International Political Economy

1. International Political Economy

2. Lesson 4 Section 4.1 International Imbalance

3. Balance of payments surpluses and deficits mean the international sector of our economy is in disequilibrium. • The importance of the balance of payments is that it measures imbalance in our international sector, thereby pointing to economic forces for change. • So is necessary to identify these forces and how they bring about change.

4. Monetary and fiscal policies are shocks to the economy that affect many economic variables, such as income, interest rates, and prices. • Changes in these variables create imbalances in the international sector, which in turn set in motion forces that modify the impact of these policies on the economy • Is necessary to examine how our earlier discussions of monetary and fiscal policies must be adjusted to recognize the influence of forces generated through the international sector of the economy • The recent increase in the openness of the world requires that macroeconomic analysis pay more attention to these forces.

5. Interest rate Fiscal policy Income Monetary policy Price level Surplus International imbalance Deficit

6. Exactly what are the forces for change that an imbalance in the balance of payments engenders? • This is a crucial question, the answer to which depends on whether the economy is operating on a flexible or a fixed exchange rate system

8. Lesson 4 Session 4.2 International Imbalance with flexibleexchange rate

9. Domesticcurrency Demand > supply Export > Import BoP surplus Exchange rate increase BoP balance Exchange rate decrease Export < Import BoP deficit Domesticcurrency Demand < supply

10. BoP surplus Exchange rate Domestic currency demand Domestic currency supply P* P1 Domestic currency S1 D1

11. BoP deficit Exchange rate Domestic currency demand Domestic currency supply P2 P* Domestic currency D2 S2

12. Under a flexible exchange rate system, the government allows the forces of supply and demand to determine the exchange rate. • If there is a balance of payments surplus, demand for our currency on the foreign exchange market exceeds its supply, so market forces cause a rise in the value of our currency. • Those who want the extra, unavailable dollars try to obtain them by offering extra foreign currency for them, so our currency becomes more valuable in terms of foreign currency • This process operates in reverse if there is a balance of payments deficit. • In this case, the demand for our currency on the foreign exchange market is less than its supply, so market forces cause a fall in its value

13. Note that under a flexible exchange rate system, any tendency toward a balance of payments surplus or deficit is automatically and instantaneously eliminated by a flexing of the exchange rate, so that our measure of the imbalance (the balance of payments) is always zero. • The balance of payments measure is nonzero only if the government engages in some net buying or selling of foreign currency. • In the context of a flexible exchange rate, the terminology "balance of payments surplus or deficit" must be interpreted as reflecting a surplus or deficit that would appear if the exchange rate were not permitted to adjust instantaneously.

14. Under a flexible exchange rate, therefore, the initial reaction of the economy to an imbalance in the balance of payments is a change in the exchange rate, which in turn creates additional forces for change in the economy. • If, with other variables constant, the exchange rate rises, demand for our exports falls because foreigners find our exports more expensive in terms of their currency. • Furthermore, imports become cheaper to us (because our currency now buys more foreign exchange), so there is a fall in demand for domestically produced goods and services that compete with imports. • Both phenomena imply that aggregate demand for domestically produced goods and services falls • Similarly, if the exchange rate falls, demand for exports and import-competing goods and services should be stimulated, implying a rise in demand for domestically produced goods and services

15. To summarize, if the economy has a flexible exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the exchange rate to change; • This change in turn causes the import-competing and export sectors of the economy to adjust, thus affecting aggregate demand for goods and services

16. Flexible Exchange Rate Imbalance BoP surplus BoP deficit Exchange rate increase Exchange rate decrease Export decrease Import increase Export increase Import decrease BoP=0

17. Lesson 4 Section 4.3 International Imbalance With a Fixed Exchange Rate

18. BoP surplus Exchange rate Domestic currency demand Domestic currency supply Pcb Domestic currency D1 S1

19. BoP deficit Exchange rate Domestic currency demand Domestic currency supply Pcb Domestic currency S1 D1

20. Under a fixed exchange rate system, the government does not allow the forces of supply and demand to determine the exchange rate. • Instead, the government fixes the exchange rate at what it believes is the "right" rate, and the central bank, armed with a stockpile of foreign exchange reserves, stands ready to buy or sell foreign currency at that rate. • If there is a balance of payments surplus, the demand for our currency by foreigners is greater than the supply, so some of these foreigners will seek extra, unavailable domestic currency. • Under a flexible exchange rate, they would have to get our currency by offering more foreign exchange, but under a fixed exchange rate this higher cost can be avoided because the Central Bank will exchange their foreign currency for domestic currency at the fixed rate

21. When the Central Bank does so, it takes the extra foreign exchange currency and in return provides domestic currency. • The most important implication of this process is that the domestic money supply increases by the increase in domestic currency times the money multiplier • When there is a balance of payments deficit, the opposite occurs. • We are supplying more domestic currency on the foreign exchange market (seeking foreign currency to take vacations abroad, for example) than there is foreign demand for domestic currency, so those of us unable to obtain foreign currency from foreigners go to the Central Bank to buy foreign exchange at the fixed rate. • To buy the foreign currency we give the Central Bank currency, removing them from public circulation and thereby decreasing the domestic money supply.

22. To summarize, if the economy has a fixed exchange rate, an imbalance in the international sector of the economy, measured by the balance of payments, automatically causes the money supply to change, in turn affecting economic activity.

23. Armed with these two general results—that international imbalance causes exchange-rate changes under a flexible exchange rate system and money-supply changes under a fixed exchange rate system—we can examine how monetary and fiscal policy are affected by repercussions from the international sector. • To maintain simplicity, all analysis ignores price-level changes and inflation. Incorporating them would not change the general results, only the breakdown of nominal income changes into real changes and price changes.

24. Lesson 4 Section 4.4 Fiscal Policy Under Flexible Exchange Rates

25. An increase in government spending leads to an increase in income and an accompanying increase in the interest rate, causing some crowding out. • The increase in income increases imports, creating a balance of payments deficit, but the increase in the interest rate causes capital inflows, creating a balance of payments surplus. • Which will dominate? • The consensus among economists on this empirical question is that the latter will outweigh the former. • Because of the high mobility of international capital, a slight increase in our interest rate causes a substantial capital inflow, outweighing the impact on the balance of payments of the accompanying rise in imports.

26. Once this empirical question is settled, it is easy to see how international forces modify the impact of fiscal policy. • Under a flexible exchange rate system, the balance of payments surplus created by a stimulating dose of fiscal policy causes the exchange rate to appreciate. • This increase decreases exports—directly decreasing demand for domestically produced goods and services. • It also in creases imports, thereby decreasing demand for domestically produced goods and services that compete against imports. • The decrease in aggregate demand for domestically produced goods and services partially offsets the impact on the economy of the stimulating dose of fiscal policy, decreasing the strength of fiscal policy in affecting the income level

27. Lesson 4 Session 4.5 Fiscal Policy Under Fixed Exchange Rates

28. When the exchange rate is fixed, the balance of payments surplus created by a stimulating dose of fiscal policy does not cause the exchange rate to rise. • Instead, it causes an increase in the money supply as the central bank buys foreign currency (the balance of payments surplus) with domestic currency. • This increase in the money supply augments the stimulating effect of the policy dose, making fiscal policy stronger in affecting the income level.

29. Reaction to Fiscal Policy This flowchart shows the reaction of the economy to an increase in government spending under both flexible and exchange rate systems (source: Kennedy 1999).

30. Lesson 4 Section 4.6 Monetary Policy Under Flexible Exchange Rates

31. An increase in the money supply lowers the interest rate, and the lower interest rate stimulates aggregate demand and moves the economy to a higher level of income. • This rise in income increases imports, creating a balance of payments deficit, and the fall in the interest rate reduces capital inflows, thus augmenting this balance of payments deficit.

32. Under a flexible exchange rate system, the balance of payments deficit causes the exchange rate to depreciate. • This lower exchange rate increases exports—directly increasing demand for domestically produced goods and services. It also decreases imports—increasing demand for domestically produced goods and services that compete against imports. • The rise in aggregate demand for domestically produced goods and services augments the impact on the economy of the stimulating dose of monetary policy, thus giving greater strength to monetary policy in affecting the income level

33. Reaction to Monetary Policy This flowchart shows the reaction of the economy to an increase in money supply under both flexible and fixed exchange rate systems (source Kennedy 1999).

34. Lesson 4 Section 4.7 Monetary Policy Under Fixed Exchange Rates

35. When the exchange rate is fixed, the balance of payments deficit created by a stimulating dose of monetary policy does not cause the exchange rate to fall. • Instead, it causes a decrease in the money supply as the Central Bank buys domestic currency with foreign exchange to prevent the balance of payments deficit from lowering the exchange rate. • The decrease in the money supply diminishes the stimulating effect of the policy dose, making monetary policy weaker in affecting the income level

36. There is more to this story however. • An increase in the money supply created the balance of payments deficit, and an automatic decrease in the money supply is decreasing the deficit. • Consequently, only when the original money supply increase has been completely wiped out will the deficit be eliminated. • The economy will regain equilibrium back where it started, so the end result of this monetary policy is no change. • This reflects an extremely important general result: • under a fixed exchange rate, monetary policy is completely ineffective as a policy tool. • Monetary policy implicitly is being used to fix the exchange rate, so is not available for other purposes

38. Lesson 4 Session 4.8 Sterilization Policy

39. Monetary policy in the context of a fixed exchange rate is ineffective because an expansionary monetary policy creates a balance of payments deficit, which automatically decreases the money supply, offsetting and eventually eliminating the original increase in the money supply. • What if, however, the monetary authorities take monetary action to counteract the automatic change in the money supply, allowing the original monetary dose to be maintained? • As the money supply decreases automatically in the preceding example, the monetary authorities could annually increase the money supply by exactly the same amount • This policy is called a sterilization policy because it "sterilizes" the automatic money-supply change that results from an imbalance in international payments under fixed exchange rates. • Pursuing this policy maintains the original monetary policy dose and allows monetary policy to retain its effectiveness

40. Unfortunately, there is a catch: • the sterilization policy maintains the imbalance in international payments. • In the example, the balance of payments deficit, which would normally disappear as it automatically decreased the money supply, now persists as this automatic mechanism is "sterilized." • What are the implications of of a continuing balance of payments deficit?

41. Consider how the government, through its agent the central bank, deals with the balance of payments deficit. • The deficit means that the supply of dollars on the foreign exchange market exceeds the demand, so those unable to obtain foreign exchange for their currency go to the government to exchange them at the fixed rate.

42. The government sells foreign currency to them atthe fixed rate, as it has promised to do, and in return obtains domestic currency, which normally would thereby be removed from public circulation, thus decreasing the money supply. • Under a policy of sterilization, of course, the central bank arranges to have these dollars put back into circulation. • The key point here is that during this process the government is selling off its holdings of foreign exchange. As long as the balance of payments deficit continues, the government's stock of foreign exchange—its foreign exchange reserves—steadily falls.

43. The major problem with sterilization policy should now be evident. • By maintaining the balance of payments deficit, the sterilization policy causes the government's foreign exchange reserves to run low, threatening its ability to continue this policy, and worse, alerting foreign exchange speculators that the dollar may soon have to be allowed to fall. • The resulting foreign exchange crisis usually results in a devaluation (a substantive fall in the fixed exchange rate value), creating embarrassment for the government and profits for speculators. • If a balance of payments surplus is being maintained by a sterilization policy, however, opposite results are obtained. • Foreign exchange reserves cumulate to embarrassingly high levels, ultimately causing an upward revaluation of the currency and, once again, profits for speculators.

44. Lesson 4 Session 4.9 Government Influence on the Exchange Rate

45. It is rare to find an exchange rate system that is fully flexible. • Usually, government intervenes in the operation of the foreign exchange market to "modify" the natural forces of supply and demand. • Sometimes intervention is intended to prop up an exchange rate for reasons of prestige, and at other times it is intended to push down the exchange rate in order to produce jobs through stimulation of demand for exports and import-competing goods and services

46. Neither of these interventions can be viewed with favor because they attempt to set the exchange rate at an unnatural level. • A more convincing rationale for government interference in this market is that without such interference the exchange rate may be volatile, so volatile that it is disruptive to international business activity. • Government action designed to cushion temporary shocks to the exchange rate, rather than to influence its long-run level, is thought to be a legitimate policy

47. The government employs two main mechanisms to influence the exchange rate. • First, it can intervene directly in the foreign exchange market, buying or selling dollars. This intervention is viable as long as the government's stock of foreign exchange reserves is not threatened, as it would be, for example, if it tried to keep the exchange rate above its long-run level through continual purchases of dollars with its foreign exchange reserves. • Second, government can influence the exchange rate by using monetary policy to change the real interest rate; changes in the interest rate in turn affect capital inflows and outflows and thus the exchange rate. • Most governments, through their central banks, adopt a combination of these two policies.