Macroeconomics Lecture 16 Capital controls and the EMS crisis Outline • EMS crisis in 1992 • Capital controls The EMS Crisis of 1992 • 1990: Sterling joins the EMS. • September 1992: Sterling forced out of EMS Why? • German unification • The sleeping dragon • Free capital flows The uncovered interest parity r r * • Risk premium • expected depreciation Return to Pound (domestic) asset: r Expected return to Dollar (foreign) asset: * r Return in $ Capital gain/loss due to (expected) depreciation Actual depreciation/ Expected depreciation depreciation pressure e LM * (r * 0 , M 0 ) LM * (r * 1 , M 0 ) A e0 IS * ( r * 0 ) e1 B IS * (r * 1 ) Y The EMS Crises • German unification: r * • Expectations about future devaluation: Run down of Foreign Reserves Speculative attack Domestic recession r • Expectations about future devaluation: Initial impact of German Unification e LM * (r0* 0 , M 0 ) LM * (r1* 0 , M 1 ) LM * (r1* 0 , M 0 ) B A e0 IS * ( r0* 0 ) e1 IS * ( r1* 0 ) Y e D+CB S0 D High r* S1 Outflow capital e0 Depreciation pressure CB buys £ £ • Run down of FR The CB buys £/sells $ • Recession Dynamic implications: • Run down of FR Expectations about devaluation • Recession Dynamic effects: Expectations and speculation e LM * (r1* 0 , M 1 ) LM * (r1* 1 , M 2 ) LM * (r1* 1 , M 1 ) C B e0 IS * ( r1* 0 ) IS * (r1* 1 ) Y Speculation e e1 CB intervention e0 time t0 From time t0 • Government gives in and devaluates • The exchange stays fixed No appreciation risk! Restrictions on private capital movements • Currency restrictions • Risk attributes • Exchange rate uncertainty. BP PNX (e, Y ) FApr (r, r ) FR * Imports increase when income increases, so Y NX e D S0 S1 Y IM NX supply of £ up (demand of $ up) £ e D and S related to trade in goods Strict capital controls FApr (r, r * ) 0 The equilibrium in the FOREX market now requires that the trade balance is in balance: Suppose NX>0. NX (e, Y ) 0 Demand for £ from exporters greater than supply of £ from importers. Appreciation pressure e NX (e0 , Y ) 0 r D S0 NX (e1 , Y ) 0 A B £ Y Economic policy and capital controls With restrictions on private capital flows in place, the domestic interest can deviate from the foreign interest rate. Thus, (1) monetary policy can potentially work through the the Keynesian transmission mechanism (via r) (2) fiscal policy can potentially be crowded out via increases in the domestic interest rate. Fixed exchange rate system with strict capital controls r NX (e0 , Y ) LM ( M 0 ) e LM ( M 1 ) S0 S1 A A C e0 B B IS (G0 ) D1 D Y £ Can monetary autonomy be recouped? M Y IM Supply of £ up depreciation pressure central bank buy up £ M Fixed exchange rate system with strict capital controls NX (e0 , Y ) r LM ( M 0 ) e C S0 S1 B A A C LM ( M 1 ) e0 IS (G1 ) B IS (G0 ) D0 D1 Y £ Can fiscal policy affect output? G Y IM Supply of £ up depreciation pressure central bank buy up £ M Notice that r increases, and crowds out private investments. Policy with fixed exchange rates Y NX M e r Fiscal Monetary first row = perfect capital mobility; second row = no capital mobility. Enjoy the Easter Break! Policy with floating exchange rates and strict capital controls Y NX M e r Fiscal Monetary Verify by going through the graphical analysis that this is correct.
Pages to are hidden for
"Macroeconomics"Please download to view full document