CHAPTER 12 Economic Policy with Floating Exchange Rates

CHAPTER OVERVIEW
Chapter 12 continues to use the open economy IS-LM-BP model that was first introduced in chapter 10 to examine the consequences of monetary and fiscal policy on internal and external policy objectives. In contrast to chapter 11, which investigated the model under fixed nominal exchange rates, the current chapter considers the case in which nominal exchange rates are permitted to float freely. Following the pattern of the previous chapter, chapter 12 first looks at monetary and fiscal policy under floating exchange rates for the case in which capital is imperfectly mobile. The relative effectiveness of the two policies is reversed as compared to the case with fixed exchange rates, so that monetary policy is relatively effective here. In contrast to the fixed exchange rate case, sterilization is no longer a central issue. For fiscal policy, the extent to which there is a slight short run impact on income declines as capital mobility increases, and goes away entirely when capital is perfectly mobile. As in the previous chapter, the two-country model under floating exchange rates with perfect capital mobility is presented next. For floating exchange rates, the chapter shows that the results of the previous chapter are reversed in that now monetary policy has a potential for a beggar-thy-neighbor effect, whereby foreign income falls as domestic income rises. Instead, under floating rates, fiscal policy now becomes the policy that tends to generate locomotive effects, so that foreign incomes rise in sync with domestic incomes in response to expansionary fiscal policy. The chapter ends with a discussion of the choice between fixed versus flexible exchange rate systems. The text makes a distinction between economic stability versus economic efficiency, and defines the more efficient system as the one that permits residents of a nation to direct resources to their alternative uses at minimum costs. The chapter indicates that floating rates incur an inefficiency due to the fact that agents must devote resources to hedging against foreign exchange market risks,, while fixed rates have the potential to induce significant risks of unhedged losses stemming from unanticipated currency devaluations brought on by government policy actions. With respect to economic stability, fixed exchange rates have the greater potential to induce income instability in the presence of variations in aggregate desired expenditure, whereas floating exchange rates have the greater potential to induce income instability in the presence of variations in the demand for real money balances.

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OUTLINE
I. Flexible Exchange Rates and Imperfect Capital Mobility A. Effect of Exchange Rate Variations in IS-LM-BP Model B. Monetary Policy C. Fiscal Policy 1. Low Capital Mobility 2. High Capital Mobility

II. Floating Exchange Rates and Perfect Capital Mobility A. Policies with Perfect Capital Mobility in Small Open Economy 1. Monetary Policy 2. Fiscal Policy 3. Fixed vs. Floating Exchange Rates B. Two-Country Example 1. Domestic Monetary Expansion 2. Foreign Monetary Expansion 3. Domestic Fiscal Expansion 4. Foreign Fiscal Expansion III. Fixed vs. Floating Exchange Rates A. Efficiency Arguments 1. Economic Efficiency 2. Realigning B. Stability Arguments 1. Autonomous Expenditure Volatility 2. Financial Volatility 3. Stability Trade-Off C. Monetary Policy IV. Summary

FUNDAMENTAL ISSUES
1. 2. 3. 4. 5. How do monetary and fiscal policy actions affect a nations real income under floating exchange rates? How does the perfect capital mobility influence the relative effectiveness of monetary and fiscal policy actions in a small open economy that permits its exchange rates to float? In a two-country setting with a floating exchange rate, to what extent can policy actions in one nation influence economic activity in the other nation? What is the basic economic efficiency trade-off faced in choosing between fixed and floating exchange rates? How does the choice between fixed and floating exchange rates depend in part on its implications for economic stability and monetary policy autonomy?

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CHAPTER FEATURES
1. Management Notebook: Is International Stock Trading Complicating Exchange Rate Forecasting?

This notebook discusses the recent trend in higher trading of various (risky) stocks in addition to the traditional trade of government bonds (relatively lower risk). Since forecasting exchange rates has been based largely on predicted capital flows, which in turn have been based on interest rate changes on relatively risk-free government bonds, we see that forecasting exchange rates is becoming more difficult as more risky stocks represent larger portions of trade in financial assets. For Critical Analysis: As trade in stocks of various risks represent larger proportions of capital flows, the twocountry analysis discussed in this chapter would have to be changed to accommodate anticipated interest rate differentials that arise due to risk differentials. 2. Policy Notebook: The Worst of Both Worlds in Poland?

This notebook examines Polands policy decisions after it pegged the zloty to a weighted average of the euro and the U.S. dollar. After aligning the zloty to the euro and the U.S. dollar, the euro lost considerable value on the foreign exchange market. Consequently, the zloty lost value to the U.S dollar and many other currencies. Unfortunately, even though the zloty lost value, Polands net exports did not improve. In fact, Polands net exports fell due to higher imports and no additional exports. Thus, the current account deficit rose. Polands national bank decided to float the zloty; whereupon it lost additional value. For Critical Analysis: The National Bank of Poland would have benefited from considering the concepts of economic efficiency and income stability discussed in the chapter. The efficiency argument could be used in the context of comparing the potential benefits and costs of plans made under fixed and flexible exchange rates. Further, the sources of shocks (either from changes in planned expenditures or demand for money) could also be used in assessing the influence of fixed or floating exchange rate arrangements for economic stability. Examination of the various shocks to the Polish economy and their effects under different exchange rate arrangements could be a useful discussion in class.

ANSWERS TO END OF CHAPTER QUESTIONS

1. A currency depreciation leads to a rise in exports. To maintain a balance-of-payment equilibrium, the nominal interest rate must decline, to induce an inflow of financial asset, or real income must rise, to induce a rise in imports. Consequently, the BP schedule, or set of interest rate-real income combinations that yield balance-of-payments equilibrium, must lie down and to the right of its previous position following a depreciation of the home currency. An expansionary fiscal policy action, such as an increase in government expenditures, shifts the IS schedule rightward along the LM schedule, inducing a rise in equilibrium real income and spurring import spending. Because capital is perfectly immobile, this unambiguously causes a balance-of-payments deficit, which result is a rightward shift of the BP schedule to a crossing point at the final IS-LM equilibrium, with a higher level of real income. The IS curve shifts to the left as government spending falls. Given the low capital mobility, there will likely be a private balance of payments surplus, resulting in a currency appreciation. Net exports consequently will fall which serves to shift the IS curve further to the left at the same time as the BP curve shifts to the left. As a result, the equilibrium interest rate and income level both fall.

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4.

The contractionary monetary policy shifts the LM curve up. Given high capital mobility, this will likely lead to a private balance of payments surplus. Thus, the currency will appreciate which will shift the BP line up and the IS curve left. Thus, income falls and the interest rate rises. As foreign government spending contracts, the foreign IS curve shifts left. this results in lower foreign income and interest rates. Capital will flow from the foreign economy to the domestic economy, which puts pressure on the foreign currency to lose value. As a result, domestic exports fall and imports rise (i.e., the domestic IS curve shifts left) while at the same time foreign exports rise and imports fall (foreign IS shifts right). At the same time, the private balance of payments line shifts down such that each economy is in equilibrium at lower interest rates and lower income levels. As the domestic government spending falls, the domestic IS curve shifts left. As a result, domestic income and interest rates fall. There is a capital outflow to the foreign economy and consequently the domestic currency loses value. Net exports rise in the domestic economy and net exports fall in the foreign economy. Thus, the domestic IS curve shifts partially back to the right and the foreign IS curve shifts to the left. A rise in Japanese government spending and a Japanese tax cut would have caused the Japanese IS schedule to shift to the right, driving up Japans nominal interest rate. This would have induced a capital inflow into Japan, which with near-perfect capital mobility would have caused Japan to experience a balance-of-payments surplus, resulting in a rise in the value of the yen. This, along with the rise in Japanese real income that would have resulted, would have induced Japanese residents to purchase more U.S. export goods, causing the U.S. IS schedule to shift rightward, thereby pushing the U.S. interest rate upward and expanding equilibrium U.S. real income. Hence, this request was in the interest of the United States if its goal was to raise its own real income level. An expansionary monetary policy action in Japan would have raised equilibrium real income but would have led to a depreciation of the yen. If the effect of higher real income on Japanese spending on U.S. export goods would have been greater than the negative effect on such spending of the lower value of the yen, then this policy action also would have been advantageous for the United States. As discussed in this chapter, fixing exchange rates does not eliminate the potential for risks resulting from devaluations or revaluations. The fact that so many realignments have occurred indicates that individuals and firms would continue to face this type of risk in a Western European regime of fixed exchange rates.

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10. Variability in government spending causes the IS schedule to shift to the right or left. Under a fixed exchange rate, unsterilized monetary interventions to stabilize the exchange rate ultimately induce LM shifts that reinforce the real-income effects of IS variations. Under a floating exchange rate, however, movements in the exchange rate cause net export expenditures to move in the opposite directions from variations in government spending, which automatically tends to stabilize the IS schedules position. Thus, in this situation in which money demand is relatively stable, a floating exchange rate is more consistent, as compared with a fixed exchange rate, with real-income stability.

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MULTIPLE CHOICE EXAM QUESTIONS

1. An appreciation in the value of a nations currency induces a A B. C. D. rightward shift in the IS schedule. leftward shift in the IS schedule. rightward shift in the LM schedule. leftward shift in the LM schedule.

Answer: B 2. How does a currency depreciation affect the countrys BP schedule? A. B. C. D. The BP schedule becomes steeper. The BP schedule becomes flatter. The BP schedule shifts to the left. The BP schedule shifts to the right.

Answer: D 3. Under floating exchange rates, an expansionary monetary policy A. B. C. D. is completely ineffective because of offsetting movements in the LM schedule. induces a leftward shift in the BP schedule. has its effect on real incomes magnified by a subsequent shift in the IS schedule. has its effect on real incomes mitigated by subsequent shift in the IS schedule.

Answer: C 4. Under floating exchange rates and high capital mobility, the effects of a fiscal expansion on real output are A. B. C. D. magnified by a shift in the LM schedule. mitigated by a shift in the LM schedule. magnified by a shift in the BP schedule. mitigated by a shift in the BP schedule.

Answer: D 5. Under floating exchange rates and low capital mobility, the effects of a fiscal expansion on real output are A. B. C. D. magnified by a shift in the LM schedule. mitigated by a shift in the LM schedule. magnified by a shift in the BP schedule. mitigated by a shift in the BP schedule.

Answer: C

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Instructors Manual International Monetary and Financial Economics When exchange rates are allowed to float, the initial impact of a fiscal policy expansion is A. B. C. D. an increase in the interest rate, an increase in income, capital inflows and a decrease in net exports. an increase in the interest rate, an increase in income, capital outflows and an increase in net exports. a decrease in the interest rate, an increase in income, capital inflows and a decrease in net exports. a decrease in the interest rate, an increase in income, capital outflows and an increase in net exports.

Answer: A 7. In a small open economy with perfect capital mobility, the effects of an expansionary monetary policy on output are A. B. C. D. offset by responses to subsequent exchange rate movements. magnified by responses to subsequent exchange rate movements. unaffected by responses to subsequent exchange rate movements. It is impossible to say without more information on the relative slope of the BP schedule.

Answer: B 8. In a small open economy with perfect capital mobility, the effects of an expansionary fiscal policy on output are A. B. C. D. offset by responses to subsequent exchange rate movements. magnified by responses to subsequent exchange rate movements. unaffected by responses to subsequent exchange rate movements. It is impossible to say without more information on the relative slope of the BP schedule.

Answer: A 9. In a small open economy with perfect capital mobility, which of the following statements is true? A. Monetary policy is more effective with floating exchange rates than it is with fixed exchange rates. B. Monetary policy is less effective with floating exchange rates than it is with fixed exchange rates. C. Both monetary and fiscal policy are more effective with fixed exchange rates than with floating exchange rates. D. Both monetary and fiscal policy are more effective with floating exchange rates than with fixed exchange rates. Answer: A 10. In a small open economy with perfect capital mobility, A. B. C. D. fiscal policy has its largest possible real-income effects when the exchange rate floats. monetary policy has its largest possible real-income effects when the exchange rate floats. fiscal policy has minimal real-income effects when the exchange rate is fixed. monetary and fiscal policies are both ineffective when the exchange rate floats.

Answer: B

Chapter Twelve 11. Domestic fiscal policy is ineffective in a small open economy with floating exchange rates because

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A. sterilization insures that any IS shifts will be completely offset by LM shifts. B. the small open economy faces a horizontal LM schedule, so a shift in the IS schedule has no effect on the interest rate. C. the small open economy faces a vertical LM schedule, so a shift in the IS schedule has no effect on output. D. expansionary fiscal policy leads to an increase in the interest rate, which induces an appreciation of the currency and induces net exports to fall, offsetting the effects of the initial fiscal expansion. Answer: D 12. In a small open economy with perfect capital mobility and a floating exchange rate, an expansionary monetary policy will result in A. B. C. D. a higher equilibrium nominal interest rate. a lower equilibrium nominal interest rate. a depreciation of the domestic currency. an appreciation of the domestic currency.

Answer: C 13. In the two-country model with floating exchange rates, the initial impact of a domestic monetary policy expansion on the domestic economy is A. B. C. D. an increase in real output and a decrease in the nominal interest rate. a decrease in real output and an increase in the nominal interest rate. an increase in real output and no effect on the nominal interest rate. an increase in real output and an increase in the nominal interest rate.

Answer: A 14. In the two-country model with floating exchange rates, the effect of a monetary policy change on the domestic economy is ______ by subsequent changes in the exchange rate and foreign income. A. B. C. D. magnified mitigated completely offset unaffected

Answer: A 15. Which policy will create a beggar-thy-neighbor effect in a system of floating exchange rates? A. B. C. D. a domestic monetary expansion in a small open economy a domestic fiscal expansion in a small open economy a domestic monetary expansion in the two-country model a domestic fiscal expansion in the two-country model

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Chapter Twelve 16. Which policy will create a locomotive effect in a system of floating exchange rates? A. B C. D. a domestic monetary expansion in a small open economy a domestic fiscal expansion in a small open economy a domestic monetary expansion in the two-country model a domestic fiscal expansion in the two-country model

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Answer: D 17. In the two-country model with floating exchange rates, a domestic monetary policy expansion leads to a(n) A. B. C. D. depreciation of the domestic currency and an increase in foreign output. appreciation of the domestic currency and a decrease in foreign output. depreciation of the domestic currency and a decrease in foreign output. appreciation of the domestic currency and an increase in foreign output.

Answer: A 18. In the two-country model with floating exchange rates, a foreign monetary expansion leads to A. B. C. D. a lower nominal interest rate and lower domestic output. a higher nominal interest rate and lower domestic output. no change in either the interest rate or domestic output. a lower nominal interest rate and an increase in domestic output.

Answer: A 19. In the two-country model, a domestic fiscal expansion leads to an increase in foreign output because A. the expansion lowers the interest rate, and thus spurs investment in the foreign country. B. the expansion leads to a higher interest rate, which induces a rightward shift in the foreign LM schedule. C. the expansion causes an appreciation of the domestic currency, which causes an increase in the net exports of the foreign economy. D. a domestic fiscal expansion does not lead to an increase in foreign output. Answer: D 20. Realignment is defined as A. the reduction in cross-country income differentials that is linked to higher returns to capital in less developed economies. B. a change in the relative price level that brings the real exchange rate back to its equilibrium value. C. a change in the official exchange rate target under a fixed exchange rate regime. D. a shift in the BP schedule that occurs as a result of a nominal devaluation in the domestic currency. Answer: C

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21. In a small open economy, floating exchange rates bring more real income stability than fixed exchange rates if A. B. C. D. there is substantial volatility in the financial sector. real wages are sticky. there is substantial volatility in aggregate autonomous expenditures. the fixed exchange rate regime is credible.

Answer: C 22. An increase in the demand for money that is not caused by a change in real income will shift the A. B. C. D. IS schedule to the right. IS schedule to the left. LM schedule to the right. LM schedule to the left.

Answer: D 23. Monetary policy autonomy refers to A. the monetary authoritys response to an increase in autonomous expenditures under fixed exchange rates. B. the monetary authoritys response to an increase in autonomous expenditures under floating exchange rates. C. a condition which induces a horizontal BP schedule. D. the ability of a central bank to engage in monetary policy independent of the actions of other central banks. Answer: D 24. Which of these is generally not a concern of policymakers in their choice of fixed versus floating exchange rate regimes? A. B. C. D. the health of the domestic banking system income stability economic efficiency monetary policy autonomy

Answer: A 25. The most economically efficient exchange rate system is one which A. B. C. D. gives the most autonomy to the nations central bankers. permits residents of a nation to direct resource to their various alternate uses at minimum cost. eliminates fluctuations in real income caused by foreign economic conditions. eliminates fluctuations in real income caused by conditions in the domestic financial sector.

Answer: B

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26. The risk of potential default by a contract counterparty is known as A. B. C. D. credit risk. market risk. operating risk. systemic risk.

Answer: A 27. Fixed exchange rates may be less efficient than floating exchange rates A. B C. D. in a small open economy subject to domestic monetary shocks. if currency realignment risk goes unhedged. if nominal exchange rate volatility is high. if operating risks are high.

Answer: B 28. A system of floating exchange rates A. B. C. D. renders fiscal policy completely ineffective in a small open economy with perfect capital mobility. renders fiscal policy completely ineffective in the two-country model with perfect capital mobility. insulates domestic incomes from shocks to the domestic financial sector. insulates domestic incomes from shocks to foreign incomes.

Answer: D (Use the following diagram to answer question 29.) R BP LM

IS y 29. At point A, which of the following will occur under floating exchange rates? A. B. C. D. The dollar will appreciate and the BP curve will shift up. The dollar will appreciate and the BP curve will shift down. The dollar will depreciate and the BP curve will shift up. The dollar will depreciate and the BP curve will shift down.

Chapter Twelve Answer: D

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(Use the following diagram to answer question 30.) R LM BP

IS y 30. At point A, which of the following will occur under floating exchange rates? A. B. C. D. The dollar will appreciate and the BP curve will shift up. The dollar will appreciate and the BP curve will shift down. The dollar will depreciate and the BP curve will shift up. The dollar will depreciate and the BP curve will shift down.

Answer: A