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