Chapter 23
FLOATING EXCHANGE RATE AND INTERNAL BALANCE

Overview

This chapter presents the analysis of the macroeconomy of a country that has a floating exchange rate. If government officials allow the exchange rate to float cleanly, then the exchange rate changes to achieve external balance.

With floating exchange rates monetary policy exerts strong influence on domestic product and income. A change in monetary policy results in a change in the country's interest rates. Both the current account and the capital account tend to change in the same direction. To keep the overall payments in balance, the exchange rate must change. The exchange rate change results in a change in international price competitiveness, assuming that it is larger or faster than any change in the country's price level-overshooting. The change in price competitiveness results in a change in net exports that reinforces the thrust of the change in monetary policy. We can picture the change in monetary policy as a shift in the LM curve, and then a shift in the IS and FE curves to a new triple intersection as the exchange rate and price competitiveness change.

With floating exchange rates the effect of a change in fiscal policy depends on how responsive international capital flows are to changes in interest rates. If capital flows are sufficiently responsive, then the exchange rate changes in the direction that counters the thrust of the fiscal policy change-an effect sometimes called international crowding out. If capital flows are not that responsive (or as we enter into the longer time period when the capital flows have slowed), the change in the current account dominates, so that the exchange rate changes in the direction that reinforces the thrust of the fiscal policy change. Both cases are shown as a shift in the IS curve, with the position of the intersection between the new IS curve and the LM curve being above or below the initial FE curve, depending on how flat or steep the FE curve is. The exchange rate change then shifts both the IS and FE curves toward a new triple intersection.

Domestic monetary shocks have strong effects on domestic product, with the exchange rate change reinforcing the thrust of the shock. The effects of domestic spending shocks depend on how responsive international capital flows are to changes in interest rates. International capital flow shocks affect the domestic economy by changing the exchange rate and the country's international price competitiveness. International trade shocks result in changes in the exchange rate that mute the effects of the shocks on domestic product.

While a cleanly floating exchange rate assures external balance, it does not assure internal balance, and changes in the floating exchange rate to achieve external balance can exacerbate an internal imbalance. Government monetary or fiscal policies may be used to address internal imbalances.

Changes in government policies adopted by one country can have spillover effects on other countries. International macroeconomic policy coordination involves some degree of joint determination of several countries' macroeconomic policies to improve joint performance. Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts at coordination are infrequent. Countries disagree about goals and about how the macroeconomy works, and the benefits of coordination often are probably rather small.

The box on "Can Governments Manage the Float?" discusses whether selective intervention which is often sterilized can have significant effects on floating exchange rates between the major currencies. The conventional wisdom in the early 1980s was that sterilized intervention was ineffective. By the early 1990s several studies concluded that interventions were often successful in having a noticeable impact on the time path of the exchange rate. Intervention to manage floating exchange rates appears to be effective some but not all of the time.

Objectives of the Chapter

From the discussion of stabilization policy under fixed exchange rates, it appears that when the economy finds itself in one of the two cases of aggregate demand-policy dilemma explored in Chapter Twenty Two, letting the exchange rate float freely (rather than attempting to juggle monetary and fiscal policies) would solve all our troubles. Since external balance would automatically be assured, we would just have to worry about tuning monetary policy and fiscal policy for internal balance. However, the exchange rate movements that achieve external balance will have a feedback effect on our domestic economy and internal balance.

This chapter compares the effectiveness of monetary and fiscal policies under different exchange rate regimes and the relative ease of stabilizing national income in a country beset by various domestic and foreign shocks.

After studying Chapter Twenty-three you should know:

1. The effectiveness of monetary policy under flexible rates.
2. The effectiveness of fiscal policy under flexible rates.
3. Which exchange rate regime performs better in the face of internal shocks.
4. Which exchange rate regime performs better in the face of external shocks.

Key Terms

G-7 countries: Canada, France, Germany, Great Britain, Italy, Japan and the United States. These countries first coordinated to intervene in exchange rate markets with the Plaza Accord in 1985. Sometimes referred to as G-8 when Russia is included.
International macroeconomic The joint determination of several countries' macroeconomic policy coordination: policies to improve joint performance. An example is the 1987 Louvre Accord among the G-7 countries.

Warm-up Questions

True or False? Explain

1. T / F The impact of fiscal policy under floating exchange rates depends on the degree of international capital mobility.

True

2. T / F Erratic monetary policy will cause more disruptions under a flexible exchange rate regime than under a fixed exchange rate regime.

True

3. T / F When exchange rates float, foreign trade shocks are more disruptive to the domestic economy.

False.  The shock would be less disruptive

4. T / F International macroeconomic policy coordination is a frequently and successfully used tool among western countries.

False

5. T / F Under floating exchange rates an increase in foreign interest rate can cause our exports to rise because it causes our currency to depreciate.

True

Multiple Choice

1. In the short run under floating exchange rates expansionary fiscal policy:

A. Causes a depreciation of the home currency.
B. Causes an appreciation of the home currency.
C. May cause a depreciation or an appreciation of the home currency.
D. Has no effect on the value of a home currency.

2. Generally success of the exchange rate regime a country adopts to stabilize its economy depends on:

A. Volume of trade.
B. The success of sterilization policies.
C. Type of shocks to which the economy is more vulnerable.
D. The economic power of the country.

3. A fixed exchange rate regime with no sterilization offers the most protection against:

A. Export demand shocks.
B. Domestic monetary shocks.
C. Import supply shocks.
D. International capital flow shocks.

4. If the people who run the monetary policy of a country are inept and erratic, a good way to protect the domestic economy would be to have a:

A. Big jail and put the monetary authorities in it.
B. Fixed exchange rate regime.
C. Flexible exchange rate regime.
D. Barter economy.

5. International macroeconomic policy coordination has been infrequent because:

A. People speak different languages, making meetings difficult.
B. Countries do not always agree on goals that are mutually consistent.
C. The gains to coordination may be small.
D. All of the above.

Problems

1. Recall that Saxony was suffering from a trade deficit and an income level that put inflationary pressure on the economy. Suppose the Saxon prime minister decides to surrender fixed exchange rates and let the scudo float instead.

a. What will happen to the exchange rate in order to achieve external balance?
b. How will that exchange rate movement affect internal balance in Saxony? If the prime minister wants to reduce income level in Saxony using aggregate demand policy:
c. What will be the impact on internal balance of a contractionary monetary policy?
d. What will be the impact on internal balance of a contractionary fiscal policy?

2. Government officials like the prime minister tend to put the Saxon economy through frequent political business cycles. If you are interested in protecting the level of income in Saxony from such election-year gyrations, would you suggest that Saxony choose a fixed exchange rate regime or a floating regime?

3. Suppose the residents of Leinster believe the Saxon government is about to fall (perhaps due to Saxon citizens' dissatisfaction over inept policy). As a result Leinsterians pull all their funds out of Saxony. What would be the impact of the Saxon economy if:

a. Saxony has a floating exchange rate.
b. Saxony has a fixed exchange rate.

4. Consider a country which is currently at its desired level of income. Determine whether the following events will cause the least fluctuation in domestic income away from the desired level: under a fixed exchange rate or under a floating exchange rate:

a. An increase in the country's exports.
b. An increase in the country's domestic money supply.
c. An increase in the flow of capital out of the country.
d. An increase in tax rates.
e. An increase in the country's imports.
f. An increase in the country's saving rate.

5. Below are drawn the IS-LM-FE curves for Leinster.

 Durmg a month-long celebration when citizens honor their patron saint Padraic, domestic spending rises dramatically. What would be the impact of this on the economy of Leinster if:

a. The exchange rate on the lira is fixed with unsterilized intervention.

b. The exchange rate on the lira is fixed with sterilized intervention.

c. The exchange rate on the lira floats.  

Suggested answers to questions and problems (in the textbook)

2. The increase in government spending affects both the current account and the capital account of the country's balance of payments. The increase in government spending increases aggregate demand, production, and income. The increase in income and spending increases the country's imports, so the current account tends to deteriorate (become a smaller positive value or a larger negative value). The increase in production, income, and spending also increases the demand for money. If the country's central bank does not permit the money supply to expand, then interest rates increase. (Similarly, the increase in the government budget deficit requires the government to borrow more to finance its deficit, increasing interest rates.) The increase in interest rates increases the inflows of financial capital into the country (and decreases outflows), so that the capital account tends to improve.

The effect of this policy change on the exchange rate value of the country's currency depends on the effect on the official settlements balance. However, we are not sure about the effect of the policy change on the country's official settlements balance. It depends on the sizes of the changes in the two accounts. If the capital account improvement is larger (as we often expect in the short run), then the official settlements balance tends to go into surplus. If the current account deterioration is larger (as we often expect in the long run), then the official settlements balance tends to go into deficit.

If the official settlements balance tends to go into surplus, then the exchange rate value of the country's currency appreciates. The country loses international price competitiveness, and net exports tend to decrease. This reduces the expansionary thrust of the increase in government spending.

If the official settlements balance tends to go into deficit, then the exchange rate value of the country's currency depreciates. The country gains international price competitiveness, and net exports tend to increase. This reinforces the expansionary thrust of the increase in government spending. 4. The decrease in demand for money tends to reduce domestic interest rates. The lower domestic interest rates encourage borrowing and spending, so domestic product and income increase because of the increase in domestic expenditure. The country's current account tends to deteriorate because the increase in domestic product and income increases imports. In addition, the country's capital account tends to deteriorate, because the lower domestic interest rates encourage a capital outflow. As the country's official settlements balance tends to go into deficit, the exchange rate value of the country's currency depreciates. The country gains international price competitiveness, and net exports tend to increase. This reinforces the expansion of domestic product and income.

Under fixed exchange rates, the central bank instead must resist the downward pressure on the exchange rate value of the country's currency by intervening in the foreign exchange market the central bank must buy domestic currency and sell foreign currency. In buying domestic currency, the central bank reduces the domestic money supply (assuming that it does not sterilize). The contraction of the domestic money supply tends to counter the initial expansion of domestic product and income.

6. a. The contractionary monetary policy increases domestic interest rates, so borrowing and spending decrease. Domestic product and income tend to decline. The decline in demand puts downward pressure on the British inflation rate.

b. The increase in British interest rates draws a capital inflow, so Britain's capital account tends to improve. The decrease in British product and income reduces imports, so Britain's current account tends to improve. Thus, Britain's overall payments tend to go into surplus, so the exchange rate value of the pound tends to increase (the pound tends to appreciate).

c. As the pound appreciates, Britain tends to lose international price competitiveness (assuming overshooting-the currency appreciation occurs more quickly than the decline in the British inflation rate). British net exports tend to decline. This reinforces the contractionary thrust of British monetary policy on domestic product and income. In addition, it also reinforces the downward pressure on the British inflation rate, both because demand declines further, and because the appreciation tends to reduce the British pound prices of imports into Britain.

8. The increase in the foreign money supplies tends to lower foreign interest rates. The lower foreign interest rates spur borrowing and spending in foreign countries. The increase in foreign product and income increases the demand for imports, so our exports increase. In addition, the exchange rate values of foreign currencies decline, so that our currency appreciates. Foreign currencies depreciate because the overall foreign payments tend to go into deficit. The foreign current accounts tend to decline as foreign imports increase, and the foreign capital accounts tend to decline as the lower foreign interest rates spur capital outflows. The appreciation of our currency lowers our international price competitiveness, so our net exports tend to decrease. This counters the more direct effect of changes in international trade on our domestic product and income. This is an example of how floating exchange rates tend to reduce the domestic impact of an international shock, in this case a foreign monetary shock.

10.

 

 a. The increase in foreign demand for exports shifts the IS curve to the right to IS' in the accompanying graph. The shock increases demand for the country's products, so domestic product and income tend to rise. The increase in foreign demand for exports shifts the FE curve to the right also, to FE'. At the initial level of income and domestic product, the current account and the overall payments balance go into surplus. A zero balance can be reestablished on the new FE' curve by increasing imports through an increase in domestic product and income. The LM curve is not directly affected, if this shock does not directly change money supply or money demand.

b. The rightward shift of the IS curve results in a new IS'-LM intersection at E' with some increase in the level of domestic product. The increase in domestic product and income also increases the country's imports. To proceed, let's examine the "normal" case in which the country then tends to have a current account and overall payments surplus, because the increase in exports is larger than the initial increase in imports. This means that the intersection of the original LM curve and the new IS' curve is to the left of the new FE' curve. If the country's official settlements balance tends to go into surplus, then the exchange rate value of country's currency appreciates.

c. The currency appreciation reduces the country's international price competitiveness, and the country's net exports decrease. As the reduction in net exports reduces demand for the country's domestic product, the IS' curve shifts back toward the original IS curve. As the current account declines with the loss of price competitiveness, the FE' curve shifts back toward the original FE curve. If nothing else fundamental changes, then the curves shift back to their original positions, and the new triple intersection is back to the original one at E. There may be little or no effect on internal balance of all of this taken together (the international trade shock in favor of the country's exports plus the appreciation of the country's currency).