a flexible exchange rate system, combinations of income and interest rates not on the BP curve will cause disequilibrium in foreign exchange markets, and force an adjustment in the exchange rate.

This will cause the BP curve to shift.

The Effects of a Currency Depreciation on the BP

Curve

Y

iBP0

A depreciation expands exports and contracts imports. For any given level of Y, a lower i is required to balance the BOP.

BP1

The Effects of a Currency Appreciation on the BP

Curve

Y

i

BP0

An appreciation contracts exports and expands imports. For any given level of Y, a higher i is required to balance the BOP.

BP1

Fiscal Policy Under Flexible Exchange Rates

With perfect capital immobility, any fiscal stimulus increases Y and i.

This creates an incipient BOP deficit, causing a depreciation and a rightward shift of the BP curve.

The depreciation increases exports, decreases imports, and shifts IS even farther rightwards.

This continues until IS, LM, and BP intersect at a common point.

Fiscal Policy Under Fixed Exchange Rates

income

iBP0

IS

LM

i0

Y0

IS'

Perfect capital immobility

BP1

IS ''

i3

Y2

Fiscal Policy Under Flexible Exchange Rates

With perfect capital immobility, any fiscal stimulus increases Y and i.

This creates an incipient BOP surplus, causing an appreciation of the currency.

The appreciation decreases exports, increases imports, and shifts IS back to the left.

Fiscal Policy Under Fixed Exchange Rates

income

i

BP

IS

LM

iE

Y0

IS'

Perfect capital mobility

Fiscal Policy Under Fixed Exchange Rates

The bottom line: • When capital is relatively immobile, fiscal

policy is more effective at increasing national income.

• When capital is relatively mobile, fiscal policy is less effective at increasing national income.

• Between these two extremes, the effect on the exchange rate depends on the relative slopes of LM and BP.

– BP steeper than LM: depreciation– LM steeper than BP: appreciation

Monetary Policy Under Fixed Exchange Rates

With perfect capital immobility, a monetary stimulus increases Y, and the increase in imports causes an incipient BOP deficit to emerge.

As currency depreciates, BP shifts rightward.

Depreciation also shifts IS rightwards.

Monetary Policy Under Fixed Exchange Rates

income

iBP

IS

LM

Ei0

Y0

LM'

Perfect capital immobility

BP'

IS'

i2

Y2

Monetary Policy Under Fixed Exchange Rates

With perfect capital mobility, any monetary stimulus increases Y.

This generates a large capital outflow and a depreciation of the home currency.

The depreciation causes LM to shift outwards.

Monetary Policy Under Fixed Exchange Rates

income

i

BP

IS

LM

iE

Y0

LM'

Perfect capital mobility

IS'

Y2

Monetary Policy Under Fixed Exchange Rates

The bottom line: When capital is relatively immobile, monetary policy is effective at increasing national income.When capital is relatively mobile, monetary policy is particularly effective at increasing national income.

Policy Coordination Under Flexible Exchange Rates Coordination of fiscal and

monetary policy may make the attainment of other targets besides income possible.

Examples of alternative targets include interest rates and exchange rates.

Consider an income and interest rate target of Y* and i*as an example.

Policy Coordination Under Flexible Exchange Rates

If fiscal policy alone is used to reach Y*, it is likely that the interest rate will overshoot the target of i*.In addition, the fiscal policy creates an incipient BOP surplus, appreciating the currency, and shifting BP back to the left.The depreciation also shifts IS part of the way back to the left.In the end, neither target is reached.

Policy Coordination: Fiscal Policy Alone

LM

BP0

IS

Y0

i0

ISFP

Y*

i*

iY*

BPFP

IS'FP

YFP

iFP

Policy Coordination Under Flexible Exchange Rates

If monetary policy alone is used to reach Y*, the increase in Ms will cause a currency depreciation, and a rightward shift in BP.

In addition, the monetary policy shifts IS rightwards.

In the end, neither target is reached.

Policy Coordination: Monetary Policy Alone

LM

BP'

IS

Y0 Y*

BP

IS'

Y'

LM'

i'

i

Y

i0

i*

Policy Coordination Under Flexible Exchange Rates

If monetary and fiscal policies are used, both i* and Y* can be attained.

Expansionary fiscal policy allows Y to increase without the expenditure switching effects.

Policy Coordination: Monetary Policy Alone

LM

IS

Y0 Y*

BP

IS'

LM'

i0

i

Y

i*

Effects of Shocks in the IS/LM/BP Model (Imperfect

K-Mobility) So far, we’ve examined the effects of

fiscal and monetary policy holding a number of factors constant, including• domestic and foreign prices,• foreign interest rate, and• expected exchange rate changes.

How are changes in such variables (“shocks”) transmitted through the economy?

Effects of Shocks: A Foreign Price Shock

If the foreign price level were to increase, the home economy would expand due to increases in exports and decreases in imports (IS shifts right).

The BP also shifts right due to expenditure switching effects of higher foreign prices.

Both effects cause i to rise, and the currency to appreciate.

These shift IS and BP back to where they started.

Foreign Price Shock

LM

IS

Y0

BP

IS'

i0

i

Y

BP'

Foreign Price Shock

LM

IS

Y0

BP

IS'

i0

i

Y

BP'

Foreign Price Shock

LM

IS

Y0

BP

i0

i

Y

Effects of Shocks: A Domestic Price Shock

If the domestic price level were to increase, the real money supply would fall, shifting LM leftwards.

Exports will fall and imports rise, so IS shifts leftwards.

The BP curve will also shift left in order to bring the BOP back into equilibrium.

Domestic Price Shock

LM

IS

Y0

BP

i0

i

Y

LM'

IS'

BP'

i1

Y1

Effects of Shocks: A Foreign Interest Rate Shock

If the foreign interest rate were to increase, the home country should experience an outflow of short-term capita; BP shifts leftwards.The home currency depreciates.This shifts

the IS curve rightward, andthe BP curve back toward the right.

Foreign Interest Rate Shock

LM

IS

Y0

BP

i0

i

Y

IS'

BP'

Foreign Interest Rate Shock

LM

IS

Y0

BP

i0

i

Y

IS'

BP'BP''

Y1

i1

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