Open Economy Macroeoconomics (Part 2) Flashcards
(19 cards)
What is an exchange rate regime?
An exchange rate regime shows how a country’s currency is being determined in the foreign exchange market against other countries rates.
-There are two major types of exchange rate regimes:
-1) Floating/Flexible exchange rate: The exchange rate fluctuates on a daily basis. Exchange rate is determined by the market forces. Examples include Canada and the U.S.
-2) Fixed exchange rate: Exchange rate is held fixed at a pre-specified level. This ensures that the market exchange rate is the same exchange rate as what is set by the bank. Examples include Hong Kong, Bulgaria, and Denmark.
What are the three ways that a central bank can maintain a fixed exchange rate?
1) Foreign exchange rate: Buy and sell the holding of official reserves. If domestic currency is depreciating, the central bank sells foreign currency, and buys domestic currency. If domestic currency is appreciating, the central bank sells domestic currency and buys foreign currency.
2) Adjust money supply via other methods such as open market operations: They may buy or sell government bonds to offset the impact of its currency interventions. If buying domestic currency (to prop it up) reduces money supply, the central bank may buy bonds to add liquidity back.
3) Imposition of capital controls: Restricting capital flows, which involves limiting the ability of people and firms to move money in or out of the country.
When is currency considered overvalued? When is currency undervalued?
-Currency is overvalued when there is excess supply of currency.
-Currency is undervalued when there is excess demand.
What are the arguments for a flexible exchange rate?
1) Monetary policy autonomy: The central bank has the freedom to design and implement monetary policy they believe suits the economy.
2) It avoids the problem of having insufficient reserves: Countries with a fixed exchange rate may sell all of foreign currency, and keep only domestic currency, and that could lead to a forced devaluation of currency. They may face a speculative attack, and it may run out of official reserves, and experience a currency crisis.
3) Fixed exchange rate could lead to an inefficient allocation of funds: Restricting the movement of financial capital prevents the investments where returns would be high. It also reduces the gains from trade.
What are the arguments for a fixed exchange rate?
1) It eliminates exchange rate uncertainty: Helps to promote international trade and international investments, which enables us to enjoy gains from trade.
2) It disciplines the central bank: The central bank can’t easily print money… unless of course currency is appreciating too much. That reduces the risk that the current government can pressure the central bank to print money to finance their policy.
3) Fiscal policy is more effective under fixed exchange rate.
How does the fixed rate regime vs flexible exchange rate regime shift what’s more effective, monetary or fiscal policy?
-Monetary policy is effective under flexible exchange rate.
What is devaluation?
-A decrease in the official value of a currency.
-When domestic currency devalues, domestic goods and services become less expensive.
-Consequently exports go up, imports go down, and net exports rise.
-When NX rises, planned expenditure increases.
-In theory, devaluation of the currency is expansionary because it increases output.
-Devaluation is usually linked to the currency crisis.
What is revaluation?
-An increase in the official value of a currency.
-Occurs when the country can defend their fixed rate.
-They have a high current account surplus usually.
-Or they are facing inflationary pressure, and the revaluation reduces that inflationary pressure.
How does exports shifting shift demand for currency?
As exports of assets drop, capital inflows drop, and demand for currency drop.
How does interest rate relate to investment?
-As interest rate raises, investment increases. People want to invest where interest rate is high, because they assume there must be high returns.
What formula captures the impact of interest rates on planned investment?
-As interest rates rise, cost of borrowing rises. As interest rates fall, cost of borrowing falls.
-That’s why change in I Planned=(-d*change in i)
-Because as interest rates drop, investments increase, so the formula must capture the inverse relation.
What formula captures the impact of domestic currency depreciation on exports or imports?
-Change in exports=(-X* change in E FC/DC)
-As domestic currency depreciates, domestic goods and services become cheaper and more attractive for locals and foreigners to buy. We put the negative sign there so that any negative impact in currency value is shown as positive in terms of exports.
-Change in imports=(IM*change in E FC/DC)
-As currency depreciates, we import less because local goods become more attractive.
Why is it that under a fixed exchange rate system, monetary policy is not effective?
-As capital flows out of the country, supply of domestic currency increases.
-Because the domestic people must purchase foreign assets in foreign currency, putting domestic currency on the market.
-That would require the central bank to intervene and maintain the fixed exchange rate by buying back domestic currency, and selling foreign reserves.
-That intervention reverses the initial increase in money supply, bringing the interest rate back to it’s initial level.
Why is it that under a flexible exchange rate, monetary policy is effective?
-Monetary policy is effective under a flexible exchange rate because the central bank can freely adjust the money supply and allow the exchange rate to respond, which enhances the transmission of monetary policy to the economy.
-When the central bank increases money supply, interest rate falls.
-As interest rate falls, planned investment rises, boosting consumption, and aggregate expenditure.
-Lower interest rates leads to capital outflows as domestic currency depreciates. More exports happen, and fewer imports.
-So output increases.
Why is fiscal policy less effective under a flexible exchange rate?
-Fundamentally, fiscal policy under flexible exchange rate finds that crowding out is more likely.
-In an open economy, when exchange rate increases, domestic assets become more attractive.
-When exports of assets rise, and imports of assets fall, capital inflows rise.
-That means that domestic currency appreciates.
-Domestic goods and services get more expensive, so planned investment decreases, and consumption decreases as well. Exports fall and imports will then rise. Net exports decrease.
-The subsequent fall in planned expenditure offsets in initial rise in planned expenditure due to government spending.
Why is fiscal policy effective under a fixed exchange rate?
-Crowding out effects of fiscal policy disappear with fixed exchange rates.
-As output increases, money demand increases as well. Interest rate rises.
-Cost of borrowing increases, and planned investment drops.
-That makes today’s consumption more expensive.
-When interest rates rise, domestic assets become more attractive.
-Exports of assets lead to an increase in capital inflows.
-To stop appreciation of domestic currency, the central bank has to buy foreign currency, and sell domestic currency.
-That increases supply of domestic currency, and increases money supply such that interest rates drop.
-Crowding out doesn’t happen.
Under a flexible exchange rate, how is output impacted when there are changes from the goods market?
If an economy experiences changes from the goods market, flexible exchange rates will lead to a smaller change in output.
Under a flexible exchange rate and a fixed exchange rate, how does a shock coming from the money market change money demand?
-Fixed exchange rate minimizes the fluctuations in output if the shock comes from the money market, let’s say through changes in demand.
-Under a flexible exchange rate, the initial change in money demand on Y is reinforced by the subsequent change in planned expenditure due to a change in exchange rate.
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