Lecture 9

1. Lecture 9 • Policy Evaluation in the AA-DD Model with Fixed Exchange Rates and Perfect Capital Mobility. The Effects of Fiscal and Monetary Policy. • Policy Evaluation in the IS-LM-BP Model with Fixed Exchange Rates and Perfect Capital Mobility

2. Professor Mario CatalanInternational Monetary Theory Policy Evaluation in the AA-DD Model with Fixed Exchange Rates and Perfect Capital Mobility

3. Professor Mario CatalanInternational Monetary Theory The Effects of Monetary Policy in the AA-DD Model- Assumption: the Short-Run Output Level is Endogenously Determined

4. Professor Mario CatalanInternational Monetary Theory A Monetary Expansion is Ineffective Under a Fixed Exchange Rate Regime

5. Professor Mario CatalanInternational Monetary Theory • In the previous graph the economy starts at Point 1, where the nominal exchange rate is fixed at the level E0. If the central bank tries to increase the money supply, it will cause an upward shift of the AA curve and a consequent depreciation of the domestic currency. According to the exchange rate regime adopted, the central bank will be forced to restore the initial level of the nominal exchange rate. It must intervene to appreciate the domestic currency. Thus, it sells OIR and buys domestic currency. This transaction reduces the level of high-powered money and the money nominal supply. The AA curve shifts back to its initial position. • Note 1: Observe that this whole process occurs instantaneously. All the variables change right away because the central bank does not let the exchange rate deviate from the target value even for a short-period of time. Therefore, output is not changed and the attempt to increase the nominal money supply has failed. Monetary policy is ineffective (non-existent) under a fixed exchange rate regime. • Note 2: Because the central bank cannot control the level of the money supply, it is also unable to control its rate of growth. Whether the changes are permanent or temporary, they are always caused by events that are not under the direct control of the central bank. “Level”, “Rate of Growth”, “Permanent”, “Temporary” lose their meanings under fixed exchange rates, the government cannot promise anything with respect to the nominal money supply.

6. Professor Mario CatalanInternational Monetary Theory The Effects of Fiscal Policies

7. Professor Mario CatalanInternational Monetary Theory A Fiscal Expansion is Effective to Increase the Short-Run Output Level Under a Fixed Exchange Rate

8. Professor Mario CatalanInternational Monetary Theory • The economy starts at point 1 (assume for simplicity that Y1 is the full employment output level) in the previous diagram. A fiscal expansion shifts the DD curve downwards and puts downward pressure on the nominal exchange rate. The central bank must intervene to restore the target exchange rate value. It must buy OIR and increase the level of the high-powered money and nominal money supply. This intervention shifts the AA curve, the shift is large enough (from AA1 to AA2) to restore the target exchange rate. • We can now differentiate the effects of temporary and permanent fiscal policy changes. • If the fiscal expansion is temporary (we assume that the expansion is reversed before prices adjust. For simplicity, we just assume that prices are fixed for the whole period in which the expansion occurs). In this case, the economy jumps from point 1 to point 3 “on impact” and then from point 3 to point 1 when the policy is reversed (the central bank must intervene selling OIR and buying domestic currency). The temporary fiscal expansion is effective to spur output during the time period in which it is implemented. • If the fiscal expansion is permanent, we must analyze the effects in three stages: the impact effects, the transition in which prices adjust slowly (prices are sticky) and the long run (when prices have fully adjusted). On impact, the economy jumps from point 1 to point 3. Because the expansion is permanent, the real exchange rate must fall in the long run (real appreciation-the price of tradable goods must increase relative to the non-tradable ones). The nominal exchange rate and the foreign price level are fixed, therefore, the domestic price level will increase in the long run. Remember that the money supply has also increased.

9. Professor Mario CatalanInternational Monetary Theory • In the transition, the price level will increase slowly, shifting the DD curve upwards and the AA curve downwards. These recurrent shifts will not necessarily maintain the nominal exchange rate at the target level E0, and the central bank could be forced to intervene in the foreign exchange market if any deviation occurs. Therefore, the economy will move slowly along the horizontal line from point 3 to point 1, with output falling slowly. In the long-run the level of the money supply and the domestic price level must be higher than initially. The time path of the variables is shown in the next slide.

10. Professor Mario CatalanInternational Monetary Theory Y R R* t t 0 0 p P 0 t 0 t RER Ms ????? We don’t know (w/o additional info) whether the CB will have to intervene in the foreign exchange market as prices adjust. It depends on the sensitivity of the AA and DD curves to changes in P. 0 t 0 t

11. Professor Mario CatalanInternational Monetary Theory Unanticipated and Permanent Increase in the Level of the Target-Fixed Exchange Rate

12. Professor Mario CatalanInternational Monetary Theory • Suppose that the economy is under a fixed exchange rate regime with a target nominal exchange rate E0. Suddenly, the government announces that the target level is (permanently) increased to E1. The following graph shows the time path of the target exchange rate. Observe that this is an unanticipated and fully credible policy announcement at t=0. Therefore, it is different from a “Tablita” exchange rate regime where the stepwise changes are pre-announced. E1 E0 0 t

13. Professor Mario CatalanInternational Monetary Theory • In order to understand the effects of this policy change, it is convenient to analyze the consequences in two stages. First, let us analyze the effects on the money and foreign exchange markets for a constant output level. Second, let us analyze the effect on the equilibrium output level in the AA-DD diagram. • Stage 1. Assume that output is constant and observe the graph that follows. Investors believe that the new target exchange rate level is permanent. Therefore, the expected level of the exchange rate increases from E0 to E1, shifting the interest parity curve upwards. Observe that when R=R*, then Et=E1. As long as the output level is kept constant, no central bank bank intervention in the foreign exchange market occurs. The effect of the announcement is to increase the current exchange rate for a given output level.

14. Professor Mario CatalanInternational Monetary Theory Announcing a new ER Target-Assumption: Constant Y E E1 E0 R R* L(R,Y0)

15. Professor Mario CatalanInternational Monetary Theory E • Stage 2 DD0 1 E1 3 2 E0 0 AA1(M1s,E1....) AA1(M0s,E1....) AA0(M0s,E0....) Y0 Y3 Y

16. Professor Mario CatalanInternational Monetary Theory • Stage 2. Consider the previous figure. The economy starts at point 0 with a short run output level Y0 and the exchange rate fixed at the level E0. As we learned in stage 1, if the the central bank announces that the exchange rate target is E1, the current exchange rate E will jump to E1 for a given initial output level (Y0). This is shown as point 1 in the figure. As we can see, the AA curve shifts upwards a distance that is equal to E1-E0. Given that we know the location of the new AA curve (this is what we have learned in stage 1), we can also see that if the output level is variable (endogenous) and if the central bank does not intervene, then the short run output level increase and the domestic currency appreciate (point 2). The central bank cannot let the exchange rate fall below the new target level. Therefore, it intervenes to depreciate the domestic currency, buying OIR and increasing the money supply until the market exchange rate is equal to the target level E1. These interventions of the central bank shift the AA curve even further to AA1. The final equilibrium is at point 3. • The policy change has 3 short-run implications: 1) the output level increases, 2) the level of OIR in the central bank’s balance sheet increases, 3) there is an immediate RER depreciation that boosts the CA balance.

17. Professor Mario CatalanInternational Monetary Theory We can now go back to stage 1 and show (graphically) the increase in output and the monetary expansion E E1 E0 R R* L(R,Y0) L(R,Y3)

18. Professor Mario CatalanInternational Monetary Theory Policy Evaluation in the IS-LM-BP Model with Fixed Exchange Rates and Perfect Capital Mobility

19. Professor Mario CatalanInternational Monetary Theory A Fiscal Expansion in the IS-LM-BP Model with Fixed Exchange Rates and Perfect Capital Mobility

20. Professor Mario CatalanInternational Monetary Theory Starting from the equilibrium point 1, the adjustment after an increase in government purchases is as follows: 1) ↑G and the IS curve shifts upwards, 2) The domestic nominal rate of interest increases (point 2), 3) R>R*; 4) Capital Inflows; 5) The capital inflows put downward pressure on the nominal exchange rate (an appreciation of the domestic currency against the foreign currency); 6) ↓E; 7) The Central Bank must intervene to restore the target exchange rate E0, it buys OIR and expands the money supply from M0s to M1s (to depreciate the domestic currency), 8) The LM curve shifts downwards as Ms increases, causing R to fall, 9) The process continues until R=R*, 10) The new short-run equilibrium is characterized by a higher output level at point 3, 11) Government purchases, consumption, imports and the output level increase. The CA balance worsens because the output expansion increases the demand for imported goods and the RER remains unchanged. R LM (M0s,P) 2 LM (M1s,P) 1 3 R* BP IS’ (T,G1,Y*,P,P*,E0) IS (T,G0,Y*,P,P*,E0) Y0 Y1 Y

21. Professor Mario CatalanInternational Monetary Theory A Monetary Expansion in the IS-LM-BP Model with Fixed Exchange Rates and Perfect Capital Mobility

22. Professor Mario CatalanInternational Monetary Theory Starting from the equilibrium point 1, the adjustment after an increase in the money supply Ms is as follows: 1) ↑Ms and the LM curve shifts downwards, 2) The domestic nominal rate of interest falls (point 2), 3) R<R*; 4) Capital Outflows; 5) The capital outflows put upward pressure on the nominal exchange rate (a depreciation of the domestic currency against the foreign currency); 6) ↑ E; 7) The Central Bank must intervene to restore the target exchange rate E0, it sells OIR and reduces the level of the money supply from M1s back to M0s (to appreciate the domestic currency), 8) The Central Bank intervention causes the LM curve to shift back its initial position (until R=R* at point 1). Monetary policy is ineffective to cause changes in the short-run equilibrium output level (it remains at Y0). R LM (M0s,P) LM (M1s,P) 1 R* BP 2 IS (T,G0,Y*,P,P*,E0) Y0 Y