Week 10: Open Economy [Policies, Exchange Rate Regimes]

Question 1

Towards the open economy IS-LM

Answer 1

■ Monetary policies target real economy, but operate through
financial markets;
■ To include them in our analysis, we need a theory for each;
■ And we have Keynesian cross for production and trade and UIP for financial markets;
■ Keynesian cross + UIP = Open economy IS-LM;
■ First stop – deriving the open economy IS line

Question 2

OE IS: Equation

Answer 2

■ With the addition of NX, IS assumes the form
Y =c0 +c1 Y −T ̄+b0 +bYY −bi(i−πe +x)+G ̄+ +mFYF −mY −nεε
■ Consumption: C = c0 + c1 Y − T ̄;
■ Investment:I=b0+bYY −bi(i−πe+x);
■ Government spending: G = G ̄;
■ Netexports:NX=mFYF−mY−nεε;

is effects through investment:

Y =c0 +c1 Y −T ̄+b0 +bYY −bi(i−πe +x)+G ̄+mFYF −mY −nεε
■ If the real exchange rate remains constant, it seems that i now
has a smaller impact on output (consider again a drop of ∆i) ∆Y = bi∆i
1−c1−bY +m
■ Same intuition as for the OE tax multiplier: part of extra expenditure generated through a drop in i ends up abroad directed to imports rather than domestic output;

Question 3

Monetary and Fiscal expansion in and OE

Answer 3

Monetary
- Starting with the FX market, a drop in i lowers the domestic return ⇒ excess demand for foreign assets ⇒ depreciation;
■ A drop in the policy rate results in an increase in output (both through stimulating investment and depreciating the currency);
■ Note that the overall effect on net exports is ambiguous: while a depreciation of the domestic currency increases exports and lowers imports, the ensuing increase in output leads to more imports;
■ In practice, we would expect to see an increase in net exports (improving trade balance);

Fiscal
■ An increase in government spending results in an increase in overall spending, which prompts an increase in output;
■ Net exports decrease: as in the Keynesian cross, spending exceeds production of domestic goods, so the shortfall needs to be covered with imports in excess of exports;

Question 4

Exchange rate adjustments

Answer 4

■ Two terms are reserved for exchange rate adjustments in fixed rate regimes: devaluation and revaluation;
■ Revaluation is the equivalent of appreciation under a fixed exchange rate regime (describes an increase in the domestic currency’s value);
■ Terminological distinction highlights the difference in the source of changes in the exchange rate: devaluation and revaluation are results of deliberate policy decisions;
■ Devaluation is the equivalent of depreciation under a fixed exchange rate regime (describes an decrease in the domestic currency’s value);

Question 5

Devaluation

Answer 5

■ Starting with the FX market, a drop in E ̄ entails that both actual and expected exchange rates decrease in line with
it E ↓= Ee ↓= E ̄ ↓;
■ With fixed prices, a nominal devaluation translates into a real one;
■ A real devaluation increases the competitiveness of domestic goods and stimulates output;
■ Again the effect on net exports is ambiguous but can be expected to be positive;
■ Note that while the effect of a devaluation is similar to that of a monetary expansion, the former can only be used
sparingly (it is a fixed rate regime after all);

Question 6

Fiscal policies in a fixed rate regime

Answer 6

■ As we saw in the case of the flexible rate regime, fiscal policies do not affect any rates of return (and we assume that exchange rate expectations are exogenous and so do not respond either);
■ Thus, fiscal policies have no effect on the nominal exchange rate;
■ As a result, they do not need any modifications in a fixed exchange rate regime and proceed exactly in the same way as with floating rates;

Question 7

Currency crisis

Answer 7

■ Note the shift of the IS line: when Ee drops, all else being equal, there is more spending for any interest rate i (if nothing else was to happen, lower Ee would cause a depreciation);
■ All else is not equal though: the CB has to respond with increasing its rate to defend the currency;
■ The result is a drop in output caused by depressed investment;
■ Note that there are no shifts of the NX line, as the exchange rate is held constant;

■ In a currency crisis, the CB faces an uneasy choice;
■ It can defend the currency at the expense of depressing the
economy;
■ Or it can find it more attractive to let the currency lose part of its value;
■ Self-fulfilling prophecy: investors’ actions (maybe unjustified) can lead to the very outcome predicted;
■ Or the crisis itself can be a deliberate speculative attack on the currency, seeking exactly to prompt a devaluation;
■ Either way, fixing the exchange rate makes the CB’s policy arrangements vulnerable to these developments;

Question 8

Gold Standard

Answer 8

• Main idea – limit money creation by pegging the currency to gold (the value of gold acts as the nominal anchor);
• Volume of money supply is limited by the stocks of gold;
• Domestic prices were determined by the relative price of gold;
• The constance of exchange rates arose naturally as mediated by exchange rates with gold;

■ Money supply determined by the stock of gold ⇒ no expansionary or contractionary monetary policies;
■ Variability of the price level, as arising from fluctuations in the relative price of gold;
■ Internal stability was completely subordinate to external stability;

Question 9

Internal balance and inflation targeting

Answer 9

■ Floating the currencies coincided with macro shocks and inflation acceleration in the 1970s;
■ That emphasised the importance of macro stabilisation policies;
■ Ultimately, explicit inflation targetting was arrived at as the mechanism for setting the nominal anchor (gained traction from the 1990s);
■ Political independence is added to boost the credibility;
■ Advantages discussed abov