International Monetary Economics

Lecture 7: Monetary and Fiscal Policy under Flexible Exchange Rates

Master d’Affaires Publiques SciencesPo Spring 2013

Pierre-Olivier Gourinchas

Slide 7-2

§  Temporary Changes in Monetary and Fiscal Policy §  Permanent Shifts in Monetary and Fiscal Policy §  Liquidity Traps §  Summary

Roadmap

Slide 7-3

Figure 7-1: Short-Run Equilibrium: The Intersection of DD and AA

Output, Y

Exchange Rate, E

AA

Y1

E1 1

Short-Run Equilibrium for an Open Economy: The DD and AA Schedules

DD

Slide 7-4

Temporary Changes in Monetary and Fiscal Policy

§  Two types of government policy: •  Monetary policy

– Works through changes in the money supply. •  Fiscal policy

– Works through changes in government spending or taxes. •  Temporary policy shifts are those that the public expects to

be reversed in the near future and do not affect the long-run expected exchange rate.

•  Assume that policy shifts do not influence the foreign interest rate and the foreign price level.

•  Assume also that the domestic price level is constant.

Slide 7-5

§ Monetary Policy •  An increase in money supply (i.e., expansionary monetary

policy) raises the economy’s output. •  But the channel of transmission is fundamentally different

than in the close economy: expansionary monetary policy lowers the nominal interest rate which leads to a depreciation of the currency.

Temporary Changes in Monetary Policy

Slide 7-6

Figure 7-2: Output and the Exchange Rate in Asset Market Equilibrium

Domestic-currency return on foreign- currency deposits

Foreign exchange market

Money market

E1 1'

i1 L(i, Y)

Real domestic money holdings

Domestic interest rate, i

Exchange Rate, E

0

Real money supply

MS1 P

1

Temporary Changes in Monetary Policy

Slide 7-8

DD

Figure 7-3: Effects of a Temporary Increase in the Money Supply

Output, Y

Exchange Rate, E

AA1

1 E1

Y1

Temporary Changes in Monetary Policy

Slide 7-10

Table 7-1: The Dance of the Dollar, 1980-1984

Temporary Changes in Monetary Policy

1980 1981 1982 1983 1984GDP Growth (%) -0.5 1.8 -2.2 3.9 6.2Unemployment Rate (%) 7.1 7.6 9.7 9.6 7.5CPI Inflation (%) 12.5 8.9 3.8 3.8 3.9Real Interest Rates (%) 2.5 4.9 6.0 5.1 5.9Real Exchange Rate 117.0 99.0 89.0 85.0 77.0Trade Surplus (% of GDP) -0.5 -0.4 -0.6 -1.5 -2.7

Source: Economic report of the President

Selected Macro Variables for the United States, 1980-1984

Slide 7-11

§  Fiscal Policy •  An increase in government spending, a cut in taxes, or some

combination of the two (i.e, expansionary fiscal policy) raises output.

•  The expansionary effect is partially offset by an appreciation of the currency.

Temporary Changes in Fiscal Policy

Slide 7-12

DD1

Figure 7-4: Effects of a Temporary Fiscal Expansion

Output, Y

Exchange Rate, E

AA

Y1

E1 1

Temporary Changes in Fiscal Policy

Slide 7-14

Table 7-2: The Bush 2000 Fiscal Expansion

Temporary Changes in Fiscal Policy

1998 1999 2000 2001 2002 2003 2004GDP Growth (%) 4.2 4.4 3.7 0.8 1.9 3.0 4.4Unemployment Rate (%) 4.5 4.2 4.0 4.7 5.8 6.0 5.5CPI Inflation (%) 1.6 2.7 3.4 1.6 2.4 1.9 3.3Federal Funds Rate 5.4 5.0 6.2 3.9 1.7 1.1 1.4Real Exchange Rate 100.0 98.2 97.3 91.4 88.2 89.8 98.2Trade Surplus (% of GDP) -1.8 -2.8 -3.9 -3.7 -4.2 -4.8 -5.7

Source: Economic report of the President

Selected Macro Variables for the United States, 1998-2004

Slide 7-15

§  Policies to Maintain Full Employment •  Temporary disturbances that lead to recession can be offset

through monetary or fiscal policies. – Temporary disturbances that lead to overemployment can be

offset through contractionary monetary or fiscal policies.

Policies to Maintain Full Employment

Slide 7-16

Figure 7-5: Maintaining Internal Balance After a Temporary Fall in World Demand for Domestic Products

Output, Y

Exchange Rate, E

DD1

AA1

Yf Y2

E2 2

DD2

1 E1

Policies to Maintain Full Employment

Slide 7-18

DD1

Figure 7-6: Policies to Maintain Internal Balance After a Money-Demand Increase

Output, Y

Exchange Rate, E

AA1

AA2

Yf Y2

E2 2

1 E1

Policies to Maintain Full Employment

Slide 7-20

Permanent Changes in Monetary and Fiscal Policy

§ A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.

§ A Permanent Increase in the Money Supply

•  A permanent increase in the money supply causes the expected future exchange rate to rise proportionally.

Slide 7-21

DD1

Figure 7-7: Short-Run Effects of a Permanent Increase in the Money Supply

Output, Y

Exchange Rate, E

AA1

1 E1

Yf

Permanent Change in Monetary Policy

Slide 7-23

§ Adjustment to a Permanent Increase in the Money Supply •  The permanent increase in the money supply raises output

above its full-employment level. – As a result, the price level increases to bring the economy

back to full employment.

Permanent Change in Monetary Policy

Slide 7-24

Figure 7-8: Long-Run Adjustment to a Permanent Increase in Money Supply

Output, Y

Exchange Rate, E

DD1

AA2

Yf

AA1

Y2

E2 2

E1 1

Permanent Change in Monetary Policy

Slide 7-26

§ A Permanent Fiscal Expansion •  A permanent fiscal expansion changes the long-run

expected exchange rate. –  If the economy starts at the long-run equilibrium, a permanent

change in fiscal policy has no effect on output.

Permanent Change in Fiscal Policy

Slide 7-27

DD1

Figure 7-9: Effects of a Permanent Fiscal Expansion

Output, Y

Exchange Rate, E

DD2

AA1

Yf

1 E1

Permanent Shifts in Fiscal Policy

3

Slide 7-29

Macroeconomic Policies and the Current Account

§  XX schedule •  It shows combinations of the exchange rate and output at

which the NX balance would be equal to some desired level. •  It slopes upward because a rise in output encourages

spending on imports and thus worsens the current account (if it is not accompanied by a currency depreciation).

•  It is flatter than DD.

Slide 7-30

•  Monetary expansion causes NX to increase in the short run. •  Expansionary fiscal policy reduces NX.

–  If it is temporary, the DD schedule shifts to the right. –  If it is permanent, both AA and DD schedules shift

Macroeconomic Policies and the Current Account

Slide 7-31

Figure 7-10: How Macroeconomic Policies Affect the Current Account

Output, Y

Exchange Rate, E

AA

Yf

E1 1

DD

XX

4

3

2

Macroeconomic Policies and the Current Account

Slide 7-32

§  Liquidity Trap: •  When the nominal interest rate reaches 0. •  Central bank cannot lower interest rates any further.

– Why?

•  Conventional monetary Policy becomes ineffective… •  How serious is it?

– Japan (Krugman, 1998) – Now…

Liquidity Traps

Slide 7-33

Liquidity Traps

Figure 7-11: The 2-sided diagram and the liquidity trap

Domestic-currency return on foreign- currency deposits

Foreign exchange market

Money market

E1 1'

i1

Real money supply

MS P 1

L(i, Y1)

Real domestic money holdings

Domestic interest rate, i

Exchange Rate, E

0

Slide 7-34

§ Monetary Policy becomes ineffective •  Increase in money supply leaves interest rate unchanged

(nominal and real) •  Aggregate demand remains unchanged

•  The economy remains depressed.

Liquidity Traps

Slide 7-37

DD1

Figure 7-12: Monetary Policy in a Liquidity Trap

Output, Y

Exchange Rate, E

1 E1

Yf

Liquidity Traps

AA1

Slide 7-38

Table 7-3: Japan’s Liquidity Trap

Liquidity Traps

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003GDP growth 0.99% 0.30% 1.01% 1.91% 3.37% 1.82% -1.13% 0.10% 2.80% 0.37% 0.34% 1.01%

Inflation 1.71% 1.28% 0.70% -0.13% 0.14% 1.72% 0.65% -0.34% -0.67% -0.74% -0.92% -0.86%

Budget surplus (% of GDP) 0.80% -2.44% -3.73% -4.67% -5.04% -3.77% -5.51% -7.18% -7.43% -6.08% -7.11% -7.69%

Government Debt/GDP 68% 74% 79% 87% 94% 100% 111% 125% 133% 142% 147% 156%

Short term interest rate 4.46% 2.98% 2.23% 1.23% 0.59% 0.60% 0.72% 0.25% 0.25% 0.12% 0.06% 0.04%

Exchange Rate (JPY/USD) 126.7 111.2 102.2 94.1 108.8 121.0 130.9 113.9 107.8 121.5 125.3 119.8

Source: OECD Economic Outlook

Selected Macro Variables for Japan, 1992-2003

Slide 7-39

§ How to stimulate the economy? •  Fiscal policy:

•  Non conventional monetary policy •  Committing to future inflation

Liquidity Traps

Slide 7-40

DD1

Figure 7-13: Fiscal Policy in a Liquidity Trap

Output, Y

Exchange Rate, E

1 E1

Yf

Liquidity Traps

AA1

Slide 7-41

Figure 7-14: Non-Conventional Monetary Policy. Central Bank Assets.

Liquidity Traps

Slide 7-42

§  Figure 7-10: Central Bank Liabilities.

Liquidity Traps

Slide 7-43

Summary

§ A temporary expansionary monetary policy causes a depreciation of the currency and a rise in output.

§ A temporary expansionary fiscal policy causes an appreciation of the currency and a small rise in output.

§  Permanent changes in policy •  Permanent changes in the money supply cause sharper

exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.

•  Permanent shifts in fiscal policy are crowded out by real exchange rate movements.

Slide 7-44

§  Liquidity trap: when nominal interest rates reach zero, conventional monetary policy stops working. Instead, stimulative policy requires •  Active fiscal policy •  Credible inflationary policy

Summary