ECON344-FINC344

International Finance

Week 6

FT – Chapter 18

Exchange Rates &

Macroeconomic Policies
Slides prepared by
April Knill, Ph.D., Florida State
University
This week’s key concepts:

• Demand in the Open Economy

• Goods Market Equilibrium: The

Keynesian Cross

• Goods and Forex Market Equilibria:

Deriving the IS Curve

• Money Market Equilibrium:

Deriving the LM Curve

• The Short-Run IS-LM Model of an

Open Economy

• Stabilization Policy
 Unconventional Monetary Policy

• During the GFC (2007-08), conventional monetary

policy tools were limited for Fed. Why? The zero
lower bound (ZLB) problem, i.e. Fed had no further
room to lower the interest rate, limiting their ability
to conduct monetary policy and causing problems in
the economy.

• To provide additional economic stimulus, the Fed

turned to unconventional monetary policy, adding
balance sheet management.
 Unconventional Monetary Policy

• A large-scale expansion of the Fed’s balance sheet

of approximately 3.6 trillion dollars involved buying
long-term assets, including mortgage-backed
securities and Treasury bonds, with the objective of
lowering long-term interest rates.

• The RBNZ’s balance sheet expansion also outpaced

the Fed in late 2020 and over 2021. The RBNZ
continued to increase its assets through and beyond
August 2022, resulting in the RBNZ’s balance sheet
reaching 318% of its value in the base period.
Large Scale Asset Purchase (LSAP)
Programme in NZ
 Exchange Rate Regimes and
Macroeconomic Policies

• To gain a more complete understanding of how an

open economy works, we now extend our theory
and explore what happens when exchange rates
and output fluctuate in the short run.

• One key lesson you will learn is that the

feasibility and effectiveness of macroeconomic
policies depend crucially on the type of exchange
rate regime in operation.
 Demand in the Open Economy
Preliminaries and Assumptions

• The foreign economy can be thought of as “the

rest of the world” (ROW). The key assumptions
we make are as follows:

 Because we are examining the short run, we

assume that home and foreign price levels, − P and
−
P*, are fixed due to price stickiness. As a result of
price stickiness, expected inflation is fixed at zero,
−
πe = 0. If prices are fixed, all quantities can be
viewed as both real and nominal quantities in the
short run because there is no inflation.
 Demand in the Open Economy

Preliminaries and Assumptions

 We assume that conditions in the foreign
−
economy such as foreign output Y* and the
−
foreign interest rate i* are fixed and taken as
given. Our main interest is in the equilibrium
and fluctuations in the home economy.

 The income Y is equivalent to output: that is,

gross domestic product (GDP).
 Demand in the Open Economy
Consumption
• The simplest model of aggregate private
consumption relates household consumption C to
disposable income Yd.

• This equation is known as the Keynesian

consumption function.
 Demand in the Open Economy
Consumption

The Consumption Function

The consumption function relates private consumption, C, to disposable
⎯
income, Y − T.
The slope of the function is the marginal propensity to consume, MPC.
 Demand in the Open Economy
Investment
• The firm’s borrowing cost is the expected real
interest rate re, which equals the nominal interest
rate i minus the expected rate of inflation πe: re =
i − πe.
• Since expected inflation is zero, the expected
real interest rate equals the nominal interest
rate, re = i.
• Investment I is a decreasing function of the real
interest rate; that is, investment falls as the real
interest rate rises.
• Remember that this is true only because when
expected inflation is zero, the real interest rate
equals the nominal interest rate.
 Demand in the Open Economy
Investment

The Investment Function The investment function relates the quantity of

investment, I, to the level of the expected real interest rate, which
equals the nominal interest rate, i, when (as assumed in this chapter)
the expected rate of inflation, πe, is zero. The investment function slopes
downward: as the real cost of borrowing falls, more investment projects
are profitable.
 Demand in the Open Economy
The Government
• The government’s role is simple. It collects an
amount T of taxes from private households
and spends an amount G on government
consumption of goods and services.

• In the unlikely event that G = T exactly, we

say that the government has a balanced
budget. If T > G, the government is said to be
running a budget surplus (of size T − G); if G
> T, a budget deficit (of size G − T or,
equivalently, a negative surplus of T − G).

−
• Government purchases = G = G
−
Taxes = T = T.
 Demand in the Open Economy
The Trade Balance
• The Role of the Real Exchange Rate If Home’s
exchange rate is E, the Home price level is P −
(fixed in the short run), and the Foreign price
−
level is P*(also fixed in the short run), then the
real exchange rate q of Home is defined as q =
− −
EP*/P.
 We expect the trade balance (difference
between exports and imports) of the home
country to be an increasing function of the
home country’s real exchange rate. That is, as
the home country’s real exchange rate rises
(depreciates), it will export more and import
less, and the trade balance rises.
 Demand in the Open Economy
The Trade Balance
• The Role of Income Levels
 We expect an increase in home income to be
associated with an increase in home imports
and a fall in the home country’s trade balance.
 We expect an increase in rest of the world
income to be associated with an increase in
home exports and a rise in the home country’s
trade balance.
• The trade balance is, therefore, a function of
three variables:
TB TB ( EP* 
/ P , Y T , Y * T *
 )
Increasing Decreasing Increasing
function function function
 Demand in the Open Economy
The Trade Balance

The Trade Balance and the Real Exchange Rate

The trade balance is an increasing function of the real exchange rate,
⎯ ⎯
EP*/P.
When there is a real depreciation (a rise in q), foreign goods become more
expensive relative to home goods, and we expect the trade balance to
increase as exports rise and imports fall (a rise in TB).
 Goods Market Equilibrium: The
Keynesian Cross
Supply and Demand
Aggregate demand, or just “demand,” consists of
all the possible sources of demand for this supply
of output.
Supply = GDP Y

Substituting we have
Demand = D C  I G  TB

D C(Y  T )  I(i) G  TBEP * / P ,Y  T ,Y *  T * 

The goods
 market equilibrium condition is

 
Y  C (Y  T )  I (i )  G  TB EP * / P , Y  T , Y *  T *
                    

D
Deriving the IS Curve

Deriving the IS Curve

The Keynesian cross is in
panel (a), IS curve in panel
(b), and forex (FX) market in
panel (c).
The economy starts in
equilibrium with output, Y1;
interest rate, i1; and exchange
rate, E1.
Consider the effect of a
decrease in the interest rate
from i1 to i2, all else equal. In
panel (c), a lower interest rate
causes a depreciation;
equilibrium moves from 1′ to
2′.
Equilibrium in Two Markets

Deriving the IS Curve

(continued)
A lower interest rate boosts
investment and a depreciation
boosts the trade balance.
In panel (a), demand shifts up
from D1 to D2, equilibrium
from 1” to 2”, output from Y1
to Y2.
Deriving the IS Curve

Deriving the IS Curve

(continued)
In panel (b), we go from point
1 to point 2. The IS curve is
thus traced out, a downward-
sloping relationship between
the interest rate and output.
When the interest rate falls
from i1 to i2, output rises from
Y1 to Y2.
The IS curve describes all
combinations of i and Y
consistent with goods and FX
market equilibria in panels (a)
and (c).
Deriving the IS Curve

• One important observation is in order:

In an open economy, lower interest rates stimulate demand
through the traditional closed-economy investment channel
and through the trade balance.

The trade balance effect occurs because lower interest rates

cause a nominal depreciation (in the short run, it is also a
real depreciation), which stimulates external demand via the
trade balance.

• The IS curve is downward-sloping. It illustrates the negative

relationship between the interest rate i and output Y.
Summing Up the IS Curve

IS IS(G,T ,i * , E e , P*, P)
Factors That Shift the IS Curve up: (since the demand curve D shifts up)



The opposite changes lead to a decrease in demand and shift the demand
curve down and the IS curve to the left.
Money Market Equilibrium
• We derive a set of combinations of Y and i that ensures
equilibrium in the money market, a concept that can be
represented graphically as the LM curve.

Money Market Recap

• In the short-run, the price level is assumed to be sticky at a
–
level P, and the money market is in equilibrium when the
demand for real money balances L(i)Y equals the real money
–
supply M/P:
Deriving the LM Curve

Deriving the LM Curve (continued)

The relationship thus described between the interest rate and income, all else equal, is known as
the LM curve and is depicted in panel (b) by the movement from point 1 to point 2. The LM curve
is upward-sloping: when the output level rises from Y1 to Y2, the interest rate rises from i1 to i2. The
LM curve describes all combinations of i and Y that are consistent with money market equilibrium
in panel (a).
Summing Up the LM Curve

LM LM (M / P )



Shifts the LM Curve down (or right)

The opposite changes lead to an upward (leftward) shift of the LM curve.

The Short-Run IS-LM-FX Model of an Open Economy

Equilibrium in the IS-LM-FX Model

The domestic return, DR, in the forex market equals the money market interest rate.
Equilibrium is at point 1′ where the foreign return FR equals domestic return, i.
• Closed economy IS-LM model
– (Hicks-Hansen)
– John Hicks, Nobel Prize in 1972

• Open economy IS-LM model

– (Mundell-Fleming)
– Robert Mundell, Nobel Prize in 1999
 Macroeconomic Policies in the Short Run

• We focus on the two main policy actions:

• changes in monetary policy, implemented through changes in the
money supply
• changes in fiscal policy, involving changes in government
spending or taxes

• The effects of these policies are evaluated under two types of

exchange rate regimes:
• Floating or flexible exchange rate regime
• Fixed exchange rate regime
 Monetary Policy under Floating Exchange Rates

Monetary Policy under Floating Exchange Rates

The lower interest rate implies that the exchange rate must depreciate, rising from E1 to E2.
As the interest rate falls (increasing investment, I) and the exchange rate depreciates (increasing
the trade balance), demand increases, which corresponds to the move down the IS curve from point
1 to point 2’.
Output expands from Y1 to Y2. The new equilibrium corresponds to points 2 and 2′.
 Monetary Policy under Floating Exchange Rates

To sum up:

A temporary monetary expansion under floating exchange rates

is effective in combating economic downturns by boosting
output. It raises output at home, lowers the interest rate, and
causes a depreciation of the exchange rate.
 Monetary Policy under Fixed Exchange Rates

Monetary Policy under Fixed Exchange Rates

In panel (a) in the IS-LM diagram, the goods and money markets are initially in equilibrium at
point 1. In panel (b), the forex market is initially in equilibrium at point 1′.
A temporary monetary expansion that increases the money supply from M1 to M2 would shift the
LM curve down in panel (a).
 Monetary Policy under Fixed Exchange Rates

Monetary Policy under Fixed Exchange Rates (continued)

In panel (b), the lower interest rate would imply that the exchange rate must depreciate, rising from
E1 to⎯ ⎯ depreciation is inconsistent with the pegged exchange rate, so the policy makers
E2. This
cannot move LM in this way.
They must leave the money supply equal to M1. Implication: under a fixed exchange rate,
autonomous monetary policy is not an option.
 Monetary Policy under Fixed Exchange Rates

To sum up:

Monetary policy under fixed exchange rates is impossible to

undertake. Fixing the exchange rate means giving up monetary
policy autonomy.
Countries cannot simultaneously allow capital mobility,
maintain fixed exchange rates, and pursue an autonomous
monetary policy.
 Fiscal Policy under Floating Exchange Rates

Fiscal Policy under Floating Exchange Rates

In panel (a) in the IS-LM diagram, the goods and money markets are initially in equilibrium at
point 1.
The interest rate in the money market is also the domestic return, DR1, that prevails in the forex
market. In panel (b), the forex market is initially in equilibrium at point 1′.
 Fiscal Policy under Floating Exchange Rates

Fiscal Policy under Floating Exchange Rates (continued)

A temporary fiscal expansion that increases government spending from G1 to G2 would shift the IS
curve to the right in panel (a) from IS1 to IS2, causing the interest rate to rise from i1 to i2.
The domestic return shifts up from DR1 to DR2.
 Fiscal Policy under Floating Exchange Rates

Fiscal Policy under Floating Exchange Rates (continued)

In panel (b), the higher interest rate would imply that the exchange rate must appreciate, falling
from E1 to E2.
The initial shift in the IS curve and falling exchange rate corresponds in panel (a) to the movement
along the LM curve from point 1 to point 2. Output expands Y1 to Y2. The new equilibrium
corresponds to points 2 and 2’.
 Fiscal Policy under Floating Exchange Rates

As the interest rate rises (decreasing investment, I) and the

exchange rate appreciates (decreasing the trade balance),
demand falls. This impact of fiscal expansion is often referred
to as crowding out. That is, the increase in government
spending is offset by a decline in private spending.

Thus, in an open economy, fiscal expansion crowds out

investment (by raising the interest rate) and decreases net
exports (by causing the exchange rate to appreciate). Over time,
it limits the rise in output to less than the increase in
government spending.
 Fiscal Policy under Floating Exchange Rates

To sum up:

An expansion of fiscal policy under floating exchange rates

might be temporary effective. It raises output at home, raises
the interest rate, causes an appreciation of the exchange rate,
and decreases the trade balance. It indirectly leads to crowding
out of investment and exports, and thus limits the rise in output
to less than an increase in government spending.
(A temporary contraction of fiscal policy has opposite effects.)
 Fiscal Policy under Fixed Exchange Rates

Fiscal Policy under Fixed Exchange Rates

In panel (a) in the IS-LM diagram, the goods and money markets are initially in equilibrium at
point 1. The interest rate in the money market is also the domestic return, DR1, that prevails in the
forex market. In panel (b), the forex market is initially in equilibrium at point 1′.
 Fiscal Policy under Fixed Exchange Rates

Fiscal Policy under Fixed Exchange Rates (continued)

⎯ ⎯
A temporary fiscal expansion on its own increases government spending from G1 to G2 and would
shift the IS curve to the right in panel (a) from IS1 to IS2, causing the interest rate to rise from i1 to
i2.
The domestic return would then rise from DR1 to DR2.
 Fiscal Policy under Fixed Exchange Rates

Fiscal Policy under Fixed Exchange Rates (continued)

In panel (b), the higher interest rate would imply that the exchange rate must appreciate, falling
⎯
from E to E2. To maintain the peg, the monetary authority must now intervene, shifting the LM
curve down, from LM1 to LM2. The fiscal expansion thus prompts a monetary expansion.
In the end, the interest rate and exchange rate are left unchanged, and output expands dramatically
from Y1 to Y2. The new equilibrium is at to points 2 and 2′.
 Summary

To sum up:
A temporary expansion of fiscal policy under fixed exchange
rates raises output at home by a considerable amount. (The case
of a temporary contraction of fiscal policy would have similar
but opposite effects.)
 Stabilization Policy

• Stabilization policy refers to the use of monetary or fiscal

policies to keep the economy at (or near) its full-employment
level of output.
• If the economy is hit by a temporary adverse shock,
policy makers could use expansionary monetary and
fiscal policies to prevent a deep recession.
• Conversely, if the economy is pushed by a shock above
its full employment level of output, contractionary
policies could tame the boom.
• Example:
• Australia and New Zealand in 1997
• Demand management Asian financial crisis
 Australia, New Zealand, and the Asian Crisis of 1997

Stabilization Policy under Floating Exchange Rates

In panel (a) in the IS-LM diagram, the goods and money markets are initially in equilibrium at
point 1.
The interest rate in the money market is also the domestic return, DR1, that prevails in the forex
market.
In panel (b), the forex market is initially in equilibrium at point 1′.
 Australia, New Zealand, and the Asian Crisis of 1997

Stabilization Policy under Floating Exchange Rates (continued)

An exogenous negative shock to the trade balance (e.g., due to a collapse in foreign income)
causes the IS curve to shift in from IS1 to IS2.
Without further action, output and interest rates would fall and the exchange rate would tend to
depreciate.
 Australia, New Zealand, and the Asian Crisis of 1997

Stabilization Policy under Floating Exchange Rates (continued)

The central bank can stabilize output at its former level by responding with a monetary policy
expansion, increasing the money supply from M1 to M2. This causes the LM curve to shift down
from LM1 to LM2.
The new equilibrium corresponds to points 3 and 3′. Output is now stabilized at the original level
Y1. The interest rate falls further. The domestic return falls from DR1 to DR2, and the exchange rate
depreciates all the way from E1 to E2.
 Australia, New Zealand, and the Asian Crisis of 1997

Demand Shocks Down Under

Australian and New Zealand exports were likely to be badly hit after the 1997 Asian crisis as the
incomes of their key trading partners contracted. Both countries were operating on a floating
exchange rate, however. To bolster demand, the central banks in both countries pursued an
expansionary monetary policy, lowering interest rates, as shown in panel (a), and allowing the
domestic currency to depreciate about 30% in nominal terms, as shown in panel (b).
 Australia, New Zealand, and the Asian Crisis of 1997

Demand Shocks Down Under (continued)

This contributed to a real depreciation of about 20% to 30% in the short run, panel (c). As a result,
the trade balance of both countries moved strongly toward surplus, illustrated in panel (d), and thus
demand was higher than it would otherwise have been. In each country, a recession was avoided.
 Global Financial Crisis

• To a first-order of approximation, it can be interpreted as a

negative demand shock in deficit countries (US, UK, etc.)

“The 40% decline in the US stock market and the dramatic

fall in house prices have reduced American households’
wealth by more than $10 trillion, which is likely to reduce
annual consumer spending by more than $400 billion. And
the collapse of housing starts has lowered construction
spending by another $200 billi on”
(Martin Feldstein, Harvard, 2009)

• Countries applied textbook Keynesian policies: monetary and

fiscal stimulus
 Global Financial Crisis

• There are limits to monetary stimulus

• Not feasible? Zero bound on nominal interest rate
(liquidity trap)
• By default, a lot of the burden of the adjustment fell on
fiscal stimulus
• Real exchange rate adjustments necessary, but resistance
(dollar/renminbi, intra-euro imbalances)

• Required medium to long-run adjustments

• Rebalancing global demand (lower saving in surplus
countries, higher saving in deficit countries)
• Can be achieved by real exchange rate adjustments and
structural policies affecting saving
• Tension between short-run Keynesian stabilization
remedies and medium- to long-run adjustment policies.