Macroeconomics by 21Xw6lT

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									      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.

								
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