EC111LectNG18 - EC111 MACROECONOMICS Spring Term 2012...

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1 EC111 MACROECONOMICS Spring Term 2012 Lecturer: Jonathan Halket Week 23 Topic 8: OPEN ECONOMY MACROECONOMICS (continued) We looked at the case where the exchange rate was fixed and there was zero international capital mobility. We saw that both fiscal and monetary policy were ineffective. Now we look at three other cases. Case 2: A fixed exchange rate (e = ē) and perfect inter national capital mobility (α = ∞ ) Recall that here the BP curve is horizontal, even a small deviation from the ruling international interest rates causes huge capital flows, and eliminates any gap between home and foreign interest rates. Thus the BP curve is fixed at the international interest rate r F . Fiscal Policy Initially we have BP = 0. The government increases its expenditure, shifting the IS curve to the right. The tendency for the interest rate to deviate above r F causes a massive inflow of financial capital from abroad. The inflow of capital increases the demand for LM 2 IS 1 BP (α = ∞) LM 1 Y r r F IS 2
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2 pounds, which more than offsets the current account deficit. This puts upward pressure on the exchange rate so the Bank sells pounds in exchange for foreign currency. This increases the money supply and shifts the LM curve to the right, until the interest rate is back at r F . National income has increased and the interest rate is unchanged. Fiscal policy is powerful because, with perfect international capital mobility, it does not drive up the interest rate. Monetary Policy Starting again from BP = 0, the Bank expands the money supply, shifting the LM curve to the right. But this tends to reduce interest rate below the world rate. Massive capital outflows create a balance of payments deficit. The Bank has to buy pounds to support the exchange rate which is tending to fall as investors sell pounds. This shifts the LM curve back to the left and back to its original position. So monetary policy is still ineffective as income is not changed and neither is the interest rate. In case 1 and case 2, by fixing the exchange rate, the Bank gives up its control over monetary policy. LM 1 IS 1 BP (α = ∞) LM 2 Y r r F
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3 Case 3: A floating exchange rate (e = e*) and no inter national capital mobility (α = 0 ) Here the Bank does not intervene in the foreign exchange market (a free float) so the exchange rate settles to its equilibrium where supply of pounds is equal to the demand for pounds. Note that central banks often allow the exchange rate to vary but intervene to smooth out extreme fluctuations. Thi s is sometimes called a „managed float‟ or a „dirty float‟. Here we assume a „clean float‟ where the Bank does not intervene at all. Fiscal Policy Initially we have BP = 0. The government increases its expenditure, shifting the IS curve to the right, from IS 1 to IS 2 . This increases national income and increases the demand for imports. This in turn shifts the supply of pounds to the right and causes a depreciation of the exchange rate from e 1 to e 2 .
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