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Chapter24:FloatingExchangeRatesandInternalBalance
FloatingExchangeRates
Onewayofachievingthegoalsofexternalbalanceandinternalbalanceisto:Letthemarket-drivenvariationsinexchangerates“automatically”takecareofexternalbalanceDirectmacroeconomicpolicytowardtheproblemofinternalbalance©2016McGraw-HillEducation.AllRightsReserved.2©2016McGraw-HillEducation.AllRightsReserved.3EffectsofExpandingtheMoneySupplywithFloatingExchangeRatesExpansionaryMonetaryPolicywithFloatingExchangeRates©2016McGraw-HillEducation.AllRightsReserved.4MonetaryExpansionwithandwithoutCurrencyDepreciation©2016McGraw-HillEducation.AllRightsReserved.5Thecentralbankofthecountrylowersinterestratesbyonepercentagepoint.EffectsofExpansionaryFiscalPolicywithFloatingExchangeRates©2016McGraw-HillEducation.AllRightsReserved.6ExpansionaryFiscalPolicywithFloatingExchangeRates©2016McGraw-HillEducation.AllRightsReserved.7ShockstotheEconomyInternalShocksDomesticmonetaryshocksDomesticspendingshocksInternationalCapital-FlowShocksInternationalTradeShocks©2016McGraw-HillEducation.AllRightsReserved.8DomesticMonetaryShocksAdomesticmonetaryshockaffectstheequilibriumrelationshipbetweenmoneysupplyandmoneydemand,causingashiftintheLMcurve.Achangeinthecountry’smonetarypolicyisanexampleofsuchashock.Ifthemonetaryshocktendstoexpandtheeconomy,thentheexchange-ratevalueofthecountry’scurrencytendstodepreciate,furtherincreasingdomesticproduct(orputtingadditionalupwardpressureonthecountry’spricelevelorinflationrate)©2016McGraw-HillEducation.AllRightsReserved.9DomesticSpendingShocksDomesticspendingshocksalterdomesticexpenditure,causingashiftintheIScurve.Achangeinfiscalpolicyisanexample.Theeffectofthiskindofshockondomesticproductdependsonwhichchangesmore,internationalcapitalflowsorthecountry’scurrentaccount,becauseoftheimplicationsforthechangeintheexchangeratevalue.©2016McGraw-HillEducation.AllRightsReserved.10InternationalCapital-FlowShocksInternationalcapital-flowshocksoccurbecauseofchangesininvestors’perceptionsofeconomicandpoliticalconditionsinvariouscountries.Altersthecountry’sfinancialaccount,sotheFEcurveshifts.Pressureforachangeintheexchangeratevalue.©2016McGraw-HillEducation.AllRightsReserved.11AnAdverseInternationalCapital-FlowShock©2016McGraw-HillEducation.AllRightsReserved.12InternationalTradeShocksAninternationaltradeshockchangesthecountry’sexportsorimports.BoththeIScurveandFEcurveshift.Withfloatingexchangerates,theeffectsofinternationaltradeshocksoninternalbalancearemitigatedbytheeffectsoftheresultingchangeintheexchangerate.Forexample,anadversetradeshocktendstodepreciatethecountry’scurrency,andthisreversessomeoftheeffectsoftheshock.©2016McGraw-HillEducation.AllRightsReserved.13AnAdverseInternationalTradeShock©2016McGraw-HillEducation.AllRightsReserved.14©2016McGraw-HillEducation.AllRightsReserved.15RankingofExchange-RateSystemsbyUnitImpactsofVariousExogenousShocksonDomesticProductandIncome*Ifinternationalcapitalflowsarerelativelyunresponsivetointerestratechanges(lowcapitalmobility).†TheinducedexchangeratechangewithfloatingexchangeratesshiftstheFEcurvebacktowarditsoriginalposition.InternalImbalanceandPolicyResponsesShockstotheeconomyalterboththeinternationalperformanceofthecountry’seconomyanditsdomesticperformance.Withfloatingexchangeratesachangeintheexchangeratetakescareofachievingexternalbalancefollowingashock.Ifthecountry’soverallpaymentstendtogointodeficit,thenthecountry’scurrencydepreciates,reversingthetendencytowarddeficit.Ifthecountry’soverallpaymentstendtosurplus,thenappreciationreversesthetendencytosurplus.Monetarypolicyorfiscalpolicycanbeusedtoaddressinternalimbalance.©2016McGraw-HillEducation.AllRightsReserved.16InternationalMacroeconomicPolicyCoordinationThepoliciesadoptedbyonecountryhaveeffectsonothercountries.Apolicychangethatbenefitsthecountrymakingitmayharmothercountries.Acountrymayfailtomakeapolicychangethatbenefitsothercountries.Inprinciple,internationalmacroeconomicpolicycoordinationcanimprovecombinednationaleconomicperformance.Inpractice,majorinstancesofsuchcoordinationarerare.©2016McGraw-HillEducation.AllRightsReserved.17U.S.TradeDeficits©2016McGraw-HillEducation.AllRightsReserved.18U.STradeDeficits©2016McGraw-HillEducation.AllRightsReserved.19GlobalCrisisIntheaftermathoftheglobaleconomicandfinancialcrisis,even(shortterm)interestratesofzerocouldnotpropeltheU.S.economybacktowardinternalbalance(alowunemploymentrate):Liquiditytrap.U.S.Fedturnedtoquantitativeeasing,buyingandholdingmassive
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