Session 23

Internal and External Balancewith

Fixed Exchange Rates

Benefits of Fixed RateHelps reduce Inflation

Helps reduce uncertainty

 For example,  if a firm is exporting to the US, a rapid appreciation in the  domestic  currency  would  make  its  exports  uncompetitive  and therefore may go out of business.

Defending against Depreciation

S1$

D$Excess Demand

Dollars need to be sold

New Spot Rate

Defending against Appreciation

S1$

D$

Excess Supply

Dollars need to be bought

New Spot Rate

Money Supply & the Balance of Payment with Fixed RateGovernment sell domestic currency

There are a lot of competitions among the banks

Capital flows out to other countries offeringhigher interest rate

•When income rise, people tend to buy more importing products.•When price level increase, foreign customers will buy less domestic products.

For a decrease in the money supply, reverse the direction of all changes.

Payments Adjustments for a Surplus Country with Fixed Rates

When the domestic money is supplied, people do not need to hold money.

Expansionary Fiscal Policy & the Balance of Payment with Fixed Rate

For contractionary fiscal policy, reverse the direction of all changes.

Foreigners buy more domestic currency than its need(Less domestic currency in the system) Government have to sell its own currency

Foreigners buy less domestic currency than its need(More domestic currency still in the system) Government have to buy its own currency.

Employment & Fixed Exchange Rate

What would happen if the scenario is different from this ?

Easy fiscal policy(The government spends more budgets)

Tight monetary policy by buying the domestic currency back.( As the domestic currency is less, the interest is higher; the need to hold the money is greater.)

The government achieve both full level of employment and  the balance of payments

Perfect Capital MobilityThis happens to a small country that cannot influence global financial markets by itself.

The interest rate depends on the global interest.

For FE curve, any interest rate above or below 6% will impact on the capital inflows to this country, but will not influence the domestic product.

For LM curve, any interest rate above or below 6% will impact the need to hold the currency of this country, but will not influence the domestic product.

The defense of fixed exchange rate will not impact on the interest and the domestic production.

For IS curve, the shift of the curve has an effect on the domestic product, but no effecton the interest rate.