The exchange rate

1 31220/06/18-20/17A[1] 220306 UNIVERSITY OF STRATHCLYDE DEPARTMENT OF ECONOMICS 31 220 MACROECONOMICS Lectures 18 - 20 Open Economy Macroeconomics We now develop the IS/LM model for the analysis of open economy macroeconomic issues [Froyen, Chap. 16 (omitting section 16.2)]; before extending the model we must however consider certain matters relating to the open economy [Froyen Chap. 15]. (i) ASPECTS OF THE INTERNATIONAL SCENE International links Each national economy, as part of the wider world economy, is - to a greater or lesser degree - „open‟ in that economic links exist between it and the rest of the world. These links take two forms: on the one hand they consist of trade in goods and services with other countries (exports and imports) and, on the other, of sales and purchases of financial and real assets - lending, both short and long term, and dealings in property land and other assets. The balance of payments A country‟s balance of payments statement describes these international economic links showing the values of the various activities that have taken place over a certain period of time (normally, one year). Conventionally, the balance of payments is divided into the current account (trade in goods and services, income transfers, remittances) and the capital account (dealings in assets, both real and financial). Activities which imply acquisitions of foreign exchange - export sales, borrowing - appear on the credit side of the account, and activities denoting disposal of foreign exchange - import purchases, lending - are entered on the debit side. If the autonomous incomings and outgoings on each side of a country‟s balance of payments exactly match, its balance of payments is said to be in equilibrium. If incomings exceed outgoings, a balance of payments surplus exists, and if vice versa, a deficit. If a net deficit over the autonomous items is recorded, this shortfall has to be covered by funds acquired from some source (e.g. from reserves of foreign exchange); this balancing amount appears on the credit side of the account. Correspondingly, a net surplus appears on the debit side as representing foreign exchange acquired in excess of outgoings and allocated to reserve holdings, that allocation balancing the account. 2 Balance of payments illustration The (UK) balance of payments (a recent year; £bn.) --------------------------------------------------------------debits credits .............................................................................................................….. Current account Imports of goods 89.6 Exports of goods 79.4 Invisible debits 72.4 Invisible credits 80.0 [Current account net deficit 2.6] …………………………………………………………………………… Capital account Investment and other capital transactions (net inflows) 11.0 Balancing item * 3.6 [capital account net surplus 14.6] ------------------------------------------------------------------------------------Balance of payments ** Increase in official reserves (surplus) 12.0 __________________________________________________________ * aka (Froyen) “Statistical Discrepancy” ** aka (Froyen) “Official Reserve Transactions” Note: the current account deficit (£2.6bn) is the difference between exports and imports of commodities together with the difference between credits and debits on invisibles. In addition to these flows, there are short and long term capital flows: in the year in question there was a net inflow of £11bn recorded on the capital account. The sum of the current account balance and the balance of reported capital flows should equal the change in reserves (12bn), but as each component of the balance of payments is estimated independently - changes in reserves being recorded by the Bank of England, and exports and imports calculated from data on UK trade etc – the result is that the account may not balance because of errors and omissions; in this instance a balancing item of £3.6bn restores the balance.1 Neither a deficit nor a surplus is, over the long term, desirable or sustainable. Finite reserves of foreign exchange will eventually be exhausted by an on-going deficit, and a 1 The current a/c and capital a/c together give a surplus of £8.4bn; recorded surplus = £12bn; balancing item is therefore +£3.6bn. (Example from C. Pratten, Applied Macroeconomics, OUP, 1990) 3 continuing surplus will bring its own difficulties of monetary inflow and inflationary pressure. In the case of the open economy, for full equilibrium to exist, there must simultaneously be internal equilibrium (as in terms of IS/LM) and external equilibrium (i.e. balance of payments equilibrium) The exchange rate The exchange rate expresses the terms on which one national currency exchanges, on the foreign exchange market, for others. For example, we speak of one pound sterling buying, say, US$1.75, euros 1.50, złotych 6.08, baht 54.93, taka 90.00 or whatever. According to the circumstances, these relationships between currencies may be fixed or variable; we refer to „fixed‟ and „floating‟ exchange rate regimes. To understand how the exchange rate is determined, we need to take a brief look into the workings of the foreign exchange market. First, however, we must sort out the terminology involved. Terminology We must be clear in our usage when we speak of changes in the rate of exchange. In this discussion we adopt the „academic‟ (or American) convention in saying that the exchange rate rises when foreign currency becomes dearer in terms of the home currency, and that it falls when the home currency buys more foreign currency. We are, that is to say, treating the exchange rate as the price of foreign currency in terms of home currency (price of $1 in £s, e.g. $1 costs £0.67).2 But (unfortunately) the typical (and familiar) British usage is to read the exchange rate as an indicator of the purchasing power, over other currencies, of the pound sterling and speak of exchange rate movements from that perspective. Thus we are accustomed to think in terms of the number of units of foreign currency which one pound buys; we say, e.g., that one pound buys $1.50, rather than, as the academic convention expresses the relationship, that one dollar costs 67 pence.3 This difference of conventions can lead to a muddle. For instance, if the dollar rate alters from $1.67 per pound to $1.55, the British usage would be to put it that there has been a weakening or fall in the pound relative to the dollar (£ buys fewer $). On the other hand, in accord with the academic convention, we would say that the exchange rate has risen - dollars have become more expensive to 2 It so happens that JS, in earlier discussion of exchange rates chose – perfectly legitimately - to adopt the British usage, defining the exchange rate as the amount of foreign currency purchased by one unit of the home currency ($s per £1; e.g. £1 buys $1.50). We need to be careful of the implications – e.g. from Jim‟s angle the real exchange rate (R) equals the nominal rate (E) times the domestic price level (Pd) divided by the foreign price level (Pf) [i.e. R = E(Pd /Pf) rather than, as with our alternative usage, R = E(Pf/Pd)]. 3 Although it may at first sight seem a bit odd in this particular context, the academic convention in fact corresponds to how we ordinarily think of the price of something - we say that a pint of beer costs £1.75, or a newspaper costs 45 pence - rather than putting it that beer is 0.57 of a pint per £ or newspapers are 2.22 per £. 4 purchase with sterling - the price of one dollar has increased from 60 pence to 64.5 pence. Beware therefore whether it is the exchange rate or the currency which is being spoken of as rising or falling! Or again, to take another example, if the pound buys ¥205 today instead of ¥198 last month, that means (by the academic convention) that the yen rate has fallen (yen are cheaper to buy with sterling), but (in the British usage) the pound would be described as having risen (strengthened / appreciated) against the yen. Note further that while “the exchange rate” refers to the price of one currency in terms of another, the term “the effective exchange rate” is used to describe the price of a collection of foreign currencies (weighted by, say, their relative importance in the country‟s trade) in terms of the home currency. Under the present international financial system exchange rates (except of course between members of a currency union) are not fixed but vary with the forces of demand and supply (which may be affected by government intervention) on the foreign exchange market. This is what is described as a floating exchange rate regime (or more accurately, as a managed float). The current system may be contrasted with a fixed exchange rate regime as existed at the time of the gold standard in the nineteenth century or under the Bretton Woods system from 1945 until the early 1970s. How is the exchange rate determined? We don‟t want to go too far into that question; it will be sufficient for our purposes to understand how the exchange rate fluctuates in the short term in response to factors affecting the foreign exchange market. We do not need to consider here issues such as whether, over the longer term, the exchange rate tends to, or fluctuates about, a value consistent with „purchasing power parity‟. The foreign exchange market We may represent the foreign exchange market in terms of a simple demand and supply model. Assume only two currencies - the home currency and a foreign currency (foreign exchange); (if we wish we can call these respectively „pounds‟ and „dollars‟). Agents enter the market in order to buy or sell foreign exchange with or for domestic currency. Who is involved in such business? Let us assume that there are two categories of participating agents - those who are trading internationally in goods and services, and, in addition, professional financial operators who may be engaged in lending or borrowing or in speculative activities. [Figure18/1 overleaf] 5 ________________________________________________________________________ Figure 18/1: the foreign exchange market (the price of foreign exchange) On the vertical axis we show the price of foreign exchange; along the horizontal axis are measured quantities of foreign exchange („dollars‟ demanded and supplied). Reading up the vertical axis, the exchange rate rises (alternatively, the home currency depreciates or weakens). Price of foreign exch ($) Exchange rate rises / £ weakens Exchange rate falls / £ strengthens Dfe (e.g. to pay for M) Sfe (e.g. from X) $1 costs £1- £1 buys $1 $1 costs 80P - £1 buys $1.25 $1 costs 67P - £1 buys $1.50 $1costs 50P - £1 buys $2 Quantity of foreign exchange($) ________________________________________________________________________ Consider first the activities of the traders in goods and services. The demand for foreign exchange derives from the fact that ultimately imports have to be paid for in the suppliers‟ own currency. Domestic (UK) importers who wish to pay in dollars for purchases made abroad offer, on the foreign exchange market, pounds for dollars; alternatively, if foreign exporters are paid initially in pounds they will wish to exchange these pounds for their own currency. UK imports thus imply a demand for dollars (foreign exchange) in place of pounds. Correspondingly, exports imply a supply of foreign exchange being offered against the domestic currency: exporters, selling goods overseas, if paid in dollars will wish to exchange these dollars for pounds, and foreign importers intending to pay in pounds will offer dollars for pounds on the market. The precise mode of settlement of these export and import transactions – whether exporters are initially paid in home or foreign currency - doesn‟t matter: either way, imports imply an offer of domestic currency for foreign currency, and exports imply a demand for home currency in exchange for foreign currency. The demand curve for foreign exchange (pounds offered for dollars) is drawn downwardsloping on the assumption that import purchases depend, ceteris paribus, on the exchange 6 rate: the higher is the rate (i.e. the weaker the pound), the more expensive are foreign goods in terms of domestic currency, and the less is the demand for them. Correspondingly, the supply curve of foreign exchange is shown as upward-sloping for the reason that we may suppose the volume of export sales to vary positively with the exchange rate: the higher is the exchange rate (the weaker is the pound against the dollar) the stronger the foreign demand for exports. The point of intersection of the demand and supply curves gives the market clearing price of foreign currency in terms of home currency (of dollars in terms of pounds). Changes in exports or imports for reasons other than exchange rate variations will shift the curves and alter the exchange rate. Thus for instance: a boom in exports, ceteris paribus, would shift the supply curve to the right, increasing the supply of foreign exchange relative to the demand for it, so lowering the exchange rate (i.e. strengthening the pound against the dollar). To complete the picture we need to introduce dealings which fall under the capital account of the balance of payments. Lending and borrowing may be taking place, with such flows adding to the volume of demand for or supply of foreign exchange. Suppose for instance a continuing net inflow of funds in the form of long term borrowing by home residents: this implies a net supply of foreign currency devoted to the purchase of domestic securities: the foreign exchange supply curve would therefore lie further to the right than otherwise, and the exchange rate would be correspondingly lower. But it is not only stable, continuing flows of funds on capital account that have to be considered short term, „hot money‟ flows are another, potentially upsetting, feature of the foreign exchange market. Imagine, for instance, that the proverbial „gnomes of Zurich‟ (professional fund managers / speculators) fear that the pound is going to slump on the exchanges, and decide to shift their funds from London to New York. The result, in terms of our model, is a sudden increase in the volume of pounds offered for dollars, shifting the demand curve to the right and producing a sharp rise in the exchange rate, the speculators‟ activities in fact causing the pound to move in conformity with their predictions. Exchange rates are subject to sudden and significant movement as a result of speculative behaviour on the foreign exchange market. Government intervention Even under a floating exchange rate regime governments intervene in the foreign exchange market in order to smooth out fluctuations or perhaps to resist speculative pressure on the value of a currency. A forteriori, the authorities must intervene under a fixed rate system to maintain the agreed value of the currency. If, for instance, the home authorities wish to prevent a rise in the exchange rate (due to shortage of forex), they enter the market, selling reserves of foreign exchange (in so far as they possess such reserves) to relieve the shortage, and check the depreciation of the home currency. On the other hand, with downward pressure on the exchange rate (relative abundance of forex, the home currency tending to appreciate), the authorities would have to sell domestic currency and purchase foreign exchange on the market. See figure 18/2 for illustration of intervention to prevent depreciation of the domestic currency. 7 ________________________________________________________________________ Figure 18/2: the foreign exchange market (supporting the currency) Price of foreign exchange (i.e. the exchange rate) S”fe Dfe S’fe fixed exchange rate XDfe Quantity of foreign exchange Under a system of fixed exchange rates balance of payments equilibrium is disturbed by a fall in export sales. In the figure above the supply curve of foreign exchange moves sharply leftwards. If the authorities do nothing, an excess demand for foreign exchange will emerge on the market, causing the exchange rate to rise (the home currency to depreciate). In order to prevent that happening, the home authorities must enter the market, and „close the gap‟ by supplying foreign exchange from reserves. Thus the home currency may be supported at cost to the country‟s reserves; but, of course, such reserves are not unlimited. Correspondingly, to prevent an excess supply of foreign exchange from lowering the exchange rate (causing appreciation of the domestic currency) the authorities would have to buy foreign exchange with domestic currency. 8 Exchange rate regimes Fixed and floating exchange rates: historical background The gold standard – its heyday in the latter part of the nineteenth century, up until the First World War; wartime disruption – Britain‟s post-war return to the gold standard at the pre-war parity – The Economic Consequences of Mr Churchill (overvalued pound, deflation as a means of attempting to improve competitiveness – domestic consequences); the breakdown of the gold standard in the 1930s; the Bretton Woods system – fixed but adjustable exchange rates; the role of the IMF; floating rates again from the early 1970s. Fixed versus floating rates Fixed rates – may provide a more stable environment for international investment and growth through avoidance of uncertainty and associated costs; discipline - incentive to avoid excess demand, inflation, and B of P difficulties; less destabilising speculation (?) Floating rates – can insulate domestic economy from shocks occurring abroad and give domestic authorities more discretion in seeking simultaneously to achieve internal and external objectives (compare fixed rate – possibility of internal objective being sacrificed, with domestic deflation, to exchange rate objective). Who favours which system? If an economy is prone to disturbances from internal causes, there may be advantage in fixed rates; if subject to external shocks, floating rates may be preferred. Depreciation / devaluation; appreciation / revaluation Impact on exports and imports – price elasticities of demand; the Marshall-Lerner condition: for devaluation to yield an improvement in the trade balance (starting at a balanced position) the sum of the price elasticities of demand for exports and imports must exceed unity. While there are some difficulties with the Marshall-Lerner proposition we can take the point that currency depreciation (appreciation) does not necessarily lead to an improvement (worsening) of the trade balance; the “J-curve” effect (distinguishing between short and longer-term effects on the trade balance); we can say loosely that depreciation (appreciation) will improve (worsen) the current account if the volume effects on quantities (proportionate response in quantities demanded of exports and imports) of a change in the exchange rate exceed the value effect. The evidence suggests that, at least in the longer term, elasticities are, with respect to the trade balance, large enough to ensure a positive result from depreciation (and a negative one from appreciation). 9 The nominal and the real exchange rate ● The nominal exchange rate (E) expresses the terms on which one currency exchanges for another; e.g. $1 costs 50P or £1 buys $2. ● The real exchange rate (R) is the price of imported goods in terms of exported goods. Changes in R provide an indicator of changes in the price competitiveness of home country: rise in R = improvement; fall in R = deterioration; see example below. ● The real exchange rate (R) depends both on the nominal exchange rate (E) and on country price levels. R is constructed by multiplying the nominal exchange rate by an index of the foreign price level (Pf) and then dividing by the domestic price level (Pd), i.e. R = E(Pf/Pd). Note the possibility that a favourable effect on the trade balance of devaluation / depreciation (which has raised the nominal and real exchange rates together) may be eroded or eliminated by a subsequent fall in the real exchange rate on account of induced inflation. (The country‟s exports again cost as much to foreign buyers in real terms – i.e. in terms of foreign-produced goods – as they did before the devaluation.) Example: devaluation, nominal and real exchange rates Pre-devaluation situation: £1 = $2 [nominal exchange rate (E) = 0.5] price of 1 bottle Scotch whisky (SW) = £20 / $40; [Pd = 100] price of 1 bottle Californian wine (CW) = $10 / £5. [Pf = 100] i.e. for UK 1 SW buys 4 CW, and for USA, same terms, 4 CW buy 1 SW. [real exchange rate (R) = 0.5 x (100/100) = 0.5] At first, post-devaluation: £1 = $1 [E = 1.0] price 1 SW = £20 / $20 [Pd = 100] price 1 CW = $10 / £10. [Pf = 100] i.e. for UK, E and R have both risen; for USA, E and R have both fallen. For UK, 1 SW buys only 2 CW; for USA 2 CW buy 1 SW. [R = 1.00 x (100/100) = 1.00] Later, post-devaluation, after UK inflation (UK price level x 2). £1 = $1; price 1 SW = £40 / $40; price 1 CW = £10 / $10; i.e for UK, while E unchanged, R has fallen; for USA E same, R up. Now for UK, 1 SW again buys 4 CW; for USA 4 CW needed to buy 1 SW. [R = 1.00 x (100/ 200) = 0.5] Initally, the devaluation of the £ raised the price of CW in terms of SW, so tending to reduce UK imports and stimulate exports (the real cost of UK imports rises and the real price of UK exports to purchasers abroad falls). But, with UK inflation, the price of CW in terms of SW has fallen again, implying an increase in UK imports and fall in UK exports; the real exchange rate is back to what it was before the devaluation. 10 (ii) IS/LM – OPEN ECONOMY VERSION Let us now develop the IS/LM model for use in the analysis of open economy issues. The IS curve To take account of trade relations between the home economy and the rest of the world further expenditure flows have to be added to the circular flow model of the closed economy. Exports represent demand from abroad which impinges on the domestic economy, and imports constitute a leakage out of the circular flow. We take it that the volume of export sales (which are non-income-related) depend on factors of competitiveness (price and quality), the exchange rate (with exports a positive function of the exchange rate: exchange rate rises / £ weakens, exports up) and on the state of the world economy. Imports, on the other hand, are income-related, varying positively with domestic income; they vary also inversely with the exchange rate: exchange rate rises / £ weakens, imports down. In terms of the 45 degree line diagram, the introduction of net exports (NX = X - M) will affect both the height and the slope of the aggregate expenditure function. Correspondingly, in terms of IS/LM, the position and slope of IS should be drawn to comprehend exports and imports. In the open economy context, a further reason for the IS curve to shift is a change in the trade balance: an increase in net exports (on account of a rise in the exchange rate / devaluation or other cause) will push IS to the right and a decrease will move it to the left. Again, for the open economy, the IS curve shows combinations of Y and r at which equilibrium of the income-expenditure circular flow may be achieved. Equilibrium in this case means that all leakages - to savings, taxation and imports - are balanced by injections - in the forms of planned investment, government spending and exports. The LM curve The form of the LM curve remains unaltered, the curve still indicating Y and r combinations at which money demand can be equal to money supply. The circumstances of the open economy do however make a difference in respect of the money supply: under fixed exchange rates or a managed float, a balance of payments surplus or deficit will cause an increase or decrease in the domestic money supply. Consider briefly the mechanics of this. Suppose, for instance, that under a system of fixed exchange rates the rate of interest within the home economy tends (for whatever reason) to rise relative to rates elsewhere in the world. With internationally mobile funds, the appearance of this interest rate differential will induce an inflow of money to the home economy as international financial operators seek to exploit the perceived profit opportunity. The domestic money supply is in consequence increased. How does that happen? Fund holders, wishing to put funds held previously in, say New York, into the home country stock market, say in London, bid for the home currency on the foreign 11 exchange market. Given that the exchange rate regime is one of fixed rates, the domestic authorities are obliged to intervene in the market to prevent the home currency from appreciating; they thus sell domestic currency for foreign exchange. Our international financial operators are now equipped with holdings of domestic currency (representing an increase in the domestic money supply) and use these deposits to purchase domestic securities from domestic holders. In general, any net surplus or deficit on the balance of payments will cause the domestic money supply to increase or decrease (unless the authorities take steps to prevent that from happening). Any alterations of the money supply occurring in this way on account of international trade flows or financial activities are of course represented in the IS/LM diagram by an appropriate shift of the LM curve. The BP curve Figure 19/1: the BP curve r BP BP Y For the open economy situation we add a third curve to the IS/LM model - this is the BP (balance of payments) curve (figure 19/1). The IS/LM model thus turns into the IS/LM/BP model. Like the IS and LM curves, the BP curve indicates possible equilibrium combinations of Y and r, in this case combinations consistent with overall balance of payments equilibrium. In the general case, the BP curve would be drawn as sloping upwards from left to right. The upward slope would indicate that, with a rising level of Y tending to worsen the current account of the balance of payments, a higher value of r (relative to the world rate of interest) would induce an inflow of funds on capital account which would offset the income-associated deterioration of the current account. With Y and r rising together balance of payments equilibrium could be maintained. Note that points in Y, r space above the BP line imply a balance of payments surplus, and points below it, a deficit. The BP curve will shift with change in the exchange rate: with rise in e/rate, BP moves to right as improvement in trade balance at any level of income means less capital inflow for balance of payments equilibrium. Likewise, exogenous rise in export demand or fall in imports moves BP to right. A fall in the world interest rate, implying stronger capital inflow at existing domestic rate of interest, would also shift BP rightwards. 12 However, assuming that we are concerned with the case of a (relatively) small open economy, and assuming perfect international capital mobility, we have to recognise that the rate of interest in the home economy cannot, except very temporarily, differ from the world rate of interest. (Arbitrage operations will quickly eliminate any differential between home and world interest rates that may emerge.) The implication, with respect to the IS/LM/BP diagram is that we draw the BP curve as a horizontal line at a height corresponding to the world rate of interest; if the home economy is to achieve balance of payments equilibrium, the domestic rate of interest must be the same as the rate elsewhere. Equilibrium in the IS/LM/BP model For full equilibrium of the open economy - with both internal and external balance - three conditions have to be satisfied: (i) the circular flow of income and expenditure must be in balance - leakages must be offset by planned injections; points along the IS curve are consistent with this condition; (ii) money demand must equal money supply: points along the LM curve are consistent with this condition; (iii) the balance of payments must be in overall equilibrium; points along the BP curve are consistent with this condition. In terms of the diagram, for full equilibrium of the economy, one Y, r combination must be common to all three curves; i.e. the triple intersection of the IS, LM and BP curves indicates the unique Y, r combination which is consistent with all three conditions of equilibrium. Note BP is drawn horizontal for the small open economy situation: the domestic rate of interest is automatically brought into conformity with the world rate. See figure 19/2 below. ________________________________________________________________________ Figure 19/2: the IS/LM/BP model r IS LM world interest rate BP _____________________________________________________________ 13 Open economy case: disturbances to aggregate demand Now, do some playing around with the IS/LM/BP model. Consider how domestic and international factors interact when equilibrium is disturbed. Take firstly demand changes under a system of fixed exchange rates. ________________________________________________________________________ Figure 19/3 (a) r IS’ 1 IS” LM’ LM” 2 BP Figure 19/3 (b) r IS” IS’ LM” LM’ 2 1 BP Y Y ________________________________________________________________________ (1) Assume an improvement in business confidence and an increase in investment. The IS curve [figure 19/3(a)] consequently shifts to the right, increasing both Y and r. If the domestic rate of interest is thereby raised relative to the world rate, an inflow of funds from abroad will ensue as financial operators seek to take advantage of the interest rate differential. In the absence of intervention by the authorities, the home currency would appreciate. But under a regime of fixed exchange rates that cannot be permitted: the authorities must enter the foreign exchange market and buy foreign currency with domestic currency (to prevent the price of foreign currency falling relative to domestic currency). In so purchasing foreign exchange, the authorities - paying domestic currency to suppliers of foreign exchange - increase the domestic money supply. The LM curve accordingly also moves to the right. In these circumstances, with a fixed exchange rate, international factors have operated to strengthen the autonomously occurring domestic expansion, and Y rises by more than it would otherwise have done. But note, if interest rates were rising to the same extent abroad as at home, funds would not have been attracted, and this amplifying effect would not have taken place. (2) Now suppose a decrease in exports. IS moves [figure 19/3(b)] to the left and the rate of interest therefore falls. The result is an outflow of funds with the LM curve being pulled to the left. Again, the international movement of funds has amplified the impact of the initial disturbance on the domestic economy; but again, this amplification depends on the domestic interest rate differing temporarily from the world rate. A world-wide fall in interest rates would deter an outflow of funds. 14 Assume now a regime of floating rates of exchange. ________________________________________________________________________ Figure 19/4(a) r IS’ 1 IS” 2 BP LM Figure 19/4(b) r IS” 2 BP IS’ 1 LM Y Y ________________________________________________________________________ (1) What happens now if there is an increase in investment? [Figure 19/4(a).] As before, IS moves to the right and the rate of interest rises, but now, with floating rates, the resultant inflow of funds can be allowed to bring about an appreciation of the domestic currency. However, if that happens, the trade balance may be worsened, with exports falling and imports rising, so that the IS curve is pulled back to the left as the level of domestic activity falls. Under floating rates, the domestic impact of increased investment has been offset by the deterioration in the trade balance. But this counteracting international effect again depends on a difference emerging between home and world rates of interest. (2) Finally, suppose a loss of international competitiveness and a falling off of domestic exports. [Figure 19/4(b).] Domestic activity declines, the home rate of interest falls, funds flow outwards to benefit from higher rates of return abroad – and the domestic currency depreciates. The result of this depreciation is to boost exports and dampen imports, so raising again the level of domestic income. The international flow of funds has brought about a reversal of the initial decline in home activity. As in the previous case, this offsetting effect of international factors under a floating exchange rate works only if the domestic rate of interest is out of line with the world rate. If the world economy generally was plunging into recession, interest rates would be falling across the board. 15 MACRO POLICY IN THE OPEN ECONOMY Having constructed an analytical model appropriate for examination of macroeconomic issues in the case of the open economy, let us put it to further use in investigating the effectiveness of policy instruments. In particular, we want to look at the practicability of methods of macroeconomic management in the context of the “small open economy”. We consider the application of monetary and fiscal policies under both fixed and flexible exchange rate regimes; we (realistically) assume that funds are perfectly mobile internationally (globalisation of the world economy). Note that the treatment of these matters we are going to develop is commonly known as the Mundell-Fleming analysis. We shall take the same illustrative problem for consideration under different circumstances. We assume that the economy in question (the home economy) is initially suffering from a low level of activity; it is stuck in recession, though with balance of payments equilibrium. The conclusions we arrive at in respect of the usefulness of monetary and fiscal policies as means of raising the level of activity apply as well with respect to the effectiveness of those instruments as means of dampening domestic activity. There are the following cases to examine. 16 Monetary Policy (fixed exchange rate) ________________________________________________________________________ Figure 20/1 r IS 1 2 world rate of interest BP LM’ LM” Y’ Y ________________________________________________________________________ The initial situation is shown in Figure 20/1. At Y‟, income is below the full employment level. Suppose the authorities attempt to boost the economy by monetary relaxation: what happens? The money supply increases and the domestic rate of interest falls below the world rate. (The LM curve shifts to the right.) Immediately, there is an outflow of money with fundholders moving out of UK securities; this outflow will continue as long as the interest rate differential remains. As fundholders purchase foreign exchange with domestic currency, the net excess supply of domestic currency is absorbed by the authorities who are supplying foreign exchange out of reserves; the domestic money supply and the country‟s foreign exchange reserves both fall. Equilibrium is restored only when the interest rate differential has been eliminated by the outflow of money and (in diagrammatic terms) the LM curve has been pulled back to its original position. The authorities are back to square one - the monetary intervention has been completely ineffective. The general implication of this example is that, with fixed exchange rates and perfect capital mobility, the domestic authorities have no control over the domestic money supply; international movements of funds completely overwhelm any attempt to manage the domestic economy by monetary means. 17 Fiscal policy (fixed exchange rate) ________________________________________________________________________ Figure 20/2 r IS’ 1 2 BP IS” LM’ LM” Y’ Y” Y ________________________________________________________________________ Begin again (figure 20/2) with the same problematic situation. This time the government applies fiscal policy - a fiscal expansion - in an attempt to raise the level of domestic activity. In terms of the diagram the action of the government moves the IS curve to the right; activity rises, and so does the rate of interest. Again the emergence of an interest rate differential induces a response on the part of financial operators, but this time the international movement of funds complements the action of the domestic authorities instead of frustrating it. The rise in the domestic interest rate attracts funds from abroad. This means an increase in the domestic money supply: fundholders are selling foreign exchange for domestic currency supplied by the authorities (through the intervention which they must make in the foreign exchange market); that domestic currency is used to buy domestic securities. The money supply increases in this way until the home rate of interest is brought down into line with the world rate. In terms of the diagram the LM curve is pulled rightwards until a new equilibrium is established with IS and LM intersecting on BP at a higher level of activity than initially prevailed. The conclusion which emerges here is that, with a fixed exchange rate, fiscal policy is a powerful instrument of macroeconomic management. The effect of the international movement of funds is to strengthen the expansionary or contractionary forces brought to bear on the economy by fiscal policy. 18 Devaluation / revaluation (adjustment of normally fixed exchange rate) Under the Bretton Woods system of fixed exchange rates, a country experiencing a chronic balance of payments problem - continuing deficits – might, rather than adopting a strategy of domestic deflation*, choose to re-fix the value of its currency at a different level against other currencies (i.e. devalue). What effects would such a change have? [In the opposite situation of continuing trade surpluses, a country, or more likely its trading partners, might favour raising the value of the relevant currency (i.e revaluation).] Consider here however the consequences of a devaluation. Supposing elasticities to be appropriate (and allowing for the „J-curve effect‟), a managed rise in the exchange rate should in time yield an improvement in the trade balance. With this increase in net exports (rightward movement of the IS curve) domestic activity increases and the rate of interest rises. Note that a necessary precondition of successful use of the strategy of devaluation is that there must exist already, or must be created by monetary or fiscal measures, sufficient spare capacity within the economy to allow for this boost to domestic demand. The subsequent sequence of events will be as in the case of fiscal expansion under a fixed exchange rate (see Figure 20/2 above), with the improvement in net exports moving IS rightwards and the induced tendency for the domestic rate of interest to rise also pulling LM to the right. If all goes to plan - and inflationary pressures generated by the rise in import prices are not allowed to create an inflationary price-wage spiral, if, that is to say, the initial rise in the real exchange rate is not offset by domestic inflation (see example p.9 above) - the managed adjustment of the exchange rate will allow the objectives of balance of payments equilibrium and the maintenance of a satisfactory level of domestic economic activity to be reconciled. * Note the alternative possibility: if a country has a chronic inability to pay for its imports at the current exchange rate and going level of activity, it could attempt to achieve balance of payments equilibrium via deflation. If imports are a function of income, lowering income should, in the medium term, improve the trade balance, and in the longer term, if money wages and prices fall with unemployment, exports would tend to become more competitive. (Note that this represents an attempt to raise the real exchange rate while maintaining the nominal rate unaltered.) Such a strategy would undoubtedly be very painful, and success could not be guaranteed. Devaluation (raising –“at a stroke” both the real and nominal rates of exchange) could be a quicker and more effective route to improved competitiveness and a healthier balance of payments. 19 Monetary policy (floating exchange rate) ________________________________________________________________________ Figure 20/3 r IS’ 2 BP 1 IS” LM’ LM” Y’ Y” Y ________________________________________________________________________ While monetary policy is quite ineffective with a fixed exchange rate, it comes into its own with a floating rate. Again (figure 20/3) we consider the expansionary case. We suppose that the home country authorities relax monetary conditions, increasing the money supply and lowering the rate of interest (that of course implies a rightward movement of the LM curve.) As in the previous scenarios, the emergence of an interest rate differential between the home country rate and the world rate attracts the attention of fund holders: in this case an outflow of funds from the home country results as market operators seek to escape the relatively low home country returns. On the foreign exchange market the consequent excess supply of the home currency / excess demand for foreign exchange drives up the exchange rate (causes depreciation of the home currency). From the perspective of the home government seeking to boost the level of domestic activity, this is a helpful development: the depreciation will tend to reduce imports and stimulate exports, and as net exports rise, the level of domestic activity responds positively. In diagrammatic terms the improving trade balance pulls the IS curve to the right. A new equilibrium of national income can be attained nearer to, or at, full employment. In this case, our findings are that monetary policy works effectively with floating exchange rates. With a floating rate the indirect effect of monetary expansion - a depreciation of the currency, generating a boost to net exports - complements the direct, stimulatory impact of a lower rate of interest on the domestic economy. 20 Fiscal policy (floating exchange rate) ________________________________________________________________________ Figure 20/4 r IS’ 1 IS” 2 LM BP Y ________________________________________________________________________ Just as monetary policy is an effective instrument under one exchange rate regime, but ineffective under the other, the same is the case with fiscal policy. If fiscal expansion is undertaken with a floating exchange rate, the government will be disappointed in the result. Consider what happens (figure 20/4). Government spending increases, the level of activity rises, and so does the rate of interest. The rise of the domestic interest rate relative to the rate elsewhere attracts internationally mobile funds; this movement of funds implies an excess demand for home currency / an excess supply of foreign currency on the foreign exchange market, and consequently (from the home country perspective) a fall in the exchange rate (appreciation of the home currency). When the exchange rate falls, the home country‟s exports become less competitive and, at the same time, imports become cheaper to domestic purchasers. Net exports thus fall, dampening domestic activity. In terms of the diagram the initial rightward movement of the IS curve, brought about by the fiscal expansion, is reversed by the worsening trade balance; the improvement in domestic conditions proves temporary, and the economy returns to a condition of recession. This scenario demonstrates that, under a floating exchange rate regime, fiscal policy applied on its own is a non-starter for domestic economic management. The trouble is that a fiscal expansion or contraction generates, indirectly, powerful market forces in the international arena which produce a counteracting feed-back on the domestic economy. 21 Monetary and fiscal policy together (floating exchange rate) A final point to note however is that, with floating exchange rates, co-ordinated use of monetary and fiscal measures may be employed to achieve simultaneously desired internal objectives (as regards levels of output and employment) and an external objective in respect of the international value of the currency. Using two policy instruments, two objectives can be effectively targeted. For instance, suppose the authorities wish to boost the level of domestic activity, but without altering the exchange rate. As we have seen, under floating rates, monetary policy could be used effectively on its own to increase domestic income, but that is achieved through raising the exchange rate. The solution for the authorities would be to apply expansionary fiscal policy and monetary relaxation together. Fiscal expansion would increase domestic demand and, with simultaneous monetary expansion, the domestic rate of interest could be kept from rising, thereby avoiding any downward pressure on the exchange rate (appreciation of the currency); thus both the internal and the external objectives could be achieved. (See figure 20/5 for this scenario in terms of IS/LM.) ________________________________________________________________________ Figure 20/5 r IS’ IS” LM’ LM” Y’ Y” Y Roy Grieve March 2006 22