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"# !  & ' ()*+,-4 ;./ 0 16'=5<7>8?9@(:A      3;     ! !      2$#"QW-\L[}2$2\vD%] .M2$Uvپ(B(6+2$ ĆgO !O2$o`}s,,?XR2$V]2: ry<W"$Dt#lg?/ 2$8VE'OͥW6U2$n8+.-!*zc_N2$?vERʀ%FI 2$1x4@+Tec"2$U!!Phݧo $2$ j0qi (ox%2$(^v?Y&2$ l7d[@( fAA5% \3@8>nL%x#ʚ;%3ʚ;g4BdBd@:A 0ppp@ <4!d!dl$ 0F% <4ddddl$ 0F% <4ddddl$ 0F%  g4JdJd@:A 0pp Z0___PPT10 ___PPT9)(^((?r%09/07/04 F 2002-2004 University of WisconsinO =[EC202A Macroeconomics3f  8 Handout 2 Laura Povoledo The University of Reading>9 &3 3*&   l(EC202A Macroeconomics3f   The IS-LM-BP model Reading material that you may find useful: Abel, Bernanke and McNabb, Chapters 5 and 14. Abel, Bernanke, 5th ed, Chapters 5 and 13. Dornbusch, Fisher and Startz, 9th ed, Chapter 12. Begg, Fischer an Dornbusch, 7th ed, Chapters 28 and 29.,"3 ,A 8 . H  '               m)  Outline: The Goods Market Equilibrium in an Open Economy ; The open-economy IS curve ; The Balance of Payments and Capital Flows ; The BP curve ; The Mundell-Fleming model .  " P 3f333f3f>      I/The Goods Market Equilibrium in an Open Economy003/   BEconomies are linked internationally through two main channels: trade in goods and services; international financial markets. First, let s consider the effects of trade with the rest of the world on the goods market equilibrium and then we ll understand how to modify the IS curve. b@B(@Bff! J/The Goods Market Equilibrium in an Open Economy003/   Previously, we have seen that the goods market equilibrium condition can be expressed in two ways: 1) National saving equals investment:(c& K/The Goods Market Equilibrium in an Open Economy003/   RWhat changes in an open economy? National saving now has two uses: increase the nation s capital stock by domestic investment; increase the stock of net foreign assets by lending to foreigners. We capture this by re-writing the equilibrium condition (1) in the following way:X2R33":AS( Q L/The Goods Market Equilibrium in an Open Economy003/    Eq. (1) shows the uses of savings in an open economy. Investment I is accrued to the domestic capital stock. The current account balance CA indicates the amount of funds that the country has available for net foreign lending. z<:GY&   M/The Goods Market Equilibrium in an Open Economy003/   The closed economy equilibrium condition (1) is a special case of the open economy equilibrium condition (1) , with CA =0.r{)=    D) =  N/The Goods Market Equilibrium in an Open Economy003/   We can also re-write the equilibrium condition (2) - aggregate supply equals aggregate demand  for an open economy. The main change is that domestic spending no longer determines domestic output. Instead, spending on domestic goods determines domestic output. Define: A = spending by domestic residents Then:u(:6 53 %5  O/The Goods Market Equilibrium in an Open Economy003/   Spending on domestic goods is total spending by domestic residents less their spending on imports plus foreign demand or exports. Therefore: Where: X = exports; Q = imports. 6 <C(    P/The Goods Market Equilibrium in an Open Economy003/   7In order to obtain an equilibrium condition, we write: U/The Goods Market Equilibrium in an Open Economy003 0 What affects net exports NX? Foreign output YF (higher foreign output increases X and NX) Domestic output Y (higher domestic output increases Q and decreases NX) The real exchange rate (higher means more exports and less imports) @xLX !"[&.  QThe open-economy IS curve3  The IS curve shows the possible combinations of the interest rate r and domestic output Y, for which the goods market is in equilibrium. In the closed economy, the IS curve can be written as: Meaning: the goods market is in equilibrium when aggregate supply is equal to aggregate demand for goods. Consumption depends on Y, investment depends on r. We draw the IS line (goods market equilibrium condition) in the (r, Y) plane.$CC$   RThe open-economy IS curve3  SIn the open economy, the goods market equilibrium condition becomes: Or simply: *G( T T SThe open-economy IS curve3  oThe IS curve is shifted by changes in G, YF and the real exchange rate (we are assuming that prices are fixed).Bp&E&) E TThe open-economy IS curve3   V1LM - Money market equilibrium in the open economy223 2 1)The Balance of Payments and Capital Flows**3 * MThe Balance of Payments (from now on, BP) is the record of transactions between one country and the rest of the world. The two main accounts in the BP are the current account and the capital account: The current account records trade in goods, services, and transfer payments. The capital account records the trade in assets. x(O S >41 D / W)The Balance of Payments and Capital Flows**3 * @Balance of payments accounts = The record of a country s international transactions. Any transaction that involves a flow of money into the UK is a credit item (enters with a plus sign). Any transaction involving a flow of money out of the UK is a debit item (enters with a minus sign).!h\ \L\ \" ! 4)The Balance of Payments and Capital Flows**3 * The overall BP surplus or deficit is the sum of the current and capital account surpluses or deficits: Since residents of a country must pay for what they buy abroad, any current account deficit must be necessarily financed by an offsetting capital flow: Tg(g  3)The Balance of Payments and Capital Flows**3 * But what are the economic forces that affect the BP? To answer this question we must look at each separate component of the BP. For convenience we divide the current account into 3 components:   Z)The Balance of Payments and Capital Flows**3 * In general, NFP and NT are not much affected by current macroeconomic developments. From now on, we assume them to be equal to 0 for simplicity. We write: CA = X(YF, ) - Q(Y, ) * i BJBJ@   7)The Balance of Payments and Capital Flows**3 *  A rise in foreign income increases exports: A real depreciation improves net exports: A rise in domestic income increases imports: So the CA is a function of 3 variables: The real exchange rate measures a country's competitiveness in foreign trade. If prices stay fixed then eR and eNOM (real and nominal exchange rate respectively) always move in the same direction.9g)nx '&QR@E    R 8)The Balance of Payments and Capital Flows**3 *   Again, we look first at the separate components. It is often useful to split the capital account into two separate components: (1) the transactions of the country s private sector and (2) official reserve transactions, which correspond to the central bank activities:> 1  9)The Balance of Payments and Capital Flows**3 *  :)The Balance of Payments and Capital Flows**3 *  <)The Balance of Payments and Capital Flows**3 * The sensitivity of KA to changes in interest rate differentials is a crucial issue, since it depends on the degree of capital mobility. Three cases are possible (partial derivatives): .  =)The Balance of Payments and Capital Flows**3 * Explanation: If capital is assumed to be perfectly mobile, investors in one country can trade assets with investors in any other country without restrictions, that is, at low transaction costs and in unlimited amounts, in search of the highest yield or the lowest borrowing costs. &     ; The BP curve 3  We are now ready to write the BP equation: This equation shows the BP equilibrium condition as a function of 6 macroeconomic variables. The next task is to obtain a diagram on the (r, Y) plane that represents all the possible combinations of the domestic real interest rate r and domestic output Y, for which the above equation BP = CA + KA = 0. We call this line the BP curve/line.J,],].Y < o V ? The BP curve 3  In the (r, Y) plane the balance of payments becomes a function of the domestic real interest rate r and domestic output Y only: The slope of the BP line depends on the degree of capital mobility.V')>  l M > The BP curve 3   Y The BP curve 3   @ The BP curve 3   A The BP curve 3   B The BP curve 3   HThe Mundell-Fleming model3&    \EC202A Macroeconomics3f   Monetary Policy in the IS-LM-BP model Reading material that you may find useful: Dornbusch, Fisher and Startz, Chapter 12 (9th ed). Begg, Fischer an Dornbusch, Chapter 29 (7th ed).t',f %&3$+ftU             ]  mObjective of the lectures While the IS-LM-BP model still works under the assumption that the price level is given, it nevertheless clearly establishes the key linkages among open economies: trade, the exchange rate and capital flows. In this lecture, we want to understand how monetary policy operates in the open economy, under fixed or floating exchange rates.\ZPSZ3f o   -333FH  +  ^  Outline: Exchange rates and the equilibrium in the Balance of Payments ; The IS-LM-BP model (revision) ; Monetary Policy under imperfect capital mobility ; Monetary Policy under perfect capital mobility ; Monetary Policy without capital mobility .b " 3f333f$    _=Exchange rates and the equilibrium in the Balance of Payments>>3 > Choice of exchange rate regime:    `=Exchange rates and the equilibrium in the Balance of Payments>>3 >  a=Exchange rates and the equilibrium in the Balance of Payments>>3 >  b=Exchange rates and the equilibrium in the Balance of Payments>>3 >  c=Exchange rates and the equilibrium in the Balance of Payments>>3 >  d=Exchange rates and the equilibrium in the Balance of Payments>>3 >  e=Exchange rates and the equilibrium in the Balance of Payments>>3 >   f=Exchange rates and the equilibrium in the Balance of Payments>>3 >   gThe IS-LM-BP model (revision)3   hThe IS-LM-BP model (revision)3   iThe IS-LM-BP model (revision)3   jThe IS-LM-BP model (revision)3  . goods market equilibrium Or simply: *"( / / kThe IS-LM-BP model (revision)3  lThe IS-LM-BP model (revision)3  mThe IS-LM-BP model (revision)3  n0Monetary Policy under imperfect capital mobility113 1 o0Monetary Policy under imperfect capital mobility113 1 p0Monetary Policy under imperfect capital mobility113 1 Explanation: E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase and as interest rates fall capital outflows increase, so BP is in deficit at E1.    wg   q0Monetary Policy under imperfect capital mobility113 1 r0Monetary Policy under imperfect capital mobility113 1 !Explanation: E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase, and as interest rates fall capital outflows increase, so BP0 is in deficit at E1.x    wh   " s.Monetary Policy under perfect capital mobility//3 / t.Monetary Policy under perfect capital mobility//3 / u.Monetary Policy under perfect capital mobility//3 / v.Monetary Policy under perfect capital mobility//3 /  w.Monetary Policy under perfect capital mobility//3 / pExplanation: Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). However, any fall in interest rates will generate a massive capital outflow. The central bank must reduce the domestic money supply, to prevent a change in interest rates. As a result, the economy stays at E0.cx   w  q x.Monetary Policy under perfect capital mobility//3 / y.Monetary Policy under perfect capital mobility//3 / Explanation: E0 to E2 : An increase in money supply shifts the LM curve to the right, so the interest rate falls while the level of output demanded increases (E1). At E1, the goods and money market are in equilibrium (at the initial exchange rate), but r has fallen below rF . The lower domestic interest rate causes an outflow of capital, which causes a currency depreciation. Because of the depreciation, competitiveness increases and the IS shifts to the right. At point E2, there is no further tendency for exchange rate to change.d x   *^  T   <&   z.Monetary Policy under perfect capital mobility//3 / We have shown that, under floating exchange rates, a monetary expansion in the home country leads to exchange rate depreciation, increased exports and a higher level of domestic output. But our depreciation shifts demand from foreign goods to home goods.  {(Monetary Policy without capital mobility))3 ) |(Monetary Policy without capital mobility))3 )  }(Monetary Policy without capital mobility))3 ) !~EC202A Macroeconomics3f   Fiscal Policy in the IS-LM-BP model Reading material that you may find useful: Dornbusch, Fisher and Startz, Chapter 12 (9th ed). Begg, Fischer an Dornbusch, Chapter 29 (7th ed).h&+e $&3$+etS             "  Objective of the lecture To understand how fiscal policy operates in the open economy, under fixed or floating exchange rates. The IS-LM-BP model is our method of analysis. P3f3 33G!4 g-  #  Outline: The adjustment out of equilibrium ; Fiscal Policy under imperfect capital mobility; Fiscal Policy under perfect capital mobility ; Fiscal Policy without capital mobility ; Stabilization policy .  " P 3f333f3f$    $"The adjustment out of equilibrium *#!33 # %!The adjustment out of equilibrium""3 " &"The adjustment out of equilibrium *#!33 # '"The adjustment out of equilibrium *#!33 # ("The adjustment out of equilibrium *#!33 # )Fiscal policy (foreword)3  *Fiscal policy (foreword)3  +.Fiscal Policy under imperfect capital mobility//3 / ,.Fiscal Policy under imperfect capital mobility//3 /  Explanation: E0 to E1 : due to the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen. 4Px   )        -.Fiscal Policy under imperfect capital mobility//3 / ..Fiscal Policy under imperfect capital mobility//3 /  Explanation: E0 to E1 : after the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen. 4Px   (        /,Fiscal Policy under perfect capital mobility--3 - 0,Fiscal Policy under perfect capital mobility--3 - 1,Fiscal Policy under perfect capital mobility--3 - 2,Fiscal Policy under perfect capital mobility--3 - 3,Fiscal Policy under perfect capital mobility--3 - Explanation: After the expansionary fiscal policy, the IS shifts to the right and the domestic interest rate rises above the level of the world interest rate rF. A capital inflow occurs, leading to an appreciation of the domestic currency. The appreciation makes foreign goods cheaper for domestic citizens, and exported goods become relatively more expensive for foreigners. Therefore, net exports decrease and the IS shifts back to its original location.x *e '&  ) 4&Fiscal Policy without capital mobility''3 ' 5&Fiscal Policy without capital mobility''3 ' 6The effectiveness of monetary/fiscal policies on output depends on the exchange rate regime and on the degree of capital mobility (summary table):n3  7Stabilization policy3   8Stabilization policy3   9Stabilization policy3  ^Stabilization policy = the use of fiscal/monetary policy to restore internal/external balance. _ :Stabilization policy3  Example 1: Fixed exchange rates    ;Stabilization policy3  )Example 2: Automatic adjustment of the BP** * <EC202A Macroeconomics3f   Exchange Rate Policy in the IS-LM-BP model Recommended reading: Begg, Fischer an Dornbusch, Chapter 29 Abel, Bernanke and McNabb, Chapter 14t,O *&3$ONE        '=  'Objective of the lecture To understand exchange rate policy , as one of the tools available to policymakers to influence the level of economic activity in their country. Monetary and fiscal policy are not the only available tools. In this lecture we will see how exchange rate policy works. ^P3f34   >  Outline: Exchange rate policy in the Mundell-Fleming model ; Are devaluations effective in the long run? ; How to fix the exchange rate ; Fixed versus floating exchange rates ; Exchange rates & monetary policy.  " P 3f333f3f>      ?2Exchange rate policy in the Mundell-Fleming model 333&   @2Exchange rate policy in the Mundell-Fleming model 333&    Terminology:    A2Exchange rate policy in the Mundell-Fleming model 333&   In order to represent the effects of a devaluation in the Mundell-Fleming model, we must go back to its building blocks: since the nominal exchange rate only enters the IS and the BP lines, devaluation does not affect the LM..ynZ{n&:   B2Exchange rate policy in the Mundell-Fleming model 333&    C2Exchange rate policy in the Mundell-Fleming model 333&    D2Exchange rate policy in the Mundell-Fleming model 333&    E2Exchange rate policy in the Mundell-Fleming model 333&    F2Exchange rate policy in the Mundell-Fleming model 333&   Explanation: E0 to E1 : Devaluation means that the balance of payments equilibrium changes - shift from BP0 to BP1 -. Net exports increase  shift of IS0 to IS1 -. As output expands interest rates rise, so there will be a capital inflow. This will result in a balance of payments surplus (point E1), and excess demand of domestic currency..Gx   S  $   + U G,Are devaluations effective in the long run? *-+33 - Q: In the long run can changes in a nominal variable (the nominal exchange rate) ever have any effect on real variables (output, competitiveness)? A: No, unless there is real change in the economy at the same time. In the absence of this, the eventual effect of devaluation is a rise in all other nominal wages and prices in line with the higher import prices, leaving all real variables unchanged.  3#3>3(  H+Are devaluations effective in the long run?,,3 , MEventually, devaluation has no real effects. Most empirical evidence suggests that the effect of devaluation is completely offset by a rise in domestic wages and prices after 4-5 years. Devaluation leads to a temporary, not a permanent, increase in competitiveness. In the long run, competitiveness is determined by real factors, and it goes back to its long-run equilibrium level. However, devaluation is the simplest way to change competitiveness quickly. It may thus be an appropriate response to a real shock which needs a quick change in the equilibrium real exchange rate.  2|n<t3F3. 3D4    I+Are devaluations effective in the long run?,,3 , J+Are devaluations effective in the long run?,,3 ,  K.Fixed exchange rates and macroeconomic policy */-33 / L.Fixed exchange rates and macroeconomic policy //3 / MHow to fix the exchange rate *33  NHow to fix the exchange rate3  ZHow can a country deal with a situation in which its official exchange rate is overvalued?[[ [ OHow to fix the exchange rate *33  PHow to fix the exchange rate *33  QHow to fix the exchange rate *33  RHow to fix the exchange rate *33  SHow to fix the exchange rate *33  T%Fixed versus floating exchange rates *&$33 & U%Fixed versus floating exchange rates *&$33 & V%Fixed versus floating exchange rates *&$33 & W%Fixed versus floating exchange rates *&$33 & X%Fixed versus floating exchange rates *&$33 & Y Exchange rates & monetary policy!!3 ! Z Exchange rates & monetary policy!!3 ! /t     !"$%[&\'](^)_*`+a,b-c.d/e0f1g2h3i4j5k6l7m8n9o:p;q<r=s>t?u@vAwBxCyDzE{F: ` ̙33` ` ff3333f` 333MMM` f` f` 3>?" dd@?" ddr@!- %4 n?" dd@   @@``PP     4` p@@ :2(    6`a%  " %  T Click to edit Master title style! !$  0c%  " %  RClick to edit Master text styles Second level Third level Fourth level Fifth level!     S~  B3d#"  pH  0޽h ? ̙334,___PPT10 . wiscslide? ` ̙33` ` ff3333f` 333MMM` f` f` 3>?" dd@?" ddr@!- %4 n?" dd@   @@``PP     4` p@@ ;3@(    6@  "   U!Click to edit Master title style " "$  0n  "   RClick to edit Master text styles Second level Third level Fourth level Fifth level!     S~  B3d#"  0_H  0޽h ? ̙334,___PPT10 . 1_wiscslide( 0 8(     N| 0r0r      v* U**UU  N 0r0r E/   x* U**UUd  c $ ?Ph   4  Nء 0r0r =9(   RClick to edit Master text styles Second level Third level Fourth level Fifth level!     S  T캝 0r0r  x    v* U**UU  Tp 0r0r E/x   x* U**UUH  0Crll ? ̙3380___PPT10.@AX  x(    Nd*e 0r0r    e  p*   U**UU  Nt5e 0r0r D. e  r*   U**UU   T@e 0r0r  w  e  p*   U**UU  TxRe 0r0r D.w e  r*   U**UUH  0Crll ? 3380___PPT10.   P(  ~  s *DVn  n    s *~n  P`  n   0qqH  0޽h ? ̙33___PPT10i.t+D=' = @B +  D(  x  c $(      c $+  P`     0qqH  0޽h ? ̙33___PPT10i.t+D=' = @B +  PR(  ~  s *%   %    s *F  %  " $H  0޽h ? ̙33___PPT10i.ni+D=' = @B +  `@<(  @~ @ s *\ `    ~ @ s * P    H @ 0޽h ? ̙33y___PPT10Y+D=' = @B +L  skH(  H~ H s *L `   ~ H s * P#     H 0> jJ"`` P  'S = I (1) Closed economy Equation.(     (  H 0O  0 p \,2) Aggregate supply equals aggregate demand:,  H 0@ jJ"`  (Y = C + I + G (2) Closed economy Eq. )  &%   H H 0޽h ? ̙33y___PPT10Y+D=' = @B +   P(  P~ P s * `   ~ P s *E P#    p P 04 jJ"` m ^S = I + CA = I + NX + NFP (1) Open economy Eq.Z (     &,    P N d" `f  T Change no. 1   H P 0޽h ? ̙33y___PPT10Y+D=' = @B +  F>X(  X~ X s * `    ~ X s *  `     X <| jJ" `  vHence, Eq. (1) states that in goods market equilibrium in an open economy, the amount of national saving S must equal the amount of domestic investment I plus the amount lent abroad CA.X 2k.&   H X 0޽h ? ̙33y___PPT10Y+D=' = @B +  `W(  `~ ` s *l `   ~ ` s *7 P#    ` Nn d" `` 3  T Change no. 2   + ` 0(b  @P #What else changes in an open economy? Domestic spending on goods and services is no longer equal to domestic output. This happens because: Part of domestic output is sold to foreigners (exports); Part of spending by domestic residents purchases foreign goods (imports). Z$33e $  @`H ` 0޽h ? ̙33y___PPT10Y+D=' = @B +   h(  h~ h s *c `   ~ h s *(d P#   a h <p jJ" `   A = C + I + G   H h 0޽h ? ̙33y___PPT10Y+D=' = @B +   0p(  p~ p s *<% `  %  ~ p s *؃% P# %  6 p BĞ djJ" P`$  BSpending on domestic goods = A + NX = = C + I + G + X  Q = Domestic outputD /-  ( p 6 jJ"`P 4 "Note: A is also called absorption.b0P2022  # H p 0޽h ? ̙33y___PPT10Y+D=' = @B + ! .&Px(  x~ x s *Ї `   ~ x s * P -`   4 x 0 jJ"`i jY = C + I + G + NX (2) Open economy Equation,6   6 > x <h jJ" @ 8 *Eq. (2) states that in goods market equilibrium in an open economy, the supply of domestic goods Y is equal to spending on domestic goods, A + NX.\ 2b+  H x 0޽h ? ̙33y___PPT10Y+D=' = @B +  p 6(  x  c $6       c $d    < 0  A ?5% ??"``  @   H  0޽h ? ̙33___PPT10i.\0+D=' = @B +  e(  ~  s *E     ~  s * P   F  0 jJ"`0  \  Y = C (Y) + I(r) + G      042 jJ"`  eAS = AD.   H  0޽h ? ̙33___PPT10i.R :+D=' = @B +N   e ]  (  ~  s *@&     ~  s *' 0     0 jJ"` < eAS = AD.     6E jJ"`` {/Y = C (Y) + I(r) + G + NX(YF , Y, ) 0    &    0t jJ"`   Y = C (Y) + I(r) + G + NX(Y)      0  A ?5% ??"`I   XB  0DԔ?XB  @ 0DԔ? XB   0Dp@ _`   0@  ` <  IS(r, Y)X 0 2$     <x Ԕ?"`P  w Output, Y& 2$     < Ԕ?"` s  Kr 2  j  <e 0*jJ"`  The slope of the IS depends on size of multiplier and the elasticity of investment to domestic interest rate (which is negative, hence the negative slope of the IS). 02  H  0޽h ? ̙33___PPT10i.R :+D=' = @B +K  z(  ~  s *Qc   c  ~  s *hRc  c    04c jJ"`u  >   D  <d \pCjJ"`   P If then If then If there is a real appreciation then 8 0'0Q Q  XB @ 0DԔ?P` XB  0DԔ?` `   <d Ԕ?"` $ Kr 2     <+d Ԕ?"` p  WY 2    0c p   ^IS,0 2  XB   0D3p`_@ B   0D3pp ,$D 0B   N-Ԕ?"6@`NNN?NX H8 ,$D 0  6 0d " `p  kYF * 2AI RB  s *D `   68d " `p`@  gX* 2AI RB  s *D`   6Fd " `` jAD* 2AI RB  s *D @  6=d " `  jG * 2AI RB  s *D 0 `   6x" `  ZNX 2A RB  s *D H  0޽h ? ̙33 ___PPT10.R :+VD' = @B Dp' = @BA?%,( < +O%,( < +D' =%(D' =%(D/' =4@BB8BB%()?)?D' =.K7 BBBBB]M -0.05816 0.07222 L -3.05556E-6 -1.11111E-6 *3>*B ppt_xB ppt_y=@0BBAApBB؂<B?<* D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(+5  d(  ~  s *      0 jJ"`u P  >   D  <|@\pCjJ"` P  P If then If then If there is a real depreciation then 8 0'0Q Q  XB @ 0DԔ?XB  0DԔ?  < AD (aggregate supply > aggregate demand). Below, AS < AD.zW ' W H  0޽h ? ̙33 ___PPT10.R :+D' = @B Dp' = @BA?%,( < +O%,( < +D' =%(D' =%(D/' =4@BB8BB%()?)?D' =.K7 BBBBB]M 0.05018 -0.06111 L -3.05556E-6 -4.44444E-6 *3>*B ppt_xB ppt_y=@0BBAApBB8μBO<<* D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(+      q (  ~  s *   :  XB  0DԔ?XB @ 0DԔ? RB  s *Dp@`>  0A` ^LM,0 2    <wԔ?"`   WY 2   < Ԕ?"`s Kr 2     0ē  MD > MSJ 2       08  MD < MSJ 2    Y   6 d" ` 0  uLM slope depends on elasticity of money demand with respect to interest rates: if the latter is low then LM is steep.@v 2g  v @   6d" ` p tLM is upward sloping because if income increases money demand increases and the interest rate must increase as well.(u(2s u    0|" ` P DThe money supply is affected by changes in eNOM under fixed exchange rates, hence the LM shifts if eNOM is different from the target level eNOM*. Under floating exchange rates, the LM is not affected by eNOM.(2+ '  $ & t+  4  $  <   H  0޽h ? ̙33___PPT10i.+D=' = @B +$  ;3@(  @ @ 6|jJ"`f  ]Balance of Payments(2  x @ c $ ط    x @ c $ ȷ     @ 6)jJ"`P @  eCurrent Account(   @ 6-jJ"`P @   eCapital Account(  H @ 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + " R(  ~  s *4     s *:  "H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +   \(  \~ \ s *H   ~ \ s *   \ 6jJ"`0   BP = CA + KAR (  P \ 6x}jJ"` p 0BP = CA + KA = 0 Balance of Payments equilibrium|1(  1 H \ 0޽h ? ̙33___PPT10i.Pp,++D=' = @B +       T(  T T 6wCjJ"` O  eInvestment income from abroad(  ~ T s *TzC  C x  T c $({C C   T 6|CjJ"`0 `m  RNX (    T 6CjJ"` `  RNT (    T 6~CjJ"`c `  SNFP (   T 6nCjJ"`0 Om  i!Net exports of goods and services"(" "  T 6CjJ"` O  `Net unilateral transfers(   T H,(CdjJ" `0   RCA (  f T 0"CjJ"` * hNote: NFP (Net factor payments) is almost (but not always) equal to Investment income from abroad. Why? `i0P2X i H T 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + %   G(    6LNCjJ"`` < 2    0AAAAIA&  ` ~  s *0C  C  0 s A k?5% ?"`Y   k C1  NCd" `  What determines CA = NX ?\   0  A l?5% ??"` p  l C  HA m? ??"`@p m~   s *C`P C H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +{     `" (    6CjJ"` P < 2  ~  s *C  C x  c $C  C  0  A J?5% ??"`P  0  J C   6C" `  kYF * 2AI RB   s *D00`   6,C" `   kCA * 2AI RB  s *D0  6,/C" `0  jY * 2AI RB  s *D0  6tC" ` kCA * 2AI   6`C" `0pP kCA * 2AI RB  s *D`pRB  s *D`L   <$C" ` D 2I  RB  s *D`p 0  A ?5% ??"`0  C2  0T9C@p:  CA(YF , Y, )p &    HA N? ??"`  NH  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +    (  ~  s *DC  C x  c $C C   NCd" `. N {What about the KA ?8     HDCdjJ" `0  RKA (     6dCjJ"`0   cNet private capital inflows(     6 CjJ"`  eOfficial reserve transactions(     6(CjJ"`0   TNPKI (     60CjJ"`  SORT (  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +   ?(  ~  s *E>  >   <J>0jJ"`P`/  @Private residents selling off assets abroad or borrowing abroad.A A A :   0O>jJ"`` HExample: a current account deficit (CA < 0) can be financed in two ways:TI( I    6W>jJ"`P   ?The central bank sells foreign currency and buys home currency.@(@ @ 4   0[>jJ"` `  XExercise: what are the implications of the two options above for the capital account KA?>Y(M Y H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +       (  ~  s *e>  >   6Dg>jJ"` 0  BNPKI depends on: the interest rates differential: (r  rF) the expected depreciation of the currency: E eNOM/eNOM 2+0<290Z2 # .  @9  0       N$s>d" `.c N zBut what affects KA?6  9   6w>jJ"`0 P ` [ORT depends on the choice of exchange rate regime: fixed and floating exchange rate system.&\ X 3 ' L  @ c $ ^  @ 6G*HI- p*   0>  HSince the role of ORT is better understood in relation to the adjustment process, we write KA as a function of (r  rF) and E eNOM/eNOM: KA(r  rF, E eNOM/eNOM) 202(2E      tt               0+>   MAnswer: 2  H  0޽h ?/@    ̙33___PPT10i.Pp,++D=' = @B +&   = 5  (    BD6>jJ" ` P < 2     B5>jJ" ` P  < 2  ~  s *:>  > x  c $;>` >  0  A D?5% ??"`   D >  B|>jJ" `@P  < 2    0  A B?5% ??"` ; B >   HA <? ??"`p1  <  H>jJ" `@0  [No capital mobility(2    B>jJ" ` 0  bImperfect capital mobility(2    H>jJ" ` 0 `Perfect capital mobility(2  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +   8(  ~  s *>  >    H> "` >    0L>jJ"``  3As a result, under perfect capital mobility interest rates in one country cannot differ from the interest rates in other countries without infinite capital flows taking place.8(2f(  [   0>jJ"` `i  {In practice, capital controls and transaction costs dampen the sensitivity of KA to changes in interest rate differentials.B|(2N+ |    0(>jJ"`P p  NBut as the world economies become more and more integrated, perfect capital mobility becomes increasingly the  reality .y(2y T $ H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +g  ~v@ (    c $|>0 > *s5   H>djJ" ` pvBP = CA(YF , Y, )+ KA(r  rF , E eNOM/eNOM) = 0|<(2    Z        ~  s *(>      6>"`  B    0  A ]?5% ??"`0 Y ]  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +     P Z (  ~  s * >  >   6h>"`  B      B> 0 > *s5XB   0DԔ?@ @ XB  @ 0DԔ?@ RB   s *D3pN   0> BP(r, Y)X 0 2$    <\=Ԕ?"`p P t  w Output, Y& 2$    <7=Ԕ?"`0s4 Kr 2  4  0:=jJ"`@ 0  Changes in YF , rF, and E eNOM/eNOM shift the BP curve.A02       Z         0  A _?5% ??"``G' _ >H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +     `&~ (  ~  s *4=  =   6 R="`  B      0W=jJ"`Pu  >   ;   08[=jJ"`P   The level of r does not affect the BP since KA = 0 always (only private KA). As a result, there is only one level of Y such that CA = 0 and the BP is in equilibrium.( C  $u 0    6k=jJ"`0u\ oCase 1: No capital mobility(  XB @ 0DԔ?XB  0DԔ?  <$p=Ԕ?"`PT Kr 2    <q=Ԕ?"`p pt  WY 2   0s=@ ^BP,0 2  RB # s *D3>PP6 % s *(}="`  Note: in the case of no capital mobility, the BP line corresponds in practice to the condition that the Current Account is in balance. 2  \ & s *L="`  <To the left of the BP line, BP > 0 . To the right , BP < 0 .= 2 = H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +  $   p z (  ~  s *А=  =   6="`  B     0@=jJ"`Pu  >     0=jJ"`P   BP is upward sloping because if Y rises, there will be an increase in imports leading to a deficit in the CA, and (to balance this with a surplus in the KA) r must raise to attract more capital.(I-%&     60=jJ"`0u\ v"Case 2: Imperfect capital mobility#(#  XB @ 0DԔ?XB   0DԔ?   <=Ԕ?"`PT Kr 2     <x=Ԕ?"`p pt  WY 2   0=@ ^BP,0 2  RB  s *D3pd  s *T="`  Note: in the case of imperfect capital mobility, the BP line corresponds to the condition that the Current Account surplus/deficit is exactly offset by Net Private Capital Inflows. 2  J  s *="`  *Above the BP line BP > 0 . Below, BP < 0 .+ 2  + H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +*  A 9 p (  ~  s *=  =   6="`  B     0\=jJ"`Pu  >   !  <=0*pCjJ"`P   If capital can instantaneously move, the only level of r that ensures the equilibrium in the KA is rF . Y can be at any level because the KA dominates over the CA . (7% !&c  C   6=jJ"`0u\ t Case 3: Perfect capital mobility!(!  XB @ 0DԔ?XB   0DԔ?   < =Ԕ?"`PT Kr 2     < =Ԕ?"`p pt  WY 2   0P=@ ^BP,0 2  RB  s *D3>  0=0p4 jrF* 2     s *="`   yAbove the BP line BP > 0 . Below, BP < 0 . The different ways in which a BP imbalance is corrected depend on the choice of exchange rate regime, fixed or floating. 2 !Y  G  s *#="`  Note: in the case of perfect capital mobility, the BP line corresponds to the condition that Net Private Capital Inflows (or outflows) not be infinite. 2  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +  H(  ~  s *,=  =   6)"`  B     0cjJ"`Pu  >   S  <e\pCjJ"`P  ] If then If then If there is an expected nominal depreciation then 8 040^ ^  :  6jjJ"`0u\ jShifts in the BP curve(  XB @ 0DԔ? XB  0DԔ?     < vԔ?"` Kr 2     <wԔ?"`P pT  WY 2    0x ^BP,0 2  RB  s *DpB  s *Dp0. ,$D 0B  HԔ?"6@`NNN?N,$D 0N  0jJ"`@   Changes in YF , rF, and E eNOM/eNOM shift the BP curve.A02        Z          6(" `  kYF * 2AI   6," ``@ gX* 2AI   6d" `0 P krF * 2AI   6࢟" `0`@P NKA 2    6" ``   NKA 2  RB  s *D` RB  s *D`0 ` RB  s *DRB  s *D` RB  s *D P |  6:0*0*jJ"`  XNote 1: changes in YF do not affect the BP curve under perfect capital mobility. (Why?)fY02 '& C H  0޽h ? ̙33___PPT10.Pp,++ELN4D' = @B Dl' = @BA?%,( < +O%,( < +D' =%(D' =%(D+' =4@BB1BB%()?)?D' =.G7 BBBBBYM 0.05417 0.06643 L -3.33333E-6 3.33333E-6 *3>*B ppt_xB ppt_y=@0BBAApBBݼB<*D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(+A  r(  ~  s *I     6L"`  B     0PjJ"`Pu  >   Q  <R\pCjJ"`P  ] If then If then If there is an expected nominal appreciation then 8 040^ ^    6 ΟjJ"`0u\ jShifts in the BP curve(  XB @ 0DԔ? XB  0DԔ?     <OԔ?"` Kr 2     <Ԕ?"`P pT  WY 2    08 ^BP,0 2  B   s *Dp,$D 0RB   s *Dp0. B  NԔ?"6@`NNN?N,$D 0N  0ay jJ"`@   Changes in YF , rF, and E eNOM/eNOM shift the BP curve.A02        Z          6*B ppt_xB ppt_y=@0BBAApBB<B9<<* D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(+     4C (  4~ 4 s *y   y  XB 4 0DԔ?p  p XB 4@ 0DԔ?p   4 0f P  ^BP,0 2    4 <y Ԕ?"`   WY 2   4 <xy Ԕ?"`s Kr 2  RB  4 s *Dpp XB  4 0D3p XB 4 0Dp@@ 4 0y    TIS"0 23   4 0y `  TLM"0 2   4 0y " ` `  The graphical analysis that extends the IS-LM model to the open economy under the assumption of perfect capital mobility is called the Mundell-Fleming model.0(2&   9 4 6y d" ` `  }This model is used to explore the effects of fiscal and monetary policies under both fixed and flexible exchange rate systems~(2~ ~  4 0y " ` P EIt can also be extended to cases other than perfect capital mobility.F 2F F H 4 0޽h ? ̙33___PPT10i.Pp,++D=' = @B +F  P(  ~  s *Py  y    s *y  P`  y   0qqH  0޽h ? ̙33___PPT10i.t+D=' = @B +! & 80 (    Nvd @" ` P ~  s *,y  y  ~  s *y   y  H  0޽h ? ̙33___PPT10i.ni+D=' = @B +    R(   ~   s *y   y     s *w  y  " $H   0޽h ? ̙33___PPT10i.ni+D=' = @B + '  $(  $~ $ s *y   y  ~ $ s *`y  y   $ 0y jJ"` uFixed: Monetary authority has to intervene in foreign currency markets to maintain fixed nominal exchange rate eNOM ;`v(j3 33&o    $ 0n jJ"`  UManaged flexibility: free float but interventions to prevent excessive fluctuations ;$V(C V  $ 0W jJ"`   Floating: no intervention in foreign exchange market. Can be joint floating: a group of currencies are pegged to each other, but fluctuate with respect to all the other currencies.:(5j   $ 0W jJ"`  LERM (before Euro) was joint float with adjustably pegged exchange rate band.M(M M H $ 0޽h ? ̙33___PPT10i.Pp,++D=' = @B +u (  ,(  ,~ , s *4W   y  V , 0hW jJ"` The way in which the equilibrium in the balance of payments is achieved depends on the choice of the exchange rate regime and on the degree of capital mobility.(   , 0W    < 2  \ , 0@W jJ"`  PH@___PPT9" Let s consider 3 cases: Fixed exchange rates, no capital mobility ; Fixed exchange rates, perfect capital mobility ; Floating exchange rates .4(w(w   @`H , 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + ) @ 4|(  4~ 4 s *W   W   4 6HW " ` 1. Fixed exchange rates ( 2I&  * 4 s *W "`= fSuppose initially that there are no private sector capital flows, perhaps because of capital controls.,g 2U g X 4 0W jJ"``  fWithout capital mobility, a current account deficit (CA < 0) can only be financed by the Central Bank.Tg(3, g & 4 0W jJ"` `  The Central Bank sells foreign exchange and buys domestic currency. As a result, domestic money in circulation falls, as pounds disappear back into the Bank of England. This is called unsterilized intervention. Forex reserves fall to restore the equilibrium in the BP.H (83@     5 H 4 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + * )!` <(  <~ < s *W   W  R < 0oB jJ"` Another possibility is sterilized intervention. This happens when the Central Bank (to offset the fall in domestic money supply) buys domestic bonds  thereby restoring the domestic money supply..(  O < 0wB jJ"`  eBoth sterilized and unsterilized interventions restore the BP equilibrium under fixed exchange rates.2f(;3)&   F  < 0    < 2   < 0lB jJ"`  8However, with no long term remedial action to resolve the original reason for the CA deficit, eventually the Central Bank will run out of foreign reserves, and will be forced to adjust exchange rates.@(R3t  H < 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + + ' D(  D~ D s *\B   B   D 6B " ` 2. Fixed exchange rates ( 2I&  ~ D 0B jJ"``  In the modern world, with capital mobility, international investors have more money at their disposal than Central banks, thus making the defence of exchange rates in the manner just explained futile.(  m D 04B jJ"` ` The Central Bank no longer defends the exchange rate by buying and selling foreign reserves. Instead, it sets domestic interest rates to provide the correct incentive for speculators.(  H D 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + , )! L(  L~ L s *$B   B   L 0lB jJ"` The Central Bank must set the correct interest rate, to eliminate one-way capital flows. This is the only option open to the Central Bank if it wishes to keep exchange rates fixed, yet faces perfect capital mobility.(  h L 0B jJ"`0   This interest rate, coupled with the level of income, determines money demand. Sterilisation options in this case do not work (as international capital flows will nullify them). (   L 0B jJ"`  ?Thus perfect capital mobility undermines monetary sovereignty. @(@ @ H L 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + -  T(  T~ T s *B   B   T 6̸B " ` 3. Floating exchange rates ( 2I&   T 0$B jJ"```$  Anything that tends to create a CA surplus (resource discovery, increase in exports,& ), induces an appreciation in the exchange rate. Competi-tiveness decreases and net exports fall, until the external balance (BP equilibrium) is restored.h( 33&  Z  T 0B jJ"` ` XAnything that tends to create a CA deficit induces a depreciation in the exchange rate. Competitiveness increases and net exports rise, until the external balance (BP equilibrium) is restored.h( 33  H T 0޽h ? ̙33___PPT10i.Pp,++D=' = @B + . 2* \(  \~ \ s *B   B   \ 0B jJ"` When exchange rates float freely, there is no official intervention in the forex market and no net monetary transfers between countries since the CA and the KA (and therefore the BP) are always zero.(333&K  x  \ 0B jJ"`  EThus under floating exchange rates monetary sovereignty is restored. F(F F H \ 0޽h ? ̙33___PPT10i.Pp,++D=' = @B +g  ~v d(  d~ d s *B   B  P d 0? 0T PAssumptions: There is one general level of prices (P), and it is fixed ; Aggregate demand (AD) is: Positively related to the level of government expenditure (G) ; Positively related to overseas output (YF), which is exogenous ; Positively related to the exchange rate (eNOM) ; Negatively related to the domestic interest rate (r) .: (2W 2 2 &3333<3,3 3B3 373&  < < nnH d 0޽h ? ̙33___PPT10i.+D=' = @B +   h\(  h~ h s *B   B   h 0,> ` `. >Assumptions: Money demand (MD) is: Positively related to domestic income level (Y); Negatively related to domestic interest rate (r). Money supply (MS) is under the control of the Central Bank . Capital account is affected by the differential between domestic and foreign interest rates (r  rF) and expected depreciation E eNOM/eNOM . (282 2e 2 233 33.32333 3=3K3333 3333 333 33@(      < nnH h 0޽h ? ̙33___PPT10i.+D=' = @B +2  IA l(  l~ l s *$?   ?  _ l 0>  `.  Assumptions: Trade (or current) account (i.e. balance of goods and services) is determined by the relationship between domestic income (Y) and foreign income (YF), and by the real exchange rate  (282 2 3^33333 333  < nn l0 ZA ? ??"`P   ? H l 0޽h ? ̙33___PPT10i.+D=' = @B +I  `X0 p(  p~ p s *?   ?  ~ p s *? 0 ?   p 0> jJ"`P | AS = ADdH  &    p 0h& jJ"` +Y = C (Y) + I(r) + G + NX(YF , Y, ) ,     @        p 0& jJ"` <  1Y = C (Y) + I(r) + G + NX(Y)   &     p0  A ?5% ??"`  & XB p 0DԔ?XB  p@ 0DԔ? XB  p 0Dp@ ^`  p 0& @` ` IS(r, Y)X 0 24     p <& Ԕ?"`P  y Output, Y& 2&    p <& Ԕ?"` s  Kr 2  # p <D& 0*jJ"`  Shifts occur with exogenous changes in aggregate demand, that is G, Taxes, YF, and net exports NX (which are positively influenced by eNOM and YF) 02A  %  &     p 6& " `0pV YIS:& 23   p 0& @' AS < ADdD 2 &    p 0\& p PW  AS > ADdD 2 &   H p 0޽h ? ̙33___PPT10i.R :+D=' = @B +     @ ty (  t~ t s *&   &   t 0`R `  LM(r, Y)X 0 24   XB t 0DԔ?@@XB t@ 0DԔ? @RB t s *Dp 0P  t < Ԕ?"`pt YY 2  t <8 Ԕ?"`0 c4  Kr 2    t 0 MSJ 2      t 0z   MD < MSJ 2      t 6Hz" `` XLM& 23    t 0Bz0 _Money market equilibrium: 2  +  t 0ČzjJ"`@P l   MD(Y, r) = MS 3 333 3  & t <z0*jJ"`@   *Shifts occur with exogenous changes in MS R+02'33 3 +   t 0`zjJ"`P  MD = MSf 3 33 3  H t 0޽h ? ̙33___PPT10i.+D=' = @B +!  80P x(  x~ x s *z  z  x 6z" `` XBP& 23   x 0|z0 [External equilibrium: 2   x <z0*jJ"` @ ` C9Shifts occur with exogenous changes in YF, eNOM and rF . :02'   Z'     XB x 0DԔ?pP pXB x@ 0DԔ? P Q pRB x s *D3p P p~   x 0z0 p0P  BP(r, Y)X 0 234     x <zԔ?"`pt YY 2   x <zԔ?"`` 0  d  Kr 2    x Tz@djJ" ``M=p RpBP = CA(YF , Y, )+ KA(r  rF , E eNOM/eNOM) = 0J9(2     t           x 0z  P Or simply: 2    x0  A ?5% ??"`+  zF x HXzdjJ" ` 0  BP (r, Y) = 0 h 2&   x 0y  `0w  BP < 0T 2     x 04 P P7  BP > 0T 2    H x 0޽h ? ̙33___PPT10i.+D=' = @B +  ` |y(  |~ | s *     | 0 P _Overall model diagram(2  XB |@ 0DԔ?p`^B |@ 6DԔ?`` | 0  p  ^BP,0 2  RB | s *Dpp pXB | 0D3p @XB  | 0Dp `    | 0    TIS"0 23    | 0X  0 TLM"0 2  u  | 0±    MD < MS AS < ADd BP < 0 2022   &      | 0k 0/  &MD < MS AS < ADd BP > 0  2022 2    &     u | 0@   MD < MS AS > ADd BP > 0 2022   &    k | 0,@ 0 P  MD > MS AS < ADd BP < 0 2022   &    u | 0l@ ` 0 MD > MS AS > ADd BP > 0 2022   &    k | 0<@  @  MD > MS AS > ADd BP < 0 2022   &     | <@ Ԕ?"` Kr 2   | <p@ Ԕ?"`` d YY 2 t | <@ 0*jJ"`0` Point E in the diagram represents internal and external balance, and the six regions around it are characterised by different kinds of disequilibria .402   | <(n Z    | <n Ԕ?"`   KE 2  f | 0Gvs"` f H | 0޽h ? ̙33___PPT10i.+D=' = @B +   p  p(  h  <   XB @ 0DԔ?p XB  0DԔ?RB  s *D3pp   <tn Ԕ?"`   Kr 2     <n Ԕ?"`0V4 YY 2    0n "`` B  ^BP,0 2  H  0޽h ? ̙33___PPT10i.+D=' = @B +'   rj (  ~  s *n   n    0dn P ^Fixed exchange rates(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0(n ` p  ^BP,0 2  RB  s *Dpp pXB  0D3p @XB   0Dp0     0n    TIS"0 23     0(n  @ gLM040 2      <Tn Ԕ?"`s Kr 2     6n Ԕ?"`  YY 2   <n 0*jJ"`0 ,$D 0 DOverall money supply is completely ineffective in stimulating output in a fixed exchange rate regime. The initial equilibrium E0 cannot be changed by changes in MS.p82~ !     <n Z     < Ԕ?"`@  \E0* 2   B  s *Dp ,$@ 0  0 `P ,$ 0 gLM140 2      < Ԕ?"`@ 0 D ,$ 0 \E1* 2   B  0D) ` ,$@ 0B  0D)P P,$@ 0   68 " `` M S H 2 I&  RB  s *Dpf  0Gvs"`    0Gvs"`p p ,$D 0H  0޽h ? ̙33]U___PPT105.+Da ' = @B D ' = @BA?%,( < +O%,( < +D ' =%(D ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(DA' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+  ++0+  ++0+  +R / ia (  ~  s *       Hx  "`      0 jJ"` ` GE1 back to E0 : as the BP is in deficit, there is excess supply of the domestic currency in the international markets, and pressure to devalue, but exchange rate is fixed, so monetary authority has to intervene buying the excess (i.e. losing foreign currency reserves), and money supply MS contracts back to the original level.H 2     ' H H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B ++   >(  ~  s *X      0 P aFloating exchange rates(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0B  00  gBP040 2   RB  s *Dpp pXB  0D3p @XB   0Dp0     0G    gIS040 23 3     0L  @ gLM040 2      <Q Ԕ?"`s Kr 2     6U Ԕ?"`  YY 2 [  < Y 0*jJ"` ,$D  0 aOverall money supply is very effective in stimulating output in a floating exchange rate regime. b82b b   <8_ Z     <` Ԕ?"`@  \E0* 2   B  s *Dp ,$@ 0  0e `P ,$ 0 gLM140 2      <i Ԕ?"` @  ,$ 0 \E1* 2      6pn " `` M S H 2 I&  RB  s *Dp  0u   ,$ 0 gBP140 2   B  0Dp 0 ,$@ 0B  0D3ppp` ,$@  0  0@z P p,$  0 gIS140 23 3    6< Ԕ?"`g : k ,$ 0 \E2* 2   f  0Gvs"`    0Gvs"`p p ,$D 0  0Gvs"`P ,$D  0H  0޽h ? ̙33 ___PPT10.+!}Dh' = @B D#' = @BA?%,( < +O%,( < +D' =%(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D ' =%(D ' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(DA' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(+P+0+  ++0+  ++0+  ++0+  ++0+  ++0+  +u 0  (  ~  s *       H  "`P      0 jJ"`  >E1 to E2 : as the BP is in deficit, there is excess supply of the domestic currency in the international markets, so exchange rate depreciates, which stimulates exports and increases output: BP0 shifts to BP1 , and IS0 shifts to IS1 $0x2           H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +     (    <h 0*pCjJ"`  1gCapital controls (regulations which prevent private sector capital flows) were commonplace between 1945 and 1973 but are very rare now. Under perfect capital mobility, the BP is horizontal as the domestic interest rate r must be equal to the foreign rate rF. Alternatively: Small open economy = an economy that is too small to affect the world interest rate.h -# C&  f ~  s *H(      0` jJ"` P P >   XB @ 0DԔ?p XB  0DԔ?RB  s *D3p    <D Ԕ?"`   Kr 2     < Ԕ?"`0V4 YY 2    0H "`` B  ^BP,0 2     0P P 0T jrF* 2   H  0޽h ? ̙33___PPT10i.+D=' = @B +       (  ~  s *4       0X7 jJ"` P P >   XB @ 0DԔ?p XB  0DԔ?RB  s *D3p    <p: Ԕ?"`   Kr 2    <> Ԕ?"`0V4 YY 2    0< "`` B  ^BP,0 2     0F P 0T jrF* 2      <K 0*pCjJ"`  0Example: assume that the world consists of only European countries (simplifying assumption, but European countries are much more integrated  financially and in trade  with each other than with the rest of the world). During the 1990s: France H" fixed exchange rate After introduction of the : UK = floating exchange rate / nJ  J H  0޽h ? ̙33___PPT10i.+D=' = @B +K   c[ (  ~  s *$^       0_ P hFixed exchange rates (France) (2  XB @ 0DԔ?p`^B @ 6DԔ?``  0+B#style.visibility= `B<*D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*D' =1:Bvisible*o3>+B#style.visibility<*%(DA' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(+p+0+  ++0+  +! 1 80 (  ~  s *$     0  0X jJ"` xThus money supply is ineffective under a fixed exchange rate regime (both under imperfect and perfect capital mobility).y(y y   0 "` dBut: graphs are not enough, it is important also to explain IN WORDS the effects of monetary policy under perfect capital mobility and fixed exchange rates. Explanation: see next page. Moreover, suppose you are Jean-Claude Trichet (Governor of the Banque de France from 1993 to 2003). A famous columnist is blaming the Banque de France for keeping interest rates too high in spite of a severe recession. What is your answer to this?40n2 2Z    A  m H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B + 2 0 C(  ~  s *L:   :     HP  "``  :    0 "` P eReply to the columnist: under fixed exchange rates and perfect capital mobility, any attempt to lower the interest rate below rF is ineffective, it only depletes the foreign reserves of the central bank.P 2h L&~  L H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +%  P s(  ~  s *$B      0lC P fFloating exchange rates (UK)(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0 ` p  fBP40 2   RB  s *Dpp pXB  0D3p @XB   0Dp P    085    gIS040 23 3     0  @ gLM040 2      <X Ԕ?"`s Kr 2     6 Ԕ?"`  YY 2 Q  <\ 0*jJ"` ,$@ 0 WUnder floating exchange rates, monetary policy is highly effective in changing output. X82X X   < Z     < Ԕ?"`@  \E0* 2   B  s *Dp ,$@ 0  0 `P ,$ 0 gLM140 2      <T Ԕ?"` @  ,$ 0 \E1* 2      6 " `` M S H 2 I&  RB  s *DpB  0D3p P ,$@ 0  0|  0,$ 0 gIS140 23 3    6 Ԕ?"`P @ T ,$ 0 \E2* 2     0    jrF* 2   f  0Gvs"`    0Gvs"` P ,$@  0  0Gvs"`p p ,$D  0H  0޽h ? ̙33OG___PPT10'.+hV D' = @B D' = @BA?%,( < +O%,( < +D' =%(D}' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+  ++0+  ++0+  ++0+  ++0+  + 3 ` h(  ~  s *l        H  "``   H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +X 4 og (  ~  s *]       HX^  "`P      0_ jJ"` ` !Such a policy is known as a beggar-thy-neighbour policy, since an increase in domestic employment has been created at the expense of other countries, which now might experience higher levels of unemployment."   H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +     (    <p 0*pCjJ"`` P  Outlawing capital flows is a measure unlikely to be taken these days. How can we explain the effects of monetary policy under no capital mobility (fixed versus floating exchange rates)?2F 0t   ~  s *R      0(p jJ"` P P >   XB @ 0DԔ?p XB  0DԔ?XB  0ZD3pp @@  <p Ԕ?"`   Kr 2     <p Ԕ?"`0V4 YY 2    0$&o "` P  ^BP,0 2  H  0޽h ? ̙33___PPT10i.+D=' = @B +j   e] (  ~  s *uo   o    0o P ^Fixed exchange rates(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0po   ^BP,0 2  RB  s *Dpp pXB  0D3p @XB   0Dp@[`   0o    TIS"0 23     0!Q  @ gLM040 2      <T#Q Ԕ?"`s Kr 2     6$Q Ԕ?"`  YY 2   <,Q 0*jJ"`0 P,$@ 0 7The expansion of MS causes the movement from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the Central Bank has to buy the domestic currency to avert the depreciation, hence MS contracts back to the original level. 8x2   4 U )    <*Q Z     <=Q Ԕ?"`   \E0* 2   B  s *Dp ,$@ 0  0BQ `P ,$ 0 gLM140 2   B  0D) ` ,$@ 0B  0D)P P,$@ 0   6GQ " ` Z M S H 2 I&  RB  s *D0    <NQ Ԕ?"` @  ,$ 0 \E1* 2   f  0Gvs"`    0Gvs"`p p ,$D 0H  0޽h ? ̙33  ___PPT10 .+\D ' = @B Dl ' = @BA?%,( < +O%,( < +D ' =%(DK ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+Q  ++0+Q  ++0+Q  +,  OG (  ~  s *$dQ   Q    0leQ P aFloating exchange rates(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D ' =%(D ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(DA' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(+P+0+Q  ++0+Q  ++0+Q  ++0+Q  ++0+Q  ++0+Q  +  P(  ~  s *Q  Q    s *Q  P`  Q   0qqH  0޽h ? ̙33___PPT10i.t+D=' = @B +! 5 80 (    Nvd @" `@0 U~  s *\    ~  s *    H  0޽h ? ̙33___PPT10i.ni+D=' = @B +   R(  ~  s *Q   Q    s *Q  Q  " $H  0޽h ? ̙33___PPT10i.ni+D=' = @B +[   rj (  ~  s *HQ   Q  q  0 jJ"`0  In lecture 2, we said that the way in which the equilibrium in the balance of payments is achieved depends on the choice of the exchange rate regime and on the degree of capital mobility.(    0 jJ"` @  XJIn fact, the balance of payments is always in equilibrium, because in practice the capital account KA  finances the current account CA imbalance: BP = CA + KA = 0 (((c     0 jJ"`@ @ v.& but the way in which a current account imbalance is financed depends on the choice of the exchange rate regime and on the degree of capital mobility!(    0 jJ"`@P EWe now look at what this means for the adjustment out of equilibrium..F(' F H  0޽h ? ̙33___PPT10i.+D=' = @B +A  RJ (  ~  s *      <l Ԕ?"``` d YY 2   < Ԕ?"`s Kr 2    s * "``   <Assume that initially the economy is in E0 Because of a sudden fall in foreign output, the IS and the BP shift and the economy moves to E1. (2( 13 f3$    s * "`  <Because of the fall in exports, CA : how is this financed?2=(2 3 = XB  0Dm 0XB @ 0DԔ?^B  @ 6DԔ? RB   s *Dp@ B   0D3p`P ,$D 0   0 P p fIS40 23 3     0P P p fLM40 2     <T Ԕ?"` `$ ,$ 0 dE12 2vsvs  B  0Dp ,$@ 0  0Gvs"`   ,$@ 0XB  0Dp XB  0D3p B  NԔ?"6@`NNN?N` ) ,$@ 0B  NCKZԔ?"6@`NNN?NPp 0 ,$@ 0  < Ԕ?"`pp t  dE02 2vsvs  f  0Gvs"`e)  s * "` 0 fBP40 2   H  0޽h ? ̙33  ___PPT10o .+&D ' = @B D ' = @BA?%,( < +O%,( < +D ' =%(D ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(+8+0+  +    0 8 (  3  6pc jJ"`   wBecause of the fixed exchange rate regime, the Central Bank is committed to buy any excess supply of domestic currency.x(x x ~  s *\c   c    6$c " `p& -1. Fixed exchange rates & no capital mobility&. 2-A . XB  0DԔ?p P0 p XB @ 0DԔ?PQp   0xc @ ^BP,0 2    <[ Ԕ?"` p  WY 2 RB   s *Dp     0[  0  TIS"0 23     0P[ P  TLM"0 2  XB   0Dp@p XB   0D3p0p ^B  6D|p f  0Gvs"`h  <t[ Ԕ?"`9 Kr 2  A  6T[ jJ"`  kSince CA is in deficit, there is excess supply of domestic currency and excess demand for foreign currency.2l(3c l k  6<[ 0jJ"`  }Foreign exchange reserves fall, generating a positive number in the KA (see Abel et al. page 156). The LM shifts to the left.J~ D! ~   <[ Ԕ?"`   xY08 2  H  0޽h ? ̙33___PPT10i.+D=' = @B +  @ B(  ~  s *[   [  3  6D[ " `~& 32. Fixed exchange rates & perfect capital mobility 64 2IA2  XB  0DԔ?p P0 p XB @ 0DԔ?PQp   0`X 0  ^BP,0 2    <hX Ԕ?"` p  WY 2 RB  s *Dp     08X  P  TIS"0 23     0X P  TLM"0 2  XB   0DpPXB   0D3p0p ^B   6D|p   <X Ԕ?"` 0  xY08 2  f  0Gvs"`pS   <E Ԕ?"`9 Kr 2  ]  6سE jJ"`  _Since the interest rate is below the world level rF , private capital flows out of the country.@`(1 ,&1  -   6E 0jJ"`0  0  APrivate residents buy assets abroad, so the KA is in deficit too.0B , B i  6ȿE jJ"` 0  The Central Bank must set the correct interest rate, to eliminate one-way capital flows. Contractionary monetary policy, the LM shifts to the left.2(}    0 E PVT jrF* 2   H  0޽h ? ̙33___PPT10i.+D=' = @B +  .&P  (    6E jJ"` @B 0B 0 eBecause of the depreciation, competitiveness increases and both the IS and the BP shift to the right.Jf D3  f ~  s *___PPT10.+(sD' = @B D' = @BA?%,( < +O%,( < +D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+d  ++0+d  ++0+d  ++0+d  +k 6 z (  ~  s *I   I     HI  "`00  I    0I jJ"`   4TE1 to E2 : as the BP is in surplus, there is excess demand of the domestic currency in the international markets, and pressure to revalue, but exchange rate is fixed, so the central bank has to intervene (i.e. buying foreign currency reserves). As a result, the money supply increases and the LM shifts until the BP equilibrium is restored.U0x2    U H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +,/    5(  ~  s *4I   I    0|I P aFloating exchange rates(2  XB @ 0DԔ?p`^B @ 6DԔ?``  0LI    gBP040 2   RB  s *Dpp pXB  0D3p @XB   0Dp0     0xI    gIS040 23 3     0I  @ fLM40 2      <TI Ԕ?"`s Kr 2     6I Ԕ?"`  YY 2   <I 0*jJ"`  %So fiscal policy in a floating exchange rate regime with imperfect capital mobility is less effective in expanding Y , and rises interest rates r and exchange rates.P82s    <I Z     <I Ԕ?"`@  \E0* 2     6I Ԕ?"`Y @ ],$ 0 \E1* 2   B  6D)0p0,$@ 0  6I " `0`@ vG * 2I&  XB  0D`PB  0D3p@ P ,$@  0  0I  `@,$  0 gIS240 23 3  B  0D3p` ,$@ 0  0I   ,$ 0 gIS140 23 3    0I  ,$  0 gBP140 2   B  0DpP ,$@ 0f  0Gvs"`    0Gvs"` @,$@  0  0Gvs"` ,$@ 0  6I Ԕ?"` ,$ 0 \E2* 2   B  6;D)  ,$@  0B   6D) ,$@ 0H  0޽h ? ̙33/'___PPT10.+ƳD' = @B D~' = @BA?%,( < +O%,( < +D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D/ ' =%(D ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+  ++0+  ++0+  ++0+  ++0+  + 7  (  ~  s *       HH  "`00      0 jJ"` P vE1 to E2 : Surplus in BP means excess demand for domestic currency and the nominal exchange rate e appreciates  shift of BP0 to BP1. If prices don t change, the nominal appreciation is also a real appreciation, and exports will decrease (as they become more expensive) reducing demand  the IS shifts to the left .<02  I   < H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +     (  ~  s *      0 jJ"` P P >   XB @ 0DԔ?p XB  0DԔ?RB  s *D3p    < Ԕ?"`   Kr 2    <h Ԕ?"`0V4 YY 2    0| "`` B  ^BP,0 2     0 P 0T jrF* 2      < 0*pCjJ"`  4Example: assume that the world consists of only European countries (simplifying assumption). During the 1990s: France H" fixed exchange rate After introduction of the : UK = floating exchange rate / n V  H  0޽h ? ̙33___PPT10i.+D=' = @B +#    -(   ~   s *       0ܯ P hFixed exchange rates (France) (2  XB  @ 0DԔ?p`^B  @ 6DԔ?``   0  P   ^BP,0 2  RB   s *Dpp pXB   0D3p @XB   0Dp     0\    gIS040 23 3     0  @ gLM040 2      <̟Ԕ?"`s Kr 2     6Ԕ?"`  YY 2    <T0*jJ"` 1Fiscal policy is strengthened by capital mobility because, unlike in a closed economy , the money supply must expand to keep the interest rate constant at rF. F82 &      <Z      <Ԕ?"`@  \E0* 2   B   s *Dp`@,$@ 0   0h ,$ 0 gLM140 2   B   6D) P ,$D 0B   6D)(  ,$@ 0   6" ``@ vG * 2I&  XB   0DB   0D3p P ,$@ 0   0  ,$ 0 gIS140 23 3     6ĂԔ?"` P ,$ 0 \E1* 2   f   0Gvs"` h    0Gvs"` @ [ ,$D  0   0ɂ   jrF* 2   H   0޽h ? ̙33___PPT10.+uLD' = @B D' = @BA?%,( < +O%,( < +DY' =%(D' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<* %(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* %(++0+  ++0+  ++0+  +c  zr$ (  $~ $ s *߂   L $ <40*pCjJ"`0  nInsight Fiscal policy affects the level of aggregate demand, thus causing interest rates to change. This causes a flow of capital across borders, which affects exchange rates. Therefore the central bank has to implement monetary policy to keep interest rates constant. This policy action by the central bank will reinforce the effects of the fiscal policy on output.48ng0nh o H $ 0޽h ? ̙33___PPT10i.+D=' = @B +A  (j(  (~ ( s *    ( 0P fFloating exchange rates (UK)(2  XB (@ 0DԔ?p`^B (@ 6DԔ?`` ( 0|   ^BP,0 2  RB ( s *Dpp pXB ( 0D3p @XB  ( 0Dp    ( 0   gIS040 23 3    ( 0  @ fLM40 2     ( <\ Ԕ?"`s Kr 2    ( 6$ Ԕ?"`  YY 2 * ( < 0*jJ"`  dFiscal policy is completely ineffective in stimulating output in a floating exchange rate regime. e82e e  ( <h Z    ( < Ԕ?"`@  \E0* 2   B ( 6D)G,$@ 0B ( 6D)P,$D 0 ( 6䦛 " ``@ vG * 2I&  XB ( 0DB ( 0D3p P ,$@ 0 ( 0   ,$ 0 gIS140 23 3  f ( 0Gvs"` h  ( 0    jrF* 2   H ( 0޽h ? ̙33  ___PPT10 .+ZtD ' = @B D> ' = @BA?%,( < +O%,( < +Du ' =%(D ' =%(D' =4@BBBB%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*(D' =1:Bvisible*o3>+B#style.visibility<*(%(D' =4@BBBB%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*(D' =1:Bvisible*o3>+B#style.visibility<*(%(D' =A@BBBB0B%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*(D' =1:Bvisible*o3>+B#style.visibility<*(%(D' =4@BBBB%(E' =1B B`BPB1:Bhidden*3>+B#style.visibility= `B<*(D' =1:Bvisible*o3>+B#style.visibility<*(%(+8+0+(  +  8 # ,(  ,~ , s *x     ,  HE  "`0`    C , 0 jJ"`   qIn the end, the level of output Y does not change, although its composition does (less exports and more imports).4r02 Q r H , 0޽h ? ̙33___PPT10i.Pp,++D=' = @B +)  d\@4(  4~ 4 s *ԛ     4 04֛ P ^Fixed exchange rates(2  XB 4@ 0DԔ?p`^B 4@ 6DԔ?`` 4 0ۛ   ^BP,0 2  B 4 s *Dp ,$@ 0XB 4 0D3p0 XB  4 0DppPP`  4 00  0  gIS040 23 3    4 0,  ,$ 0 gLM140 2     4 <x Ԕ?"`s Kr 2    4 60 Ԕ?"`  YY 2  4 <0*jJ"`0 P &As the IS shifts to the right, the economy moves from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the Central Bank has to buy the domestic currency to avert the depreciation, hence MS contracts and output falls. 8x2-  4 U    4 < Z    4 <(Ԕ?"`0 P4  \E0* 2   RB 4 s *DpP p 4 0<   gLM040 2   B 4 0D  ,$@ 0B 4 0D` ,$@  0  4 <<Ԕ?"` ` ,$ 0 \E1* 2    4 6x" `0 vG * 2I&  XB 4 0D;``PB 4 0D3p ,$@ 0 4 0@  ,$ 0 gIS140 23 3  f 4 0Gvs"``   4 0Gvs"`  ,$@  0 4 0Gvs"` 0 @ ,$@ 0  4 <xԔ?"`` ,$  0 \E2* 2   H 4 0޽h ? ̙33F>___PPT10.+SD' = @B D' = @BA?%,( < +O%,( < +D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<* 4%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*4%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*4%(++0+ 4 ++0+4 ++0+4 ++0+4 +T0  P 8](  8~ 8 s *|Ȅ    8 0ɄP aFloating exchange rates(2  XB 8@ 0DԔ?p`^B 8@ 6DԔ?`` 8 0΄p gBP040 2   RB 8 s *Dp 0 XB 8 0D3p @XB  8 0Dp@[`  8 0ӄ   gIS040 23 3    8 0l؄  fLM40 2     8 <`݄Ԕ?"`s Kr 2    8 6Ԕ?"`  YY 2  8 <0*jJ"`#P GAs the IS shifts to the right, the economy moves from E0 to E1 . Output increases and imports increase. Since the BP is in deficit in E1 , the domestic currency depreciates. Because of the depreciation, competitiveness increases and both the IS and the BP shift to the right. 8s2-  4 i    8 <TZ    8 <pԔ?"`` d  \E0* 2     8 <Ԕ?"`@ ` D ,$  0 \E2* 2   B 8 0D3p ,$@  0 8 0  ,$  0 gIS240 23 3   8 0h x ,$ 0 gBP140 2   B 8 0Dp@g `,$@ 0 8 6Ԕ?"`P  ,$ 0 \E1* 2    8 6" `0 vG * 2I&  XB 8 0D;``PB 8 0D3p0 ,$@ 0 8 0ƃP p,$ 0 gIS140 23 3  f 8 0Gvs"`   8 0Gvs"`0 ` ,$@ 0 8 0Gvs"`p ,$D 0B 8 6D)P P ,$@ 0B 8 6D) 2 R ,$@  0B  8 6D) ,$@  0H 8 0޽h ? ̙33/'___PPT10.+VD' = @B D~' = @BA?%,( < +O%,( < +D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D/ ' =%(D ' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<* 8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*8%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*8%(++0+8 ++0+8 ++0+8 ++0+8 ++0+8 +  `<x(  <~ < s *    <0  `A ? "`? W  H < 0޽h ? ̙33___PPT10i.d+B#style.visibility<*@%(D' =4@BB#BB%(/%,( < +)D)' =+4 8?^CBhiddenBCBvisibleB*o3>+B#style.visibility<* @DB' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*@%(D' =4@BB#BB%(/%,( < +)D)' =+4 8?^CBhiddenBCBvisibleB*o3>+B#style.visibility<* @DB' =%(D' =%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*@%(D' =4@BB#BB%(/%,( < +)D)' =+4 8?^CBhiddenBCBvisibleB*o3>+B#style.visibility<*@++0+@ ++0+@ ++0+@ +! : H*(  H~ H s *   XB H 0DԔ?p  p XB H@ 0DԔ?p  H 0@  ^BP,0 2   H <Ԕ?"`   YY 2  H <Ԕ?"`s Kr 2  RB H s *Dpp XB  H 0D3p XB  H 0Dp6@  H 0   TIS"0 23    H 0DV `  TLM"0 2  X  H 0" ` P  For example, consider an economy initially at full employment YF and external balance. Assume that foreign output falls (war, restrictive policies abroad, & ). Both the IS and the BP shift: output falls below full potential and the BP goes in disequilibrium.(2>  g3 2&>  ^B H 6D|p B H 0Dp,$@ 0B H 0D3p0 ,$@ 0B H 6D|p ,$@ 0 H <pV Ԕ?"`   jYF* 2  & H <V Ԕ?"`  ,$ 0 xY08 2  f H 0Gvs"`hX H 0Gvs"`pC ,$@ 0B H HԔ?"6@`NNN?NPP,$@ 0B H N^Ԕ?"6@`NNN?N 4 ,$@ 0  H 6,V d" `  Notation: YF =  domestic full employment output YF =  foreign output  2=0Z2  @  %  H H 0޽h ? ̙33#  ___PPT10 .Pp,+++B#style.visibility<*H%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*H%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*H%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*H%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*H%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*H%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*H%(+8+0+HV  +,  C;P(  Px P c $7V   V   P  H7V  "`@ V   P s *AV  "` SInternal balance exists when the economy is at the full-employment level of output. T  @` P s *AV  "`P  CExternal balance exists when the Balance of Payments is equal to 0. D  @`g P 0 JV  " `p ` Problem: how to achieve 2 objectives (internal & external balance) simultaneously. Policy dilemma caused by potential conflicts between the goals of external and internal balance.   @`H P 0޽h ? ̙33___PPT10i.d PHp(  ~  s *\Z   Z    0 Z jJ"` @  In order to make precise statements about the effects of a devaluation in the IS-LM-BP model, we must clarify first: The effect of changes in eNOM on the real exchange rate eR ; The effect of changes in eR on net exports (NX H" CA) .u v    3Z         0Z jJ"``  (pIf a devaluation increases NX then both the IS and the BP shift to the right, and output increases. But only if.hq 33 8 q ssV6xX H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B + ? i(  ~  s *仪      0x@ jJ"` ` eDevaluation (pursued by a country in fixed exchange rate regime) is effective in expanding output if:f(f f   0\ jJ"`  D<4___PPT9 aRelative prices do not change, so that a decrease in nominal exchange rate will also mean a decrease in real exchange rate. This means that exports become cheaper in foreign currency and imports become more expensive in domestic currency ;"(  sZ:|\e  0@ \ jJ"`P H@8___PPT9 !Net exports NX increase in value.6"!  3 " sV6xX H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B + @ |(  ~  s *\   \  8  0\ jJ"`0  Condition 2 requires that the value of exports increases more than value of imports. This depends on the price elasticities of demand for exports and imports, and is summarised in the Marshall-Lerner condition (sum of price elasticities of demand for exports and imports exceeds 1).0  @o   e   / V6xX   0\ jJ"`0   YIn the rest of the analysis, we assume that the Marshall-Lerner condition holds and relative prices are fixed, so if there is a devaluation then NX and both the IS and the BP shift to the right.d 33   XB  0D;@O  04\ jJ"` _ Condition 1 is not satisfied in the long run, but it may be quite realistic in the short run.6`  S ` Z:|\H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B + , A (  ^B @ 6D|P Pi`,  <<\ 0*jJ"`` p fA devaluation of the domestic currency improves competitiveness and increases output in the short run.g82g g B  0Dp p ,$@ 0~  s *A\   \  XB @ 0DԔ?p`^B @ 6DԔ?``  0C\ @ `  gBP040 2   RB   s *Dpp pXB   0D3p @XB   0Dp0     0TH\    gIS040 23 3     0L\  @ gLM040 2     6P\ Ԕ?"`  YY 2   <PU\ Ԕ?"`@  \E0* 2   B  s *DpPP,$@  0  0+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D~' =%(D&' =%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =A@BBBB0B%(D' =1:Bvisible*o3>+B#style.visibility<*%(D' =4@BBBB%(D' =1:Bvisible*o3>+B#style.visibility<*%(++0+\  ++0+\  ++0+\  ++0+\  ++0+\  + B c(  ~  s *̙\   \    0(\ jJ"`   yE1 to E2 : under fixed exchange rates, money supply expands to accommodate the excess demand of domestic currency. This will give a further impulse to aggregate demand and the final equilibrium will be for a higher level of output.b0x2      T\  "`0  \  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +T  kc(  ~  s *Az  z ~  s *!z`  z   0@@ jJ"`@  IIf there is a devaluation of the home currency, the import price of raw materials increases. Domestic firms want to pass on these costs increases in higher prices. Workers realise that that consumer prices are higher, and demand higher wages. &   H  0޽h ? ̙33___PPT10i.`%+D=' = @B +  JB (    <\ " 0  < 2    H0\    \  ~  s *\ ` \   0  `A ? ?"` 0M   \ H  0޽h ? ̙3380___PPT10.`% C  0(  ~  s *8\   \  XB  0DԔ?p  p XB @ 0DԔ?p   0\ @  ^BP,0 2    <\ Ԕ?"`   YY 2   <h\ Ԕ?"`s Kr 2  RB  s *Dpp XB   0D3p XB   0Dp6@   0\    TIS"0 23     0|\ `  TLM"0 2     0H\ " `  0dFor example, consider an economy initially at full employment YF and external balance. Assume that there is a permanent fall in export demand: both the IS and the BP shift to the left. At the original exchange rate, this generates a slump that reduces wages and prices, until the resulting increase in competitiveness restores the original equilibrium.e(2>  W3 &> % ^B  6D|p XB  0DpXB  0D3p0 ^B  6D|p   <\ Ԕ?"`   jYF* 2  f  0Gvs"`hXf  0Gvs"`pC B  HԔ?"6@`NNN?NPPB  N^Ԕ?"6@`NNN?N 4   0^ "` ` ` ESTBA: the full employment level of output YF is not the foreign level of output YF !T 2)  @) $  H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +4  P4(  ~  s *(B   B    6^ jJ" ` PDevaluation can deliver an overnight improvement in competitiveness, shifting both the IS and the BP back to their original positions. Devaluation speeds up adjustment .v 0'3 E    0^ jJ" `p  <Devaluation may therefore be an appropriate response to a real shock that requires a change in the equilibrium real exchange rate. Conversely, where no real change is required, devaluation eventually generates rises in prices and nominal wages.   H  0޽h ? ̙3380___PPT10.`%D  `D(    6|n " ``  BWe are now getting close to the question of how to choose the nominal exchange rate in a fixed exchange rate regimes. The above discussion has taught us that governments cannot realistically expect to  fix the level of competitiveness or real exchange rate (not in the long/medium run), but what about the nominal exchange rate eNOM?JX R &R   ~  s *؇n   n    0 n jJ" ` Thus, we have learned that the Mundell-Fleming model is useful to analyse the effects of a devaluation in the short run. However, since it was not designed to explain how the exchange rates are determined in the long run, it cannot be used for this purpose. L n ]'&    0  `A ? ?"` ? 9  n H  0޽h ? ̙3380___PPT10.`%  d\p(  ~  s *p$^   ^    01^ jJ" `  *Fixed-exchange-rate systems are important historically and are still used by many countries. In this  subsection , we will be talking about fixed exchange rate systems only. There are two key questions we d like to answer:& 1(   @`  6 4^ jJ" `P `D<4___PPT9 vHow should the official nominal exchange rate be fixed? Which is the better system, flexible or fixed exchange rates?w w w  @`H  0޽h ? ̙3380___PPT10.`%j D j(  ~  s *A^   ^    0LB^ jJ" `` vIn a fixed exchange rate system, the government sets the nominal exchange rate, in an agreement with other countries. However, a potential problem with fixed exchange rate systems is that the official rate may not what the market wants: the currency may be overvalued or undervalued, according to whether the official rate is above or below the market value. Example: Assume the par value is 0.5 = 1 But the market value is 0.6 = 1 the euro is undervalued the pound is overvalued& g  oOq"B  ZZGHԔ?"6@`NNN?Np`IH  0޽h ? ̙3380___PPT10.`% E f(  ~  s *S^   ^  ~  s *S^ 0@ ^  k  0Y^ jJ"`p`D<4___PPT9 OThe country could devalue the currency, thus officially changing the par value;P(P P  @`  0`^ jJ"``` H@8___PPT9 IThe country could restrict international transactions to reduce the supply of its currency to the foreign exchange market (if a country prohibits people from trading the currency at all, the currency is said to be inconvertible).!(   @`  0dk^ jJ"`0 `H@8___PPT9 ~The central bank can buy its own currency, using its official reserves (the decline in official reserve assets is equal to a country s current account deficit). Thus the market value changes.!(   @`H  0޽h ? ̙33___PPT10i.Pp,++D=' = @B +  ph(  ~  s *^   ^  B  0^ jJ" `` nA country can t maintain an overvalued currency forever, as it will run out of official reserve assets. Moreover, a speculative run (or speculative attack) may end the attempt to support an overvalued currency. If investors think a currency may soon be devalued, they may sell assets denominated in the overvalued currency, increasing the supply of that currency on the foreign exchange market. This causes even bigger losses of official reserves from the central bank and speeds up the likelihood of devaluation, as occurred in Mexico in 1994 and Asia in 1997 1998.8 8 8  oOq"H  0޽h ? ̙3380___PPT10.`%:  :(  ~  s *^   ^  |  0^ jJ" `` tThus an overvalued currency can t be maintained for very long. Similarly, in the case of an undervalued currency, the official rate is below the fundamental value. In this case, a central bank trying to maintain the official rate will acquire official reserve assets. If the domestic central bank is gaining official reserve assets, foreign central banks must be losing them, so again the undervalued currency can t be maintained for long.L 0<h 0F   :\<H  0޽h ? ̙3380___PPT10.`%  ZR(  ~  s *Ė^   ^  x  0^ jJ" `` The best way for a country to make the official nominal exchange rate equal to the long run market value is through the use of monetary policy. In fact, Then:   :\<  0^ jJ"`Pm  calling: eR , the real exchange rate, which is given in the long run P, the level of domestic prices PF , the level of foreign prices  2 2A :AA!AAIAN   }   6D^ jJ"`p  ,eNOM = eR * P / PF 2  AAIh      H  0޽h ? ̙3380___PPT10.`%  d\(  ~  s *T^   ^  6  0 ` jJ" `` 8So, provided eNOM = eR * P / PF is also used by the currency traders as an  anchor value in the short run, given that eR and PF are beside the control of the government, the central bank must manage the money supply so that this equation is satisfied (i.e. ensuring equality between the par value and the market value). This is because the money supply has an effect on the domestic price level P. For example, if the currency is overvalued a monetary contraction is needed. If the currency is undervalued a monetary expansion is needed.x 02M 02?   AAI;  AI A       X     {   :\<H  0޽h ? ̙3380___PPT10.`%  80(  ~  s *^   ^     08^ jJ" `` 6This implies that countries can t both maintain the fixed exchange rate and use monetary policy to affect output (as seen previously). Using expansionary monetary policy to fight a recession would lead to an overvalued currency. So under fixed exchange rates, monetary policy can t be used for macroeconomic stabilization. However, a group of countries may be able to coordinate their use of monetary policy.   :\<H  0޽h ? ̙3380___PPT10.`%  YQ(  ~  s *,^   ^  i  0` jJ" `` Flexible-exchange-rate systems also have problems, because the volatility of exchange rates introduces uncertainty into international transactions.    :\<  0X` " `0PH@___PPT9" \There are two major benefits of fixed exchange rates: Stable exchange rates make international trades easier and less costly: certainty for exporters / importers/ investors ; Fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy; the result may be lower inflation in the long run.R6 2' 2' ]  @`H  0޽h ? ̙3380___PPT10.`%   }u  (  ~  s *L`   `    01` jJ" `` g    :\<r  0C` " `PPH@___PPT9" But there are also some disadvantages to fixed exchange rates: They take away a country s ability to use expansionary monetary policy to combat recessions ; Sudden real shocks that require a change in the equilibrium real exchange rate cannot be absorbed by nominal exchange rate adjustment, a new par value must be negotiated, via a lengthy political process ; Disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system ; Speculators can cause financial & political crises .R? 2 2 3   @`H  0޽h ? ̙3380___PPT10.`%|  0|(  ~  s *`I`   `    0J` " `0PH@___PPT9" lBenefits of floating exchange rates are: Government ignores exchange rate, no intervention needed ; No need to worry about the balance of payments ; Sudden real shocks that require a change in the equilibrium real exchange rate immediately absorbed by nominal exchange rate adjustment, the economy is thus  insulated from shocks ; Government can concentrate on internal policy objectives (inflation, unemployment, income distribution) . F) 2 2fD!   @`H  0޽h ? ̙3380___PPT10.`%  |@(  ~  s *9`   `  V  0m` " ` PH@___PPT9" Disadvantages of floating exchange rates are: Exchange rate can be volatile in the short run, causing uncertainty (harmful to investment & trade) ; Loss of external, balance of payments constraint on macro-policy may lead to inflationary bias. Large capital flows may get out of control, causing the nominal exchange rate to get  out of line with its underlying (fundamental) value .F. 2U 2 j!U   @`H  0޽h ? ̙3380___PPT10.`%  P(  ~  s *d`   `    0?` jJ" `` g    :\<  6hv` jJ" ` If large benefits can be gained from increased trade and integration, and when countries can coordinate their monetary policies closely, then fixed exchange rates may be desirable. Countries that value having independent monetary policies, either because they face different macroeconomic shocks or hold different views about the costs of unemployment and inflation than other countries, should have a floating exchange rate.   :\<  6Z` "`` `f <Which system is better may thus depend on the circumstances:== = H  0޽h ? ̙3380___PPT10.`%G  `G(  ~  s *<`   `    0$` jJ" `` g    :\<  6` "`` ` In conclusion, exchange rate policy and monetary policy are not independent. The increased trade & financial integration will undoubtedly have an effect on how monetary policy is conducted around the world.    0̧` " `p\TL___PPT9.& L^Example. The Bank of England  core purposes : Monetary Stability ; Financial Stability . You can read them online: http://www.bankofengland.co.uk/about/corepurposes/index.htm`. 2+ 2W 2'+W$t ;  B 0t @`H  0޽h ? ̙3380___PPT10.`%  ]Up(  ~  s *`   B    0ș` jJ" `` g    :\<R  0` " `  Among other things,  Monetary Stability means, according to the Bank of England:  & stable prices and confidence in the currency . And, under  Price stability and monetary policy , we can read:  The first objective of any central bank is to safeguard the value of the currency in terms of what it will purchase at home and in terms of other currencies. Monetary policy is directed to achieving this objective and to providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money, in other words the interest rate .y 2R3 ( /#J' y  @`H  0޽h ? ̙3380___PPT10.`%3 0 0X,(  X^ X S Pg   B  X c $` =9(  B  " H X 0Crll ? ̙3380___PPT10.@~z(4 0 `8(  `d ` c $Pg   @  ` s *@ =9(  @  " H ` 0Crll ? ̙3380___PPT10.@~zX7 0 ph(  d  c $Pg   `   s *\ =9(  `  RWhy the signs?  H  0Crll ? ̙3380___PPT10.@~z(8 0 8(  d  c $Pg   `   s *h` =9(  `  " H  0Crll ? ̙3380___PPT10.@~z9 0 (  d  c $Pg   \   s *` =9(`  \ H@___PPT9" BThe U.S. current account has been consistently in deficit over the last two decades, and in each of these years, the U.S. experienced a net inflow of capital. Why buy/sell? What happens to reserves? ,"  H  0Crll ? ̙3380___PPT10.@~z>: 0 N(  d  c $Pg   `   s *` =9(  `  8 H  0Crll ? ̙3380___PPT10.@~z(; 0 8(  d  c $Pg   `   s *` =9(  `  " H  0Crll ? ̙3380___PPT10.@~zb< 0 r(  d  c $Pg   `   s *Da =9(  `  \Examples of the 3 cases?  H  0Crll ? ̙3380___PPT10.@~z(= 0 8(  d  c $Pg   a   s *a =9(  a  " H  0Crll ? ̙3380___PPT10.@~z(> 0 8(  d  c $Pg   a   s *^` =9(  a  " H  0Crll ? ̙3380___PPT10.@~z(? 0 8(  d  c $Pg   B   s *a =9(  \  " H  0Crll ? ̙3380___PPT10.@~z(@ 0 8(  d  c $Pg   a   s *a =9(  a  " H  0Crll ? ̙3380___PPT10.@~z(A 0 8(  d  c $Pg   a   s *0` =9(  a  " H  0Crll ? ̙3380___PPT10.@~z(B 0  8(   d   c $Pg   `    s * a =9(  `  " H   0Crll ? ̙3380___PPT10.@~z(H 0 88(  8d 8 c $Pg   a  8 s *$&a =9(  a  " H 8 0Crll ? ̙3380___PPT10.@~zI 0 pD8(  Dd D c $Pg    D s *ŝ =9(   "  H D 0Crll ? ̙33J 0 L8(  Ld L c $Pg   a  L s *+a =9(  a  "  H L 0Crll ? ̙33K 0 T8(  Td T c $Pg   a  T s *0a =9(  a  "  H T 0Crll ? ̙33L 0 \8(  \d \ c $Pg   a  \ s *p6a =9(  a  "  H \ 0Crll ? ̙33M 0 d8(  dd d c $Pg   a  d s *;a =9(  a  "  H d 0Crll ? ̙33N 0  l8(  ld l c $Pg   a  l s *LAa =9(  a  "  H l 0Crll ? ̙33O 0 @t8(  td t c $Pg   a  t s *Fa =9(  a  "  H t 0Crll ? ̙33(P 0 `|x(  |d | c $Pg   a  | s *dLa =9(  a  b:What is an equilibrium condition, and what is an identity? ;  H | 0Crll ? ̙33W 0 (  d c $Ph   a  3 r\Ra (e(e#" 0e=9(  a  " H  0Crll ? ̙3380___PPT10.dY 0  (  d  c $Pg   a {  s *pWa =9(  a  Under fixed exchange rates, if CA+NPKI=0, Official Reserve Transactions are 0 and the LM does not move. There cannot be an equilibrium such as CA+NPKI+ORT=0 with ORT different from 0. Under floating exchange rates (so assume ORT=0), CA+NPKI=0 always since the depreciation/appreciation in the foreign exchange market is immediate. Also note: the US is on the BP curve, since up to now the CA deficit has been matched by sufficient NPKI. However, a protracted CA<0 is unsustainable.  H  0Crll ? ̙3380___PPT10.@~z(Z 0   8(   d   c $Pg   a    s *ba =9(  a  " H   0Crll ? ̙3380___PPT10.@~z(] 0  8(  d  c $Pg   a   s *Hha >9(  a  " H  0Crll ? ̙3380___PPT10.V]_ 0  (m(  (d ( c $Pg   a  ( s *ma >9(  a  W/Fluctuation band: 2.25%, raised to 15% in 1993. 0 H ( 0Crll ? ̙3380___PPT10.@~z(` 0 0 08(  0d 0 c $Pg   a  0 s *sa >9(  a  " H 0 0Crll ? ̙3380___PPT10.@~z(a 0 P 88(  8d 8 c $Pg   a  8 s *ya >9(  a  " H 8 0Crll ? ̙3380___PPT10.@~z(b 0 p @8(  @d @ c $Pg   a  @ s *ha >9(  a  " H @ 0Crll ? ̙3380___PPT10.@~z(c 0  H8(  Hd H c $Pg   a  H s *a >9(  a  " H H 0Crll ? ̙3380___PPT10.@~z(d 0  P8(  Pd P c $Pg   `  P s *$` >9(  `  " H P 0Crll ? ̙3380___PPT10.@~z(e 0  X8(  Xd X c $Pg   a  X s *Ha >9(  a  " H X 0Crll ? ̙3380___PPT10.@~z(f 0  `8(  `d ` c $Pg   a  ` s *a >9(  a  " H ` 0Crll ? ̙3380___PPT10.@~z(p 0  8(  d  c $Pg   a   s *8a >9(  a  " H  0Crll ? ̙3380___PPT10.@~z(r 0  8(  d  c $Pg   a   s *4a >9(  a  " H  0Crll ? ̙3380___PPT10.@~zv 0 % (  d  c $Pg   a   s *ԩa >9(  a  ]Jean-Claude Trichet is now (since 2003) the president of the ECB (the European Central Bank).&   K H  0Crll ? ̙3380___PPT10.@~z(w 0 @ 8(  d  c $Pg   a   s *a >9(  a  " H  0Crll ? ̙3380___PPT10.@~z(y 0 p 8(  d  c $Pg   a   s *Da >9(  a  " H  0Crll ? ̙3380___PPT10.@~zz 0  (  d  c $Pg   a   s *a >9(  a  RBeggar-thy-neighbor or competitive devaluations is one of the reasons for the EMU.&   @ H  0Crll ? ̙3380___PPT10.@~z( 0  8(  d  c $Pg   a   s *|a >9(  a  " H  0Crll ? ̙3380___PPT10.V( 0   8(   d   c $Pg   a    s *a >9(  a  " H   0Crll ? ̙3380___PPT10.@~z( 0  8(  d  c $Pg   a   s *la >9(  a  " H  0Crll ? ̙3380___PPT10.@~z( 0 008(  0d 0 c $Pg   a  0 s *a >9(  a  " H 0 0Crll ? ̙3380___PPT10.@~z( 0 D8(  Dd D c $Pg   a  D s *\a >9(  a  " H D 0Crll ? ̙3380___PPT10.@~z( 0 L8(  Ld L c $Pg   a  L s *a >9(  a  " H L 0Crll ? ̙3380___PPT10.@~z( 0 d8(  dd d c $Pg   a  d s *a >9(  a  " H d 0Crll ? ̙3380___PPT10.V( 0 @t8(  td t c $Pg   a  t s *`a >9(  a  " H t 0Crll ? ̙3380___PPT10.@~z( 0 `|8(  |d | c $Pg   a  | s *a >9(  a  " H | 0Crll ? ̙3380___PPT10.@~z( 0 8(  d  c $Pg   a   s *a >9(  a  " H  0Crll ? ̙3380___PPT10.@~z( 0 8(  d  c $Pg   a   s *da >9(  a  " H  0Crll ? ̙3380___PPT10.@~z( 0 8(  d  c $Pg   a   s *a >9(  a  " H  0Crll ? ̙3380___PPT10.@~z 0 1)(  d  c $Pg   a   s *e >9(  a  CIn E2, output is above full employment so prices will start rising.8D ? D H  0Crll ? ̙3380___PPT10.@~z( 0 8(  d  c $Pg   e   s *4 e >9(  e  " H  0Crll ? ̙3380___PPT10.@~z( 0 @8(  d  c $Pg   e   s *e >9(  e  " H  0Crll ? ̙3380___PPT10.@~z> 0 N(  d  c $Ph   e   s *Le >9(  e  8It is preferable to use the words  market value instead of  fundamental value as in Abel and Bernanke s book, because the concept of fundamental value (for the nominal exchange rate) can be misleading. There is no reliable, unilaterally accepted model of exchange rates yet, so how can we talk about a fundamental value of the nominal exchange rate?  Market value is simply what the markets want, the markets evaluation of exchange rate. 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