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FIXED EXCHANGE RATE:MONETARY & FISCAL POLICY

FIXED EXCHANGE RATE:MONETARY & FISCAL POLICY. The effect of expansionary monetary policy Monetary policy + BP + Imperfect Capital Mobility The effect of expansionary Fiscal policy Fiscal policy + BP + Imperfect Capital Mobility Monetary policy + BP + Perfect Capital Mobility

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FIXED EXCHANGE RATE:MONETARY & FISCAL POLICY

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  1. FIXED EXCHANGE RATE:MONETARY & FISCAL POLICY • The effect of expansionary monetary policy • Monetary policy + BP + Imperfect Capital Mobility • The effect of expansionary Fiscal policy • Fiscal policy + BP + Imperfect Capital Mobility • Monetary policy + BP + Perfect Capital Mobility • Fiscal policy + BP + Perfect Capital Mobility

  2. THE EFFECT OF EXPANSION MONETARY POLICY Ms1/p1 LM(M1/p1) R R • The amount of money demanded at the real income crosses the supply of real money balances at the equilibrium • Pt A : eqm in money mkt A R1 A R1 Md(Y1) IS Y1 • A country’s eqm. nominal int. rate and the eqm. Level of real income arises in an IS-LM eqm. • Pt. A: IS=LM

  3. THE EFFECT OF EXPANSION MONETARY POLICY Ms1/p1 Ms2/p1 LM(M1/p1) R R • Suppose Central bank undertake an expansionary monetary policy by increasing the nominal qty of $ (M1M2) • Given price level P1 LM(M2/p1) A A R1 R1 B R2 C R3 R3 C Md(Y1) IS Y2 Y1 • Ms  R (R3) • LM shift to the right • The fall in R generates a rise in desired real investment • Thus, Y increase

  4. THE EFFECT OF EXPANSION MONETARY POLICY Ms1/p1 Ms2/p1 LM(M1/p1) R R • Md (dd for real money balances) • Md shift upward (Md(Y2)) • The equilibrium nominal R  to R2 LM(M2/p1) A A R1 R1 B R2 B R2 C R3 R3 C Md(Y2) Md(Y1) IS Y2 Y1 1 2 • Y : real income (Y1  Y2) • Movement along IS curve (CB) • R (R2)

  5. By given P is fixed (unchanged)  Expansionary monetary policy action causes a liquidity effect A reduction in the equilibrium nominal interest rate stemming (slow down) from an increase in the nominal qty of $ in circulation The term for a fall in the equilibrium R induced by an increase in Ms: that stimulates desired investment and expands equilibrium real income.

  6. BOP eqm at A BP relatively steeper (low CM) An M (nominal qty of $) with larger amount) LM shift to LM2 New eqm point below and to the right BP generates BOP deficit at B MONETARY POLICY + BP + IMPERFECT CAPITAL MOBILITY (ICM) R BP LM1 LM2 A R1 B R2 IS Y1 Y2 Y

  7. Because CM is low,BOP deficit occur at B (why??) A rise in Y Stimulates an in import causes BOP deficit at B, R Because CM is low, the very little capital flow out of the country MONETARY POLICY + BP + IMPERFECT CAPITAL MOBILITY (ICM) R BP LM1 LM2 A R1 B R2 IS Y1 Y2 Y

  8. For high CM, BP flatter When LM shift to the right (LM1-LM2) R↓(R1-R2) A decline of nation’s R to R2 ----Causes a significant outflow of capital Key distribution to the resulting BOP deficit at pt B MONETARY POLICY + BP + IMPERFECT CAPITAL MOBILITY (ICM) R LM1 LM2 BP A R1 B R2 IS Y1 Y2 Y

  9. LOW CM in y induces the nation’s residents to seek to acquire other nation’s currencies so that they may purchase more imports dd for foreign exchange Pressure on nation’s currency value HIGH CM R induces residents to acquire more foreign assets Entailing acquiring greater volumes of foreign currencies Tend to depress the value of their nation’s currency in the forex mkt. NOTES: from both figures: nations experience a BOP deficit there would be market pressure for the nation’s exchange rate to change

  10. This would offset the rise in dd for foreign currencies (by its own citizens) However, by selling forex reserve its asset would decline The dom. money stock would begin to fall Central Bank would have to add sufficient dom. Assets (bonds, securities, portfolio) This action would prevent its total asset from falling this would be a sterilized intervention (to maintain fixed exchange rate) because the action prevent changes in forex reserve from affecting the nation’s money stock To keep the exchange value of its nation’s currency from declining (pt B)Central Bank would have to sell some of its foreign exchange reserve

  11. In the absence of sterilization, the CB’s asset would decline – required a reduction in the amount of circulating money liabilities a nation’s nominal money stock  M (M2 to M1) Eqm back at A If CB choose NOT to sterilized R BP LM1 LM2 A R1 B R2 IS Y1 Y2 Y

  12. Thus, the Central Banks’s sales of foreign reserves to maintain fixed exchange rate cause the LM shift back to original location • A non-sterilized monetary expansion with a fixed exchange rate leads to an eventual contraction of the money stock.

  13. An g IS shift to the right  y (y1 to y3) THE EFFECT OF EXPANSION FISCAL POLICY R LM1 B R2 A C raises the dd for real money balances causing R(R1 to R2)  Upward movement along LM (A to B) R1 IS2 IS1 Y1 Y3 Y

  14. R reduces investment expenditure  Y to y2  Movement along IS to B THE EFFECT OF EXPANSION FISCAL POLICY R LM1 B R2 A C R1 The fall in investment (because of increase in R) following a rise in g  CROWDING OUT EFFECT IS2 IS1 Y1 Y2 Y3 Y

  15. g or T A decline in real private investment spending (I) induced by a rise in dd for money (Md) and nominal interest rate ( R) caused by a rise in eqm. Real income ( Y) that follows an expansionary fiscal policy action.

  16. Intial eqm. Pt A: IS=LM=BP (y1, R1) g IS shift to the right New eqm at B (y2, R2) FISCAL POLICY + BP WITH ICM BP R LM1 B R2 A C R1 y  induces rise in import  Causes trade deficit  R  generates an inflow of some financial resources from other nations IS2 IS1 Y1 Y2 Y

  17. From low CM Capital mobility not very significant BOP deficit at B (below and right BP line) R R LM1 BP B R2 • From high CM • Causes significant inflow of financial resources from abroad • There is a sizeable capital account surplus • BOP surplus (above and left BP line) A C R1 IS2 IS1 Y1 Y2 Y

  18. HIGH CM BOP surplus Upward pressure on nation’s currency value in forex mkt. To maintain fixed exchange rate requires the CB to purchase additional forex reserve To sterilized the effect, an accumulation of more foreign exchange reserve has on the money stock – the CB has to sell dom. Bonds This allow economy remain at B LOW CM BOP deficit Downward pressure on nation’s currency value To keep fixed exchange rate, CB must intervene by selling foreign exchange reserve Eventually, the CB would have to devalue or abandon a fixed exchange rate With sterilization

  19. Fr A to B : BOP imbalance LOW CM Non sterilization results in a reduction in the nation’s money stock Because the CB sells forex reserve to maintain fixed exchange rate in the face of BOP deficit FISCAL POLICY + BP WITH ICM: WITHOUT STERILIZATION

  20. $ stock LM shift to the left New eqm at C IS2 =LM2 = BP Higher R (R3) Lower y (Y2 to Y3) Generates reduction of import Reducing trade deficit Improve BOP end pressure on CB to sell forex reserve to defend fixed exchange rate FISCAL POLICY + low CM WITHOUT STERILIZATION BP R LM2 LM1 R3 C R2 B A R1 IS2 IS1 Y1 Y2 Y

  21. If the CB does not sterilize  the nation $ stock grows as the CB’s foreign reserve   LM shift to the right  R (R2 to R3)  Reducing capital inflow  BOP balance at C Y  (y2 to y3) EFFECTIVE FISCAL POLICY + high CM WITHOUT STERILIZATION R LM1 LM2 B BP R2 A C R1 IS2 IS1 Y3 Y1 Y2 Y • BOP surplus at B • The nations experiences significant capital inflow (because of R) • The CB starts to accumulate forex reserve in efforts to maintain a fixed exchange rate

  22. If a nation were to reach a point at which flows of funds and financial asset were as mobile across the borders as within their borders They would experience Perfect Capital Mobility (PCM) and uncovered interest- parity condition to hold FIXED EXCHANGE RATE & PERFECT CAPITAL MOBILITY (PCM)

  23. PCM = uncovered int parity condition hold R = the sum of R* anticipated home currency depreciation and a risk premium • However, if we assumed that NO Anticipated dom. Currency depreciate no risk premium  R=R*  BP line horizontal at R* : because a very small variation in nation’s nominal R induces very large shift in financial resources across the nation’s borders

  24. MONETARY POLICY + BP + PCM R (below R*) induce significant outflow capital from the country BOP DEFICIT to prevent decline in nation’s value of currency the CB must sells FR if CB intervention are sterilized: the CB can maintain eqm at B for some period  if CB intervention are not sterilized: Foreign Reserves causes $ stock to fall back to original level R LM1 LM2 R1=R* A BP R2 B IS1 Y1 Y2 Y • Expansionary $ stock • Ms • LM shift to the right • New eqm at B

  25.   R (above R*) •  BOP SURPLUS (higher R induces more capital fr abroad) • To maintain fixed exchange rate : CB accumulate FR In the absence of sterilization: •  FR • qty of $ in circulation • LM shift to the right • New eqm at C • y (y3) • EFFECTIVE FISCAL POLICY + BP + PCM R LM1 LM2 B R2 A C BP R1=R* IS2 IS1 Y1 Y2 Y • g • AD • IS shift to the right • New eqm at B

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