Macroeconomic Policy and Floating Exchange RatesC h a p.docx

Macroeconomic Policy and Floating
Exchange Rates
C h a p t e r 1 8
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
Copyright © 2009 Pearson Education, Inc. Publishing as
Prentice Hall
18 – ‹#›
CHAPTER ORGANIZATION
Introduction
Fiscal and Monetary Policy
Changes in Fiscal Policy
Changes in Monetary Policy
Monetary and Fiscal Policy in an Open Economy
Trade Flow Adjustment and Current Account Dynamics
Summary
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2

INTRODUCTION
Fiscal and monetary policies are two macroeconomic policies
that governments employ to affect domestic output, maintain
full employment and price stability
These are the 2 macroeconomic policies used to achieve the 3
goals of any economic policy
These polices have an effect on the exchange rate, the current
account, interest rates, and short-run capital flows within an
environment of floating exchange rates
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FISCAL AND MONETARY POLICY
Fiscal policy entails using changes in government taxation
and/or spending to affect the level of economic activity GDP
Monetary policy uses changes in the money supply and/or
interest rates to affect a county’s GDP
Changes in these policies have predictable effects on the
exchange rate, the current account balance, and short-run
capital flows
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In this chapter (Ch18) we’ll assume these policies are conducted
in a floating exchange rate regime ERR (effects in a fixed ERR
are in Ch19)
The assumption is that the government does not employ fiscal
and/or monetary policy in an attempt to generate a balanced

current account, but to affect the output and price level
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It used to be common practice for governments to focus fiscal
and/or monetary policy on obtaining what is known as an
external balance
Governments now tend to use monetary and fiscal policy to
focus on a country’s internal balance
Internal balance refers to the levels of unemployment and
inflation that fit the preferences of the citizens of various
economies
The focus on internal balance comes at the expense of external
balance considerations
Policies designed to achieve a desired internal balance may
have large consequences for a country’s external balance
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CHANGES IN FISCAL POLICY
In most countries, government spending is such a large part of
the GDP that any changes can have a critical impact on an
economy
Substantial amounts spent on transfer payments mean tax
revenues add to this amount
A portion of total government spending is usually financed
through borrowing, thereby having a significant impact on
country’s domestic financial markets and interest rates

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The demand for loanable funds is the total demand for loans in
the economy
It includes private sector demand from the public’s consumption
activities that must be financed and business demand for funds
for investment
The public sector demand is generated by the government’s
need for funds which is the difference between total government
spending and total taxes collected
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The supply of loanable funds represents the total amount of
money available to be borrowed by the private and public
sectors of the economy
This is represented as perfectly inelastic; the amount of
loanable funds is not related to the interest rate
In the short-run, the amount of money held in savings by the
public determines the supply of loanable fund
Prentice Hall
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Figure 18.1 Supply and Demand for Loanable Funds and

Expansionary Fiscal Policy
Interest Rate (i)
ie
Loanable Funds (L)
S
D
E
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The government adopts an expansionary fiscal policy by
choosing to lower tax revenues and/or have higher government
spending
This leads to a government budget deficit (or larger deficit)
Assume government borrows to finance and does not print
money
This will have a predicable effect on interest rates as in Fig
18.1
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An expansionary fiscal policy causes an increase in the demand
for loanable funds (from D to D’)

In a closed economy, this would cause interest rates to rise
(from ie to i’)
In an open economy with freely flowing international capital,
the rise in interest rates causes an inflow of capital and an
increase in the supply of loanable funds (from S to S’)
This inflow of capital lowers domestic interest rates (from i’
back to ie)
Prentice Hall
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Interest Rate (i)
ie
i’
Loanable Funds (L)
F
G
S
D
D’
E
S’

Prentice Hall
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The net result of an expansionary fiscal policy in an open
economy is that less upward pressure is put on interest rates
than would be the case in a closed economy
A larger federal government budget deficit tends to increase
domestic interest rates which causes an inflow of foreign capital
into the country
The capital flows have an effect on the equilibrium exchange
rate (as described in Ch15)
This effect is shown in Fig. 18.2
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Figure 18.2 Effects of Expansionary Fiscal Policy on the
Exchange Rate
Exchange Rate (XR)
XRe
XR’
Foreign Exchange (FX)
X
M
S
D
E

S’
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In an economy with a balanced current account, if the
government adopts an expansionary fiscal policy and domestic
interest rates rise, the inflow of foreign capital requires foreign
investors to sell foreign currency to buy dollars
The supply of foreign exchange increases (from S to S’) and the
nominal exchange rate appreciates (from XRe to XR’)
The capital inflows encouraged by the higher interest rates will
result in a capital account surplus and a current account deficit
(M-X at XR’)
Prentice Hall
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Therefore, an expansionary fiscal policy puts upward pressure
on domestic interest rates which leads to an increase in the flow
of capital from abroad into the domestic financial markets
leading to an appreciating currency and a current account deficit
However, we need to consider the effect of an expansionary
fiscal policy on the domestic economy (using tools of AD and
AS from Ch17)?
In a closed economy, this would lead to an increase in domestic

output and price level
Prentice Hall
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Figure 18.3 Effects of Fiscal Policy on Equilibrium Output
and Price Level
Price Level (P)
Pe
P’
Real GDP (Y)
Ye
F
AS
AD
E
AD’
Y’
Prentice Hall
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In an open economy, the effects are less clear as an
expansionary fiscal policy has two conflicting effects

The policy increases AD as the government reduces taxes and/or
increases spending –the direct effect
On the other hand, the policy reduces AD as the exchange rate
appreciates and the current account balance deteriorates – the
indirect effect
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and Price Level
Price Level (P)
Pe
P’
Real GDP (Y)
Ye
AS
AD
AD’
Y’
AD’’
AD’’’
Direct Effect: AD’
Indirect Effect: AD’’/AD’’’

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Direct Effect: Closed Economy Effect
Indirect Effect: Open Economy Effect
20
The net effect depends on the magnitude of the two effects
Conclusion: Expansionary fiscal policy in an open economy is
less effective at changing equilibrium output and price levels
than in a closed economy
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Contractionary Fiscal Policy
A contractionary fiscal policy would entail some combination of
higher taxes and/or lower government spending
This reduces a government budget deficit or increases size of a
surplus
Adopting a contractionary fiscal policy causes the overall
demand for loanable funds to shrink (from D to D’) and lowers
the interest rate (from ie to i’)
Prentice Hall
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Contractionary Fiscal Policy
Interest Rate (i)
ie
i’
Loanable Funds (L)
F
S
D
E
D’
S’
G
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The lower domestic interest rate affects capital flow into the
country as domestic and foreign investors would tend to invest
less domestically and domestic investors would tend to invest
more capital abroad
The net result would be an outflow of capital from domestic
economy and the supply of loanable funds would decrease (from
S to S’) raising interest rates (from i’ back to ie)

A contractionary fiscal policy puts less downward pressure on
domestic interest rates in an open economy than in a closed
economy
Prentice Hall
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Figure 18.5 Effects of Contractionary Fiscal Policy on the
Exchange Rate
Exchange Rate (XR)
XRe
XR’
X
S
D
E
D’
M
Prentice Hall
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A contractionary fiscal policy lowers the federal government

budget deficit which decreases domestic interest rates and
causes an outflow of capital
This increases the demand for foreign exchange (from D to D’)
and the exchange rate rises or the domestic currency depreciates
(from XRe to XR’)
This causes the capital account to become negative which
causes the current account to become positive (X-M at XR’)
Prentice Hall
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Therefore, a contractionary fiscal policy puts downward
pressure on domestic interest rates which leads to an decrease in
the flow of capital from abroad into the domestic financial
markets leading to an depreciating currency and a current
account surplus
What about the effects in a closed vs. open economy?
In a closed economy, this would lead to an decrease in domestic
output and price level
Prentice Hall
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and Price Level
Price Level (P)
Pe

P’
Real GDP (Y)
Ye
AS
AD
Y’
AD’
Prentice Hall
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In an open economy with free international capital flows, a
contractionary fiscal policy causes AD to decrease and the
domestic currency to depreciate as the government increases
taxes and/or reduces spending—the direct effect
The contractionary fiscal policy increases AD as the currency
depreciates and the current account balance improves—the
indirect effect
A contractionary fiscal policy in an open economy is less
effective in changing equilibrium output than it is in a closed
economy
Prentice Hall
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and Price Level
Price Level (P)
Pe
P’
Real GDP (Y)
Ye
AS
AD
Y’
AD’’
AD’’’
AD’
Indirect Effect: AD’’/AD’’’
Prentice Hall
18 – ‹#›
30

The net effect depends on the magnitude of the two effects
Conclusion: In open economies with international capital
mobility, contractionary fiscal policy is not as particularly
effective in changing the equilibrium levels of output & prices
Fiscal policy can still, however, affect interest rates, exchange
rates, capital flows and current account balances and the effects
are noticeable in the economy and have an effect on business
decision making
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CHANGES IN MONETARY POLICY
Most central banks in developed countries use discretionary
monetary policy in an attempt to affect the short-run
performance of the economy by changing the growth rate of the
money supply and/or interest rates
Our interest is in explaining the effects of changes in monetary
policy on exchange rates, the current account and by extension
on a country’s overall economy
Prentice Hall
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Expansionary Monetary Policy
An expansionary monetary policy results when a central bank
increases the money supply or money supply growth rate
Increases in the money supply increase the supply of loanable
funds (from S to S’) initially causing a decrease in the interest
rate (from ie to i’)
The decrease in interest rates causes a capital outflow

Prentice Hall
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Expansionary Monetary Policy
Interest Rate (i)
ie
i’
Loanable Funds (L)
F
S
D
E
S’
Prentice Hall
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Capital outflows cause demand for foreign exchange to increase
(from D to D’) and the currency depreciates (from XRe to XR’)
which worsens the capital account causing a deficit
This translates into a current account surplus as exports increase
and imports decrease (X-M at XR’)

An expansionary monetary policy indirectly leads to a current
account surplus when capital is mobile between countries
Prentice Hall
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Figure 18.8 Effects of Expansionary Monetary Policy on the
Exchange Rate
Exchange Rate (XR)
XRe
XR’
X
S
D
E
D’
M
Prentice Hall
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In a closed economy, monetary policy is generally effective
because lower interest rates increase both consumption and
investment spending—the direct effect
AD increases (shifts from AD to AD’)
In an open economy, the fall in interest rates induces
depreciation of the domestic currency and capital outflow
improving the current account as exports increase and imports
decrease—the indirect effect
The AD curve shifts even further to the right (from AD’ to
AD’’)
Prentice Hall
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Figure 18.9 Effects of Monetary Policy on Equilibrium
Output and Price Level
Price Level
(P)
Pe
P’
Real GDP (Y)
Ye
F
AS
AD
E

AD”
Y’
P”
AD’
G
Y”
Indirect Effect: AD’’
Prentice Hall
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38
These movements in the exchange rate, the financial account
and the current account tend to reinforce the initial effects of
monetary policy on the domestic economy
Conclusion: The net result is that in an open economy with
capital mobility, monetary policy is effective in increasing the
level of economic activity (influencing output and price levels)
Prentice Hall
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Contractionary Monetary Policy
In contractionary monetary policy, the central bank decreases
the money supply or reduces the money supply growth rate
The most notable effect is an increase in domestic interest rates
In developed countries, decreasing money supply is done
through selling government bonds, which decreases the supply
of loanable funds (from S to S’) causing a rise in interest rates
(from ie to i’)
Prentice Hall
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Contractionary Monetary Policy
Interest Rate (i)
ie
i’
Loanable Funds (L)
E
S’
D
F
S

Prentice Hall
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This increase in domestic interest rates attracts foreign capital
In order to buy domestic financial assets, foreign investors must
sell foreign currency and buy domestic currency in the foreign
exchange market
The capital inflow will increase the supply of foreign exchange
(from S to S’) causing a decrease in the exchange rate (from
XRe to XR’)
This creates an exchange rate appreciation
Prentice Hall
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Figure 18.11 Effects of Contractionary Monetary Policy on
the Exchange Rate
Exchange Rate (XR)
XRe
XR’
Foreign Currency (FX)
X
S
D
E
S’
M

Prentice Hall
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The capital inflows and appreciating exchange rate create a
capital account surplus and a current account deficit (M-X at
XR’)
In a closed economy, a contractionary monetary policy is
effective because the increased interest rate reduces the growth
rate of consumption and/or investment
The reduction in total spending causes a decrease in AD
lowering output and the price level
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In an open economy, the effects are larger. Why?
The initial effect of a contractionary monetary policy is to
decrease AD – the direct effect
The increase in interest rate induces capital flows into the
country and an appreciation of the currency
The current account deteriorates as exports fall and imports
rise—the indirect effect
Conclusion: In an open economy with free international capital
mobility, contractionary monetary policy is highly effective in
changing equilibrium levels of output and price

Prentice Hall
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Figure 18.12 Effects of Monetary Policy on Equilibrium
Output and Price Level
Price Level
(P)
Pe
P’
Real GDP (Y)
Ye
F
AS
AD”
G
AD
Y’
P”
AD’
E
Y”
Indirect Effect: AD’’

Prentice Hall
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46
Figure 18.13 Crowding Out in a Closed Economy
Interest Rate (i)
ie
i’
Loanable Funds (L)
E
D
F
S
D’
G
L
L’
Prentice Hall
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MONETARY AND FISCAL POLICY
IN AN OPEN ECONOMY
The effects of government policies are often described in terms
of effects on a country’s external and internal balances
The current account balance represents the external balance
while the equilibrium level of output and price level is the
internal balance
At any point in time, there is an optimal balance of output level
and price level implying full employment and stable prices
This is rarely observed
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IN AN OPEN ECONOMY
Governments frequently use fiscal and monetary policy to
achieve an acceptable balance between output and price level
Fiscal and/or monetary policy can be used to influence internal
or external balance
In many cases, governments cannot balance both and have to
choose which is more important
Typically internal balance is seen as most important and fiscal
and/or monetary policy is focused on achieving an optimal
internal balance
Prentice Hall
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IN AN OPEN ECONOMY

Although both fiscal and monetary policy affect the current
account and exchange rates, they are usually not the primary
focus of policy
The public and the press tend to think the exchange rate and the
current account are the primary targets of macroeconomic
policies
While this may be the case, macroeconomic policy is often
focused on a country’s internal balance
The policy mix of a country is the effects of various
combinations of fiscal and monetary policy
Prentice Hall
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IN AN OPEN ECONOMY
Table 18.1 Effects of Different Fiscal and Monetary
Policies Under Flexible Exchange Rates and Free Capital
MobilityEffect onEquilibrium
OutputEquilibrium Price LevelExchange
RateCurrent
AccountFiscal PolicyInternal BalanceExternal
BalanceExpansionary–DirectIncreaseIncrease–
IndirectDecreaseDecreaseAppreciatesDeteriorates–NetLittle or
no EffectLittle or no
EffectAppreciatesDeterioratesContractionary–
DirectDecreaseDecrease–
IndirectIncreaseIncreaseDepreciatesImproves–NetLittle or no
EffectLittle or no EffectDepreciatesImprovesMonetary
PolicyExpansionary–DirectIncreaseIncrease–
IndirectIncreaseIncreaseDepreciatesImproves–NetLarge
IncreaseLarge IncreaseDepreciatesImprovesContractionary–
DirectDecreaseDecrease–
IndirectDecreaseDecreaseAppreciatesDeteriorates–NetLarge

DecreaseLarge DecreaseAppreciatesDeteriorates
Prentice Hall
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IN AN OPEN ECONOMY
Consistent Policy Mixes
In a recession, the real GDP is below the full employment level
The government wants to increase output by adopting an
expansionary monetary policy and/or expansionary fiscal policy
A combination of both would tend to increase output and price
level
The potential for rising prices may be deemed an acceptable
risk
Prentice Hall
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IN AN OPEN ECONOMY
The effect on the exchange rate is unclear depending on
magnitude of change in the two policies on domestic interest
rates
The effect on the current account is also unclear depending on
the effect on interest rates
From a policy perspective, battling a recession and letting the
external balance adjust as needed is a safe option
The domestic economy would improve and the external balance
is unlikely to change by a large amount in either direction

Prentice Hall
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IN AN OPEN ECONOMY
A similar scenario emerges if the problem is inflation
The economy is temporarily producing output at greater than
full employment levels
The government would employ a combination of contractionary
monetary and fiscal policies
The effects on internal balance are that both equilibrium output
and the price level would fall
The effects on the external balance (exchange rate and current
account) are unclear since policies move in opposite directions
Prentice Hall
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IN AN OPEN ECONOMY
This policy mix does not appear to be a problem as the internal
balance moves in the desired direction without dramatic changes
in the external balance
When governments adopt similar fiscal and monetary policies,
the equilibrium level of output and the price level (internal
balance) can be changed without making drastic changes in the
exchange rate or current account balance (external balance)
Prentice Hall
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IN AN OPEN ECONOMY
Inconsistent Policy Mixes
Mixtures of fiscal and monetary policies that are inconsistent
with one another (one expansionary, the other contractionary)
are inconsistent with internal balance objectives
Why would a government adopt such a mixture when the effects
are unclear?
Often different policy makers are in control of fiscal and
monetary policy
In the U.S., elected officials control the fiscal policy while the
independent Federal Reserve determines the monetary policy
Prentice Hall
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IN AN OPEN ECONOMY
The effect of inconsistent policies can be ambiguous on the
domestic economy (internal balance)
However, the effect on the external balance is explicit (see
Table 18.1)
An expansionary fiscal policy and contractionary monetary
policy leads to an appreciation of the currency and decreased
current account
The policies reinforce one another and the effect on the external
balance can be significant
Prentice Hall
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IN AN OPEN ECONOMY
Similarly, a contractionary fiscal policy coupled with an
expansionary monetary policy leads to a depreciation of the
domestic currency and an improvement in the current account
balance
The point of our discussion is that inconsistent policy mixes can
have extreme effects on a country’s external balance
The effect of changes in the country’s exchange rate can have a
dramatic impact on the competitiveness of individual firms with
tradable goods
Prentice Hall
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IN AN OPEN ECONOMY
Figure 18.14 Federal Budget Deficit and the Balance on
Current Account for the U.S., 1980-1996
50 –
0 –
–50 –
–100 –
–150 –
–200 –
–250 –
–300 –
Federal Deficit
Current Account
Year
1980

1985
1995
1990
In Billions of Dollars
Prentice Hall
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IN AN OPEN ECONOMY
Figure 18.15a U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
9 –
6 –
3 –

0 –
–3 –
Real Interest Rate
Year
1980
1985
1995
1990
Long-Run Real Interest Rate
Prentice Hall
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IN AN OPEN ECONOMY
Figure 18.15b U.S. Real Exchange Rate and Long-Run Interest
Rate, 1980-1996
140 –
130 –
120 –
110 –
100 –
90 –
80 –
Real Exchange Rate
Year
1980
1985
1995
1990
Real Exchange Rate 1973 = 100

Prentice Hall
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Implicit in our analysis was an assumption of no lag in the
effects of monetary and fiscal policies on macroeconomic
variables
If financial markets are relatively efficient, then interest rates
are affected quickly
Moreover, high capital mobility allows the exchange rate to
change relatively quickly
However, the response of trade flows to changes in exchange
rates may not always happen quickly
TRADE FLOW ADJUSTMENT AND CURRENT ACCOUNT
DYNAMICS
Prentice Hall
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The price of imports and exports may not change instantly as
the exchange rate changes
International trade may respond slowly to changes in prices
compared to the response of financial markets
The time it takes for the exchange rate to affect a country’s
exports and imports and the current account balance may be as
long as six months to a year
DYNAMICS

Prentice Hall
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In the long-run, as a country’s currency depreciates, its exports
expand and imports contract (and vice versa)
In the short-run, as a country’s exchange rate changes, the
response of exports and imports and current account balance
could very easily be in the opposite direction
In part, this is because international trade is often conducted
between parties on a contract basis
DYNAMICS
Prentice Hall
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Also, in the short-run, demand for the more expensive imports
(and demand for exports, which are cheaper to foreign buyers
using foreign currencies) remain price inelastic
This is due to time lags in the consumer's search for acceptable,
cheaper alternatives
The net effect is that the current account may initially worsen
after a depreciation and only improve after a lag
DYNAMICS
Prentice Hall
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The effect on the current account balance has been called the J-
curve
This reflects the tendency for the current account balance to

initially worsen when a currency depreciates
Only after contracts are renewed to reflect the new exchange
rate will the current account begin to improve
It is important for policy makers to take the lag effect into
account
DYNAMICS
Prentice Hall
18 – ‹#›
DYNAMICS
Figure 18.16 The J Curve
Current Account Balance
Current Account Surplus
Time
Current Account Deficit
0
t0
t1
Prentice Hall
18 – ‹#›
Governments use fiscal policy to change the level of taxation
and/or government spending at the national level to affect the
level of economic activity (GDP). Governments use monetary
policy to change the money supply or interest rates to affect a

country’s level of economic activity.
A country’s exchange rate and its current account balance
represent its external balance
Expansionary fiscal policy occurs when a government chooses
to adopt some combination of lower tax revenue and/or higher
government spending
SUMMARY
Prentice Hall
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In an open economy with international capital mobility,
expansionary fiscal policy leads to a rise in interest rates which
causes and inflow of foreign capital
A contractionary fiscal policy in an open economy is not very
effective in reducing the price level or real GDP
Expansionary monetary policy occurs when a government
chooses to increase the money supply or the money supply’s
growth rate
SUMMARY
Prentice Hall
18 – ‹#›
In an open economy with international capital mobility,
expansionary monetary policy leads to a fall in interest rates
which causes an outflow of foreign capital
A contractionary monetary policy would lead to higher interest
rates, lower output, and a lower price level
Consistent policy mixes can be effective in solving internal
balance problems
SUMMARY

Prentice Hall
18 – ‹#›
Mixtures of fiscal and monetary policy that are inconsistent
with one another are also inconsistent with internal balance
objectives
In the long run, as a country’s currency depreciates, its exports
expand and imports contract. In the short run, its current
account balance could very easily move in the opposite
direction.
SUMMARY
Prentice Hall
18 – ‹#›

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