1、Economic Policy in the Open Economy Under Flexible Exchange RatesChapter 26:Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Learning ObjectivesAnalyze the impact of fiscal policy on e, trade, and exchange rates under flexible exchange rates.Analyze the impact

2、of monetary policy on e, trade, and exchange rates under flexible exchange rates.Show how external economic shocks affect the domestic economy under flexible exchange rates. IntroductionThe effectiveness of monetary and fiscal policies at influencing national e differ dramatically under fixed and fl

3、exible exchange rate systems.Do flexible exchange rate systems make countries more vulnerable to external shocks such as the recent global recession?The Effects of Fiscal and Monetary Policy Under Flexible Exchange RatesUnder a flexible exchange rate system, combinations of e and interest rates not

4、on the BP curve will cause disequilibrium in foreign exchange markets, and force an adjustment in the exchange rate.This will cause the BP curve to shift.The Effects of a Currency Depreciation on the BP CurveYiBP0A depreciation expands exports and contracts imports. For any given level of Y, a lower

5、 i is required to balance the BOP.BP1The Effects of a Currency Appreciation on the BP CurveYiBP0An appreciation contracts exports and expands imports. For any given level of Y, a higher i is required to balance the BOP.BP1 Fiscal Policy Under Flexible Exchange RatesWith perfect capital immobility, a

6、ny fiscal stimulus increases Y and i.This creates an incipient BOP deficit, causing a depreciation and a rightward shift of the BP curve.The depreciation increases exports, decreases imports, and shifts IS even farther rightwards.This continues until IS, LM, and BP intersect at a common point.Fiscal

7、 Policy Under Fixed Exchange Rates eiBP0ISLMi0Y0ISPerfect capital immobilityBP1IS i3Y2 Fiscal Policy Under Flexible Exchange RatesWith perfect capital immobility, any fiscal stimulus increases Y and i.This creates an incipient BOP surplus, causing an appreciation of the currency.The appreciation dec

8、reases exports, increases imports, and shifts IS even back to the left.Fiscal Policy Under Fixed Exchange Rates eiBPISLMiEY0ISPerfect capital mobility Fiscal Policy Under Fixed Exchange RatesThe bottom line: When capital is relatively immobile, fiscal policy is more effective at increasing national

9、e.When capital is relatively mobile, fiscal policy is less effective at increasing national e.Between these two extremes, the effect on the exchange rate depends on the relative slopes of LM and BP.BP steeper than LM: depreciationLM steeper than BP: appreciation Monetary Policy Under Fixed Exchange

10、RatesWith perfect capital immobility, a monetary stimulus increases Y, and the increase in imports causes an incipient BOP deficit to emerge.As currency depreciates, BP shifts rightward.Depreciation also shifts IS rightwards.Monetary Policy Under Fixed Exchange Rates eiBPISLMEi0Y0LMPerfect capital i

11、mmobilityBPISi2Y2 Monetary Policy Under Fixed Exchange RatesWith perfect capital mobility, any monetary stimulus increases Y.This generates a large capital outflow and a depreciation of the home currency.The depreciation causes LM to shift outwards.Monetary Policy Under Fixed Exchange Rates eiBPISLM

12、iEY0LMPerfect capital mobilityISY2 Monetary Policy Under Fixed Exchange RatesThe bottom line: When capital is relatively immobile, monetary policy is effective at increasing national e.When capital is relatively mobile, monetary policy is particularly effective at increasing national e. Policy Coord

13、ination Under Flexible Exchange RatesCoordination of fiscal and monetary policy may make the attainment of other targets besides e possible.Examples of alternative targets include interest rates and exchange rates.Consider an e and interest rate target of Y* and i*as an example. Policy Coordination

14、Under Flexible Exchange RatesIf fiscal policy alone is used to reach Y*, it is likely that the interest rate will overshoot the target of i*.In addition, the fiscal policy creates an incipient BOP surplus, appreciating the currency, and shifting BP back to the left.The depreciation also shifts IS pa

15、rt of the way back to the left.In the end, neither target is reached.Policy Coordination: Fiscal Policy AloneLMBP0ISY0i0ISFPY*i*iY*BPFPISFPYFPiFP Policy Coordination Under Flexible Exchange RatesIf monetary policy alone is used to reach Y*, the increase in Ms will cause a currency depreciation, and

16、a rightward shift in BP.In addition, the monetary policy shifts IS rightwards.In the end, neither target is reached.Policy Coordination: Monetary Policy AloneLMBPISY0Y*BPISYLMiiYi0i* Policy Coordination Under Flexible Exchange RatesIf monetary and fiscal policies are used, both i* and Y* can be atta

17、ined.Expansionary fiscal policy allows Y to increase without the expenditure switching effects.Policy Coordination: Monetary Policy AloneLMISY0Y*BPISLMi0iYi* Effects of Shocks in the IS/LM/BP Model (Imperfect K-Mobility)So far, weve examined the effects of fiscal and monetary policy holding a number

18、 of factors constant, includingdomestic and foreign prices,foreign interest rate, andexpected exchange rate changes.How are changes in such variables (“shocks”) transmitted through the economy? Effects of Shocks: A Foreign Price ShockIf the foreign price level were to increase, the home economy woul

19、d expand due to increases in exports and decreases in imports (IS shifts right).The BP also shifts right due to expenditure switching effects of higher foreign prices.Both effects cause i to rise, and the currency to appreciate.These shift IS and BP back to where they started.Foreign Price ShockLMISY0BPISi0iYBPForeign Price ShockLMISY0BPISi0iYBPForeign Price ShockLMISY0BPi0iY Effects of Shocks: A Domestic Price ShockIf t