Chapter 6 International Trade, Exchange Rates, and ...


Published on

1 Like
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Chapter 6 International Trade, Exchange Rates, and ...

  1. 1. Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy
  2. 2. Introduction <ul><li>Current account balance includes (1) NX, (2) net international investment incomes, and (3) net international transfer payments </li></ul><ul><li>Since (2) and (3) are usually small, we suppose NX equals current account balance. </li></ul>
  3. 3. Introduction <ul><li>S + (T-G) – NX = I </li></ul><ul><li>– NX stands for: (1) foreign borrowing, or (2) negative net exports, or (3) negative current account. </li></ul><ul><li>NX<0 implies investment is allowed to be larger than domestic saving. But this benefit of foreign borrowing is offset by the need to pay interest to foreigners. </li></ul><ul><li>Trilemma: it is impossible to maintain simultaneously (1) independent control of domestic monetary policy, (2) fixed exchange rates, and (3) free flows of capital </li></ul>
  4. 4. Definitions <ul><li>Balance of Payments includes two parts: </li></ul><ul><ul><li>Current account: exports and imports of goods and service, receipts and payments of investment incomes, and transfer payments </li></ul></ul><ul><ul><li>Note: Purchases and sales of assets are excluded </li></ul></ul><ul><ul><li>Capital account: purchases and sales of foreign assets by US residents and purchases and sales of American assets by foreign residents </li></ul></ul>
  5. 5. Credit items <ul><li>Any transaction that creates a payment of money to a US resident </li></ul><ul><ul><li>Exports </li></ul></ul><ul><ul><li>investment income on US assets held in foreign country </li></ul></ul><ul><ul><li>transfers to US residents </li></ul></ul><ul><ul><li>Purchases of US assets by foreigners </li></ul></ul>
  6. 6. Debit items <ul><li>Any transaction that creates a payment of money to foreigners by US residents </li></ul><ul><ul><li>Imports </li></ul></ul><ul><ul><li>Investment income paid on foreign holdings of assets within the United States </li></ul></ul><ul><ul><li>Transfer payments by US residents to foreigners </li></ul></ul><ul><ul><li>Purchases of foreign assets by US residents </li></ul></ul>
  7. 7. Balance of Payments <ul><li>BP has surplus when total credits > total debits </li></ul><ul><ul><li>When this happens, US receive more foreign money from the credits than the sum of dollars US residents pay out for the debits </li></ul></ul><ul><li>BP outcome = Current account balance + capital account balance </li></ul>
  8. 8. US BP <ul><li>Since the early 80s, US has run a persistent current account deficit </li></ul><ul><li>In the same period, the US has also run a persistent capital account surplus (but less than current account deficit) </li></ul><ul><li>When a nation runs a capital account surplus, households, firms, and government have net borrowing from foreigners </li></ul>
  9. 9. Table 6-1 <ul><li>Line 1-a is net export ( NX ) = foreign trade surplus or deficit </li></ul><ul><li>Line 2 and 3 show how the current account deficit was financed: </li></ul><ul><ul><li>Borrowing from foreign private sector, the capital account surplus, line 2 </li></ul></ul><ul><ul><li>Borrowing from foreign central banks, line 3 </li></ul></ul><ul><li>BP = Official settlements balance </li></ul><ul><li>= increase in US official reserve assets (- if increase; + if decrease) – increase in foreign official assets </li></ul>
  10. 10. Foreign borrowing <ul><li>Current account must be financed by one of the following borrowings: </li></ul><ul><ul><li>Capital account surplus : Net borrowing from foreign households, firms, and governments </li></ul></ul><ul><ul><li>Net borrowing from foreign central banks, which is counted as the increase in foreign official asset , and as a balance of payments deficit </li></ul></ul>
  11. 11. Foreign lending <ul><li>A current account surplus implies a reduction in foreign indebtedness or an increase in the nation’s net investment surplus </li></ul><ul><li>The relationship: </li></ul><ul><li>Change in net international investment position = current account balance </li></ul>
  12. 12. Figure 6-1 The U.S. Current Account Balance and Its Net International Investment Position, 1975 – 2001
  13. 13. Fig 6-1 <ul><li>The effects of the decrease in net international investment position </li></ul><ul><ul><li>Foreign assets owned by US residents generate income (interest or dividend) for US residents </li></ul></ul><ul><ul><li>US assets held by foreign residents generate income that US must send abroad </li></ul></ul><ul><ul><li>The decrease causes the net foreign investment income to go down </li></ul></ul><ul><ul><li>In 1981, the income was 1.1% of GDP, but in 2001, the income was down to –0.2% of GDP </li></ul></ul>
  14. 14. Fig 6-1 <ul><li>The effect on the growth in the standards of living: </li></ul><ul><ul><li>If the current account had been balanced over the 1981-2001 period, the total income of US citizens would have been 1.3 percent higher each year </li></ul></ul><ul><ul><li>The US productivity grew at 1.8 percent per year, the current account deficit wiped out 2/3 of a year’s growth in productivity </li></ul></ul>
  15. 15. Exchange rates <ul><li>For US, the foreign exchange rate of the yen is expressed as </li></ul><ul><li>x yen per dollar </li></ul><ul><li>Exception: the exchange rate of the British pound is expressed as </li></ul><ul><li>x dollars per pound </li></ul><ul><li>Appreciation: increase in the value of the US dollar </li></ul><ul><li>Depreciation: decrease in the value </li></ul>
  16. 16. The market of foreign exchange <ul><li>Fig 6-3 </li></ul><ul><li>Demand for US dollar comes from need </li></ul><ul><ul><li>To purchase US goods and service </li></ul></ul><ul><ul><li>To invest in US factories </li></ul></ul><ul><ul><li>To repay previous loans </li></ul></ul><ul><ul><li>To pay interest and dividends </li></ul></ul><ul><ul><li>To save in the US and to buy government securities </li></ul></ul>
  17. 17. Figure 6-3 Determination of the Price in Swiss Francs of the Dollar
  18. 18. The market of foreign exchange <ul><li>The slope of the demand curve </li></ul><ul><ul><li>If the price elasticity of Swiss demand for US imports is zero, the curve is vertical </li></ul></ul><ul><ul><li>If the elasticity is negative, then the curve is downward sloping </li></ul></ul>
  19. 19. The market of foreign exchange <ul><li>The supply of dollars comes from the payments by US citizens to foreigners: US imports and capital outflows </li></ul><ul><li>The supply curve </li></ul><ul><ul><li>Is vertical if the price elasticity of the US demand for Swiss imports is –1.0 </li></ul></ul><ul><ul><li>Why? When the elasticity is –1, the total expenditure is constant </li></ul></ul><ul><ul><li>The curve is upward sloping when the elasticity is < -1 (larger than 1 in absolute value) </li></ul></ul>
  20. 20. Equilibrium <ul><li>D = S </li></ul><ul><li>If the rate is larger than the equilibrium, then S > D: </li></ul><ul><ul><li>The supply of dollars created by US imports and by capital outflows exceeds the demand for dollars created by US exports and capital inflows </li></ul></ul><ul><ul><li>Foreigners holding excess US dollars will sell them on the market and drive down the rate </li></ul></ul>
  21. 21. Equilibrium <ul><li>Government can intervene to maintain a target rate </li></ul><ul><ul><li>It can buy up the excess supply of dollars held by foreigners </li></ul></ul><ul><ul><li>How does the government pay for these dollars? By international reserves. </li></ul></ul>
  22. 22. Nominal and Real Exchange Rates <ul><li>The real exchange rate is equal to the nominal exchange rate adjusted for the differences in inflation rates between the two countries: </li></ul><ul><ul><li>e = e’ x P / Pf </li></ul></ul><ul><ul><li>e: real exchange rate </li></ul></ul><ul><ul><li>e’: nominal exchange rate </li></ul></ul><ul><ul><li>P: domestic price level </li></ul></ul><ul><ul><li>Pf: foreign price level </li></ul></ul>
  23. 23. Nominal and Real Exchange Rates <ul><li>Example. In 2002, the price levels of US and Mexico are both 100. The nominal exchange rate = real e.r. = 10 pesos/ $ </li></ul><ul><li>In 2003, the price level of US is still 100, but the level of Mexico is 200. If nominal e.r. remains at 10 pesos/$, the real e.r will be 5 pesos/$. </li></ul><ul><li>Since 1 dollar can buy half as many pesos now, the dollar has a real depreciation against the peso </li></ul>
  24. 24. Nominal and Real Exchange Rates <ul><li>Normally, countries that experience unusually high inflation find that their nominal e.r. depreciates while their real e.r. remains roughly unchanged. </li></ul><ul><li>In the above example, if real e.r. is the same, then nominal e.r. must be 20 pesos/$. </li></ul><ul><li>We care about the real e.r., not the nominal e.r., b/c real e.r. is a major determinant of net exports. </li></ul>
  25. 25. Nominal and Real Exchange Rates <ul><li>When there is a real appreciation (the real e.r. appreciates), imports become cheap while exports become expensive. So domestic profit decreases. </li></ul>
  26. 26. The theory of PPP <ul><li>The purchasing power parity (PPP) theory: In open economies the prices of traded goods should be the same everywhere after adjustment for custom duties and the cost of transportation. </li></ul><ul><li>The theory implies that the real e.r. should be constant. Set it to 1, then </li></ul><ul><li>1 = e’ x P / Pf => </li></ul><ul><li>e’= Pf / P </li></ul><ul><li>The equation says that if PPP holds, when Pf increases faster than P, nominal e.r. must appreciate. </li></ul>
  27. 27. The Big Mac Index <ul><li>If PPP worked perfectly, goods would cost the same in all countries after conversion into a common currency. </li></ul><ul><li>The Economist magazine has collected data on the prices of Big Mac in numerous countries. See p. 167. </li></ul><ul><li>Implied PPP of the dollar = Big Mac price in Taiwan / price in US = 70 / 2.54 = 27.6 </li></ul><ul><li>Price of US dollar in foreign exchange market was 32.9. </li></ul><ul><li>Dollar was overvalued by: (27.6 – 32.9) / 32.9 = -16% </li></ul>
  28. 28. Exchange Rate Systems <ul><li>Flexible exchange rate system. </li></ul><ul><li>Suppose US is having BOP deficit. This means more dollars are flowing abroad than are coming back. </li></ul><ul><li>If US government does not intervene, an outflow of dollars would increase supply of dollars and the price would go down. </li></ul><ul><li>In the end, the BOP deficit will be eliminated by a decline in the e.r. sufficient to raise exports and cut imports. </li></ul>
  29. 29. Exchange Rate Systems <ul><li>Fixed exchange rate system. </li></ul><ul><li>During the post-WWII era prior to 1973, most major countries maintained this system. </li></ul><ul><li>Under this system, central banks agreed in advance to finance any surplus or deficit in the BOP. </li></ul><ul><li>The funding came from foreign exchange reserves, mainly in gold and dollars. </li></ul>
  30. 30. Fixed Exchange Rate System <ul><li>In the 1950s and 1960s, the German central bank, Bundesbank, maintained a rate of 4.0 marks per dollar. </li></ul><ul><li>When US had negative BOP, the excess supply of dollars put downward pressure on the rate. </li></ul><ul><li>Suppose without intervention, the rate would be 3.5 marks per dollar. </li></ul><ul><li>The Bundesbank could intervene by purchasing the excess dollars and adding them to its foreign exchange reserves. </li></ul>
  31. 31. Fixed Exchange Rate System <ul><li>A nation cannot increase or decrease its foreign exchange reserve without bound. </li></ul><ul><li>If the imports of a country keeps increasing, and the country pays for them by drawing down its reserves, eventually it would run out of reserves. </li></ul><ul><li>The country would be forced to reduce, or devalue, its echange rate. </li></ul><ul><li>Mexico in 1994. </li></ul>
  32. 32. Fixed Exchange Rate System <ul><li>If the exports of a country keeps increasing, the country’s reserves of dollars will grow. If the country does not want to keep that much amount, it must incresae, or revalue, its echange rate. </li></ul><ul><li>Germany in 1969. </li></ul>
  33. 33. Current Exchange Rate Systems <ul><li>Most countries use managed (or dirty) flexible exchange rate system. </li></ul><ul><li>Central banks intervene the market often. </li></ul><ul><li>Why? Central banks in Europe and Japan fear a collapse of the dollar, which would make American exports more competitive and reduce the American demand for imports. </li></ul>
  34. 34. Fig 6-4 <ul><li>The effective exchange rate of the dollar is a weighted average of the rate against Deutsche mark, British pound, Japanese yen, and others. </li></ul><ul><li>The base year is 1980. If e.r. > 100, then the dollar in that year is stronger than in 1980. </li></ul><ul><li>Nominal e.r. 1971-73: depreciation, the transition to the flexible e.r. system </li></ul><ul><li>1980-88: strong dollar, which exacerbated the US recession of 1981-82, and slowed the pace of recovery in 1984-85. </li></ul>
  35. 35. Fig 6-4 <ul><li>1995-2002: strong dollar, as a result of weak Asian and European currencies. </li></ul><ul><li>Real exchange rate has mimicked nominal exchange rate, except: </li></ul><ul><li>1995-2001, the real e.r. appreciated more rapidly than the nominal. This indicated that the US price level increased more than the foreign price level. </li></ul>
  36. 36. Figure 6-4 Nominal and Real Effective Exchange Rates of the Dollar, 1970 – 2001 Source: Federal Reserve System Board of Governors, G-10 Index, 1970-1972; Major Currencies Index, 1973-2001.
  37. 37. The Trilemma <ul><li>It is impossible for a country to have simultaneously an independent domestic monetary policy, fixed change rate, and free flows of capital. </li></ul><ul><li>Mexico in 1994, Southeast Asia in 1997, Russia and Brazil in 1998, and Argentina in 2001 </li></ul>
  38. 38. The Trilemma <ul><li>During the crises, each country experienced: </li></ul><ul><ul><li>A withdrawals of foreign capital </li></ul></ul><ul><ul><li>A massive depreciation of the nominal exchange rate </li></ul></ul><ul><ul><li>A stock market crash </li></ul></ul><ul><ul><li>A sharp increase in interest rates </li></ul></ul><ul><ul><li>A collapse of domestic spending </li></ul></ul><ul><li>The initial cause of the crises was the attempt to maintain a fixed exchange rate in a world of free capital movements </li></ul>
  39. 39. The Trilemma: Europe <ul><li>In early 2002, euro currency was introduced and traditional currencies were retired. </li></ul><ul><li>By permanently fixing exchange rates among the member nations, each of which allowed free capital movements among the member nations,the euro deprived each member nation of the freedom to pursue its own domestic monetary policy. </li></ul>
  40. 40. The Trilemma: Free capital flows and fixed exchange rates <ul><li>When there is large capital inflows, and the exchange rate is fixed, the inflows increase the demand for the local currency. </li></ul><ul><li>To maintain the exchange rate, the central bank must use the capital inflows to accumulate international reserves. </li></ul>
  41. 41. The Trilemma: Free capital flows and fixed exchange rates <ul><li>Then these extra reserves cause rapid growth in money supply and inflation. </li></ul><ul><li>Often, the central banks could not prevent prices on real estate and on the stock market from rising in the asset-price “bubble.” </li></ul>
  42. 42. The Trilemma: Free capital flows and fixed exchange rates <ul><li>While asset prices were rising, more foreign investors invested to enjoy profits (the hot money), and this added to the capital inflows. </li></ul><ul><li>Eventually, the bubble “burst,” and prices for real estate and on the stock market began to drop. </li></ul><ul><li>Foreigners ran for the exits and converted capital inflows into capital outflows </li></ul>
  43. 43. The Trilemma: Free capital flows and fixed exchange rates <ul><li>Could flexible exchange rate system do better? </li></ul><ul><li>Maybe not. The expected profits for foreign investors would include the appreciation of the local currency, as well as the rising asset prices. </li></ul><ul><li>The asset-price bubble would burst as well, and the exchange rate would drop. </li></ul><ul><li>The size of the fluctuations could be larger. </li></ul>
  44. 44. The Trilemma: Free capital flows and monetary policy <ul><li>Perfect capital mobility is never a reality. </li></ul><ul><li>With perfect capital mobility, a tiny increase in domestic interest rates above the world interest rate would cause an infinite inflow of capital to buy domestic financial assets. </li></ul><ul><li>The price of domestic financial assets will go up, causing the interest rate to go down. (Vice versa for foreign countries.) </li></ul>
  45. 45. The Trilemma: Free capital flows and fiscal policy <ul><li>To offset the stimulus to the domestic economy caused by capital inflows, the government can tighten fiscal policies. </li></ul><ul><li>This causes more budget surpluses and reduces the public debt. </li></ul><ul><li>Fiscal policy is more effective. </li></ul>
  46. 46. The Trilemma: The choices <ul><li>Fixed exchange rate makes the central bank loses control over the monetary policy. </li></ul><ul><li>Flexible exchange rate might overshoot and becomes highly unstable, especially when there are huge capital inflows and outflows. </li></ul><ul><li>Some argued that the real problem is not the exchange rate system, but the need for controls on capital movements. </li></ul>
  47. 47. The Trilemma: The choices <ul><li>The capital control can be complete (China), partial, or nonexistent. </li></ul><ul><li>A partial control is like the one introduced in Chile, which required a nonrefundable deposit on any capital inflows withdrawn prior to one year. </li></ul><ul><li>Taiwan uses QFII system. Foreign capital inflows must file with the government first. </li></ul>
  48. 48. Net Exports <ul><li>E = C + I + G + NX </li></ul><ul><li>If NX < 0 (foreign trade deficit), it can offset some of the increase in C , I , or G </li></ul><ul><li>Fig 6-5 </li></ul>
  49. 49. Figure 6-5 U.S. Real Exports, Real Imports, and Real Net Exports, 1960 – 2001
  50. 50. Net Exports <ul><li>NX = NXa – nx Y = autonomous component of net exports (determined mainly by foreign income) + induced net exports </li></ul><ul><li>Other things (exchange rate and foreign income) equal, NX is low when economy is booming, and is high when in recessions. </li></ul><ul><li>When exchange rate appreciates, US exports become more expensive, so NX decreases </li></ul>
  51. 51. Figure 6-6 U.S. Real Net Exports and the Real Exchange Rate of the Dollar, 1970 – 2001
  52. 52. Net Exports <ul><li>To put exchange rate into the net export equation: </li></ul><ul><li>NX = NXa – nx Y – ue </li></ul><ul><li>Fig 6-6, NX dropped more in 1995-2001 than in 1980-85, when exchange rate appreciated in both periods, since Y was higher in 1995-2001. </li></ul>
  53. 53. Exchange rates and interest rates <ul><li>The demand for dollars stems from two sources: the desire to buy American products and the desire to buy financial assets denominated in dollars (bank deposits, US government bonds, and the bonds issued by US corporations) </li></ul><ul><li>The relative attractiveness of US and foreign securities depends on the interest rate differential </li></ul>
  54. 54. Exchange rates and interest rates: Policy <ul><li>Suppose money supply is fixed, and the US government increases G, then both real income and the interest rate increase. Foreigners attempt to buy US securities, and the dollar appreciates. </li></ul><ul><li>Suppose fiscal policy does not change, but the Fed reduces money supply, then real income drops and interest rate rises. The dollar appreciates. </li></ul><ul><li>Fig 6-7. </li></ul>
  55. 55. Figure 6-7 The U.S. Real Corporate Bond Rate and the Real Exchange Rate of the Dollar, 1970 – 2001
  56. 56. Fig 6-7 <ul><li>Prior to 1995, real exchange rate moved in the same direction as the interest rate. </li></ul><ul><li>After 1995, real interest rate did not move much, but real exchange rate appreciated. This was due to the stock market boom that attracted foreign investors. </li></ul>
  57. 57. Small Open Economy <ul><li>A small open economy has no influence on the world level of interest rates ( r^f ). </li></ul><ul><li>Assume perfect capital mobility. </li></ul><ul><li>Then the interest differential </li></ul><ul><li>r – r^f = 0 </li></ul><ul><li>If r > r^f , there will be enough capital inflows to bring down r . And vice versa. </li></ul><ul><li>BP has huge surplus in the first case, and huge deficit in the second case. </li></ul><ul><li>BP is balanced only if r – r^f = 0 </li></ul>
  58. 58. Small Open Economy <ul><li>BP line is horizontal in ( Y,r ) space. </li></ul><ul><li>Fig 6-8. Fixed exchange rates. </li></ul><ul><li>Monetary expansion: </li></ul><ul><ul><li>LM shifts out, IS is fixed. </li></ul></ul><ul><ul><li>Interest rate drops to r_1 , causing capital outflows. </li></ul></ul><ul><ul><li>To keep the exchange rate from devaluation, the country uses its international reserves to satisfy the demand. This reduces money supply. </li></ul></ul><ul><ul><li>Eventually the interest rate must go up to the world level. </li></ul></ul><ul><ul><li>The above adjustment move quickly. The central bank is impotent. </li></ul></ul>
  59. 59. Figure 6-8 Effect of an Increase in the Money Supply with Fixed Exchange Rates
  60. 60. Small Open Economy <ul><li>Fig 6-9. Fixed exchange rates. </li></ul><ul><li>Fiscal expansion: </li></ul><ul><ul><li>IS shifts out, LM is fixed. </li></ul></ul><ul><ul><li>Interest rate increases to r_1 , causing capital inflows. </li></ul></ul><ul><ul><li>To keep the exchange rate from revaluation, the country accumulates its international reserves. This increases money supply, and shifts LM out. </li></ul></ul><ul><ul><li>Eventually the interest rate must go down to the world level. </li></ul></ul><ul><ul><li>The fiscal policy is very effective since there is no crowding out. </li></ul></ul>
  61. 61. Figure 6-9 Effect of a Fiscal Policy Stimulus with Fixed Exchange Rates
  62. 62. Small Open Economy <ul><li>Fig 6-10. Flexible exchange rates. </li></ul><ul><li>Monetary expansion: </li></ul><ul><ul><li>LM shifts out, IS is fixed. </li></ul></ul><ul><ul><li>Interest rate drops to r_1 , causing capital outflows. </li></ul></ul><ul><ul><li>This leads to depreciation, which boosts net exports and shift IS. </li></ul></ul><ul><ul><li>Once the economy arrives at E3 , the exchange rate stops depreciation. </li></ul></ul><ul><ul><li>Higher income boosts imports. At E3 , the two effects on NX offset each other. The current and capital accounts are in balance </li></ul></ul>
  63. 63. Figure 6-10 Effect of a Monetary and Fiscal Policy Stimulus with Flexible Exchange Rates
  64. 64. Small Open Economy <ul><li>Fig 6-10. Flexible exchange rates. </li></ul><ul><li>Fiscal expansion: </li></ul><ul><ul><li>IS shifts out, LM is fixed. </li></ul></ul><ul><ul><li>Interest rate increases, causing capital inflows. </li></ul></ul><ul><ul><li>This leads to appreciation, which boosts imports and shift IS leftward . </li></ul></ul><ul><ul><li>International complete crowding out. </li></ul></ul><ul><ul><li>LM is fixed during the adjustment. </li></ul></ul>
  65. 65. Small Open Economy: summarize <ul><li>With fixed exchange rates, fiscal policy is highly effective and the central bank is forced to accommodate fiscal policy actions. Monetary policy is impotent. </li></ul><ul><li>With flexible exchange rates, monetary policy is highly effective. The central banks can control the money supply and can stimulate the economy by causing the exchange rate to depreciate. Fiscal policy is impotent and international crowding out is complete. </li></ul>
  66. 66. Large Open Economy <ul><li>When the economy is large enough, the capital inflows and outflows are not powerful to push its domestic interest rate into exactly equality with the world level. </li></ul><ul><li>Capital mobility is imperfect. </li></ul><ul><li>BP line will have a positive slope (Fig 6-11): </li></ul><ul><ul><li>When r < r^f , there is a continuing capital outflows and so capital account has deficit. </li></ul></ul><ul><ul><li>To have a balanced BP, current account must have surplus, which requires the income to be low. </li></ul></ul><ul><ul><li>When r > r^f , the income must be high to make BP balanced </li></ul></ul>
  67. 67. Figure 6-11 The BP Line in a Small and Large Open Economy
  68. 68. Large Open Economy <ul><li>With fixed exchange rates, </li></ul><ul><ul><li>Monetary policy is still impotent </li></ul></ul><ul><ul><li>Fiscal policy is effective, but less so than in a small open economy, since interest rate will rise with an expansionary fiscal policy </li></ul></ul><ul><li>With flexible exchange rates, </li></ul><ul><ul><li>Fiscal policy is still impotent (Fig 6-6, NX dropped significantly in 1981, following the shift to fiscal deficits (p.130)) </li></ul></ul><ul><ul><li>Monetary policy is highly effective, and boosts income more than in a small open economy </li></ul></ul>
  69. 69. The Trilemma in US <ul><li>The US keeps its exchange rate flexible and allows free capital flows. </li></ul><ul><li>So the US has been able to maintain control over monetary policy. </li></ul><ul><li>The free inflows of private capital financed the huge increase in the US current account deficit that occurred in 1998-2001. </li></ul><ul><li>The willingness of foreign central banks to accumulate large stocks of dollar reserves provided the other funds to US. </li></ul>
  70. 70. The Trilemma in the Euro <ul><li>By adopting a single currency in 1999, twelve nations in Europe chose to emulate the US by having a fixed exchange rate within the borders of the twelve nations while allowing the exchange rate of the euro to float against other currencies. </li></ul><ul><li>The trilemma implies that the twelve nations have given up the ability to maintain independent monetary policy (a symbol of national sovereignty) </li></ul><ul><li>The European Central Bank now plays a role like that of the Fed of US. </li></ul>
  71. 71. Exercises <ul><li>Questions: #3, 4, 12, </li></ul><ul><li>Problems: #2, 4, 6, 7 </li></ul>