The Chinese currency for Macro econ Class

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Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

12 Income, Money and Interest Rates under Fixed and Partially Fixed Exchange Rates

Overview

In this chapter, we learn:

●●● How interest rates determine investment spending

●●● What money is, and how the supply and demand for money is determined

●●● How equilibria in the real and financial sides of the economy are determined

●●● How fiscal and monetary policies affect output and interest rates

●●● How external equilibrium is defined, and what determines it

●●● What fixed exchange rates imply for monetary policy

●●● How fiscal, monetary and exchange rate policy affect output, exchange and interest rates.

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

12.1 Introduction In November 2013, in the face of capital outflows and a weakening currency, the Russian central bank raised interest rates, and intervened in the foreign exchange market, buying up rubles with their holdings of US dollars.

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.032

.034

M 1

M 2

M 3

M 4

M 5

M 6

M 7

M 8

M 9

M 1

M 2

M 3

M 4

M 5

M 6

M 7

M 8

M 9

M 1

2013 2014

USD/RUB [left scale]

7-day repo (%) [right scale]

Chart 12.1: The US dollar/Russian ruble exchange rate (1/S) (blue, down is a depreciation), and the Russian overnight interest rate (red). Why did policymakers think these actions would work to stem the flow of capital out of the country? What were the consequences of these measures? We can’t answer that question without a model of why and how interest rates are determined, and how higher interest rates affect capital flows. In this chapter and the next, we develop an integrated model of how the economy interacts with the rest of the world, where savings can move across borders, and the value of the currency can change. To begin with, we examine how the economy behaves when the central bank commits to keeping the exchange rate pegged at a certain value (or close to a certain value). 12.2 Describing an Economy with Money and Interest Rates: IS-LM In order to analyze the role of the financial sector, we modify the model discussed in Chapter 11. That requires that at least one component of aggregate demand depends on a financial sector variable. What we’ll do is to let investment in physical capital (factories and equipment) depend

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

on the interest rate. Hence, on the real side of the economy, everything remains the same as in Chapter 11, except for the investment function. (12.1) ̅ The parameter -b is the interest sensitivity of investment, and indicates the change in investment spending for a one percentage point change in the interest rate. This equation indicates that firms always undertake a certain amount of investment ( I ) which changes in ways that are determined by factors outside of the model. For instance, a sudden increase in optimism regarding future sales by firm owners might spur greater purchases of plant and equipment in anticipation of these greater sales. The other part of the equation indicates that the higher the interest rate on paper assets, the lower the rate of investment. Why does investment spending have this relationship with the interest rate? One can think of the choices facing the owner of a firm. She has two options: either put the firm’s savings in a bank, or spend on new factories or machinery. Each investment option yields a rate of return – one is the interest rate received from the bank and the other the rate of return on the new piece of machinery or new factory. The higher the interest rate, the higher the opportunity cost of investment spending, and hence the less investment spending undertaken. This might be easier to see if one considered all the projects a firm k faces. Let’s rank the projects from the highest rate of return (RoR) to lowest rate of return.

Figure 12.1: Investment projects and rates of return facing firm k, and interest rates To understand the motivation for equation 12.1, consider the choices facing firm k. It has to determine the amount of investment to undertake. When the interest rate it faces is i0, then the projects from 0 to the eight, totaling an amount of Ik0 , provide a rate of return in excess of the interest rate -- the return the firm would gain from putting the funds in the bank. The firm will therefore find it to its advantage to invest in all the projects up to Ik0.

i, RoR

Ik0 Ik1

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

When the interest rate facing the firm rises to i1 (the white arrow) but the firm faces the same set of investment projects to decide amongst, then only the top three projects exceed the interest rate. The firm will now only proceed on these projects totaling Ik1, which is less than the original amount of Ik0. Investment spending by the firm declines (the thin arrow). To summarize, there is a negative relationship between interest rates and investment spending in plant and equipment at the firm level. The same holds true when one aggregates up to the economy level, since all the firms face a similar decision. Now we turn to incorporating this negative relationship into the solution for equilibrium income in Chapter 11. But because investment depends on the interest rate, rather than taking a single value, the resulting expression will be a combination of points. Solving out for income leads to the following expression, relating the income to the interest rate. (12.2) ̅ <IS curve> Notice that this looks very similar to equation (11.12), except that now there is a “-bi” term. This seems like a small difference, but conceptually, it’s very important. This expression, called the IS curve, means that for lower levels of interest rates, investment, a component of aggregate demand, is higher, and thus income is also higher. The IS curve is also drawn for a given level of autonomous spending and a given level of the exchange rate (which is why there is a bar over the real exchange rate). Since the interest rate is free to move, there is a different equilibrium income for each given interest rate. Thus (12.2) is an expression for a line, rather than a specific value (that’s why there is no “0” subscript on Y). Now to introducing money. It’s useful to spend a moment discussing how money differs from income, even though in everyday discussion we use the terms interchangeably. Essentially, what we are doing is to decompose the economy into a real sector (what we spent Chapter 11 and the preceding part of this chapter discussing) and a financial sector. To model the financial sector, we make a big simplification by assuming there are only two assets: money and bonds.1 Then, under the proper assumptions, the financial sector equilibrium can be characterized by the money market, so that we don’t need to separately keep track of the bond market as well.2 The two assets are distinguished in the following way. Money is an asset that is useful for transactions, but yields no returns. Bonds, in contrast, are not useful for transactions, but provide a return, in this case the interest rate i. In reality, there is no sharp dividing line between money and bonds – savings accounts pay interest, but are pretty easy to convert to cash that can be used to make purchases.

1 We also make the assumption that all the private sector liabilities net out with the private sector assets. For instance, the corporate bond (liability) issued by General Motors and held by Citibank (an asset) wash out, so we don’t need to keep track of them. 2 If the price elasticity of bonds is infinite, so that all government bonds issued are demanded at a given price, then the only market that has to be tracked in order to know if the financial sector is in equilibrium is the money market.

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Equilibrium in the money market is described by the standard quantity demanded equals quantity supplied condition:

(12.3)

Money supply is assumed to be given exogenously, set by the central bank. That means that the number of pieces of paper called money is a fixed number (which changes when the central bank decides to increase or decrease the number of pieces of paper). That’s why we put an overbar over the M.3

(12.4)

Money demand is a positive function of income and a negative function of the interest rate.

(12.5)

Money demand rises with income because it is assumed that the number of transactions rises with income. Recall, the only way one can make transactions is using money, hence the positive relationship. The parameter k is the income sensitivity of money demand, the change in dollars of money demanded for a one unit change in real income. The parameter -h is the interest sensitivity of money demand, the change in dollars demanded when the interest rate rises by one percentage point. Why does money demand depend negatively on the interest rate? It’s because the interest rate is the return on the alternative asset (bonds), and so it serves as the opportunity cost of holding money. As the return on bonds goes up, one holds less money. Substitute (12.4) and (12.5) into (12.3) and solve for the interest rate to yield:

(12.6) <LM curve>

The LM curve represents the combinations of income levels and interest rates such that the money market (and hence the bond market) is in equilibrium. It’s a positive relationship because higher income levels are associated with higher money demand levels which, with a given money supply, implies a higher interest rate to equilibrate the market. There are two unknowns, and two equations. To determine equilibrium income and interest rates, we can solve the system by substituting one equation into the other. The answer is given in equation (12.7): 3 Since we are holding the price level constant, an overbar is also placed over the variable P as well.

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

(12.7) ̅ where ≡

Notice that equilibrium income now depends on the level of autonomous spending, the real exchange rate, and the money stock (in real terms). The equilibrium interest rate is a complicated function of autonomous spending, real exchange rate and the money stock. The equilibrium income level and interest rate is depicted in Figure 12.1:

Figure 12.1: IS-LM equilibrium Equilibrium income and interest rates are determined by the intersection of the two curves. Note the following aspects of these curves:

 The position of the IS curve depends upon , , , . Increases in , , shift out the IS curve, while an increase in shifts in the curve.

 The position of the LM curve depends upon the real money stock, ( / ). An increase in

shifts down (or out) the LM curve. Only at the combination of i0 and Y0 is it true that both the goods market and the money market are in equilibrium. It’s easiest to explain the intuition for the IS-LM model by showing how policy works in model. First we’ll consider fiscal policy (as discussed in Chapter 11), second, monetary policy and finally, exchange rate policy.

Y0 Y

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

The increase in government spending increases autonomous spending (remember ̅ is part of ̅); initially GDP rises by ΔG = ΔA. But the increase in GDP means that more goods have to be produced, and production requires that the factors of production have to be paid. With the resulting income, households have higher disposable income, a portion of which they consume. In the absence of any other effects, the multiplier chain described in Chapter 11 would occur – each real dollar increase in government spending, yields a stream of increases in spending of 1+c+c2+c3+c4+… > 1 (ignoring imports and investment). In Figure 12.2, the government spending increase shows up as the outward shift of the IS curve (gray arrow); if interest rates were to stay constant, income would rise to Y’0. However, we can’t just ignore what happens to investment spending. In particular, we know that investment depends on the interest rate, and it’s possible that the interest rate could change in response to the increase in government spending. In fact, it’s very likely that interest rates will change. Recall that money demand depends on income. As GDP and income rises (due to the above mechanism), the quantity of money demanded rises. However, the central bank is assumed to hold the money supply constant. If at the beginning, the quantity of money demanded equaled the quantity of money supplied (i.e., the economy was on the LM curve), then under new conditions and the old interest rate, the quantity of money demanded would have to exceed the quantity of money supplied. Hence, the interest rate would have to be higher in order to re- equilibrate the quantity of money demanded to the (fixed) quantity of money supplied.

Figure 12.2: Expansionary fiscal policy in IS-LM

Y0 Y

(higher gov’t spending)

Y’0Y1

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Due to the higher interest rate, income does not rise to Y’0 (which would have been the case using the model in Chapter 11) but only to Y1. Equivalently, the increase in output G̂ is smaller than that which would have been implied by the simple Keynesian multiplier ( G ). The reason the increase in output is less in this model is because of “crowding out” due to the heightened transactions demand for money. Let’s trace out the chain of events: Higher output (due to higher government spending) leads to higher money demand which, given a constant money supply, results in a higher interest rate. The higher interest rate depresses investment spending, thereby offsetting in part the increase in output. Notice that, unless the LM curve is vertical, or the IS curve is perfectly flat, output increases. Now we turn to monetary policy. In this model, monetary policy involves changes in money supply.4 If M increased when P is constant, then M/P rises, and the LM shifts out rightward (shown by the gray arrow in Figure 12.3).

Figure 12.3: Expansionary monetary policy in IS-LM When the quantity of money supplied increases, at the original income levels and interest rates, an excess quantity of money supplied occurs (remember, before the change in monetary policy, the quantity of money demanded equals quantity of money supplied, since the economy was on the LM curve). That means that interest rate has to change in order to induce households and firms to hold the additional dollars that are now circulating. Since the interest rate is the

4 In the real world, monetary policy is often described as a change in the interest rate that the central bank controls. An increase in the money supply, holding everything else constant, is the same as a decrease in that interest rate.

Y0 Y

(higher money supply)

i’0

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

opportunity cost of holding money, the interest rate must decline to re-equilibrate the money market. Holding income constant, the interest rate would have to fall to i’0. That however, is not the end of the story. The lower interest rate results in a higher level of investment spending, thus a higher level of aggregate demand and hence output (which in turn induces some additional money demand). Interest rates end up at i2, and income at Y1. To sum up, expansionary monetary policy works by driving down interest rates and hence spurring investment which, by the multiplier process, increases income. Finally, we examine the impact of exchange rate policy. Consider a devaluation of the exchange rate. This spurs net exports (an increase in exports and a decrease in imports), which results in an increase in aggregate demand. This shifts out the IS curve in Figure 12.4 (gray arrow), resulting in an increase in output.

Figure 12.4: Exchange rate devaluation in IS-LM A way to determine the magnitude of output changes is to relate the change to changes in the policy variables. Take equation (12.7), and break it up into the constituent changes (i.e., take a total differential):

(12.8) ∆ ∆ ∆ ∆ ∆ ∆

Y0 Y

(weaker currency)

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

The change in income or GDP can be attributed to changes in the amount of autonomous spending (like the part of investment that doesn’t depend on interest rates, or government spending on goods and services), changes in the amount of money supply, or changes in the real exchange rate. To determine the impact of changes in government spending only, one sets all the other changes to zero, so that after re-arranging, one obtains the following expression for a change in government spending:

∆

∆ 0

For a change in the real money supply only, the impact on income is:

∆

∆ / / 0

The final policy tool in this economy is exchange rate devaluation/revaluation. For a change in exchange rates only, the impact on income is:

∆

∆ 0

This indicates that if the exchange rate rises (devalues or depreciates), then exports increase and imports decrease, leading to a boost in income by way of the usual multiplier process. Thus far, we haven’t incorporated any restrictions on how exchange rates or financial flows might be affected by the country’s interaction with the rest of the world. In order to account for this dimension, we need to include some sort of equilibrium condition related to the external balance. 12.3 Introducing an External Balance Condition The external balance condition is built upon the Balance of Payments identity, outlined in Chapter 9. Recall the identity states that the current account and the financial account and official reserves transactions (ORT) has to sum to zero: (12.9) ≡ 0 In words, this means that if there is a deficit on the current account, either the financial account must be in surplus, FA>0 (foreigners are lending enough to finance the deficit), or foreign exchange reserves are declining (ORT > 0). The equilibrium concept of the balance of payments is one where official reserves transactions are zero. This can be written as: (12.10) 0

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

where we have assumed the current account can be approximated by the trade balance. In words, our definition of external equilibrium is one where foreign exchange reserves are unchanged, neither increasing nor decreasing. This is a reasonable condition, since it’s sustainable. . We have already described how the trade balance behaves in Chapter 11. However, we have yet to describe what the financial account depends upon. (12.11) ∗̅ Where κ is the sensitivity of financial flows to interest differential, or the change in dollars of inflow for a one percentage change in the interest rate (relative to the foreign country’s interest rate). The higher the home interest rate, the more financial capital flows to the home country, holding all else constant. The intuition is that the higher the return on home assets, the more attractive those assets are, and the more likely they are to be purchased. (For instance, a foreign purchase of a US government bond is the same as lending to the United States.) Substituting in the expressions for the trade balance (exports minus imports) and the financial account into (12.10), and re-arranging to solve for the interest rate yields BP=0 curve:

(12.12) ∗̅ <BP=0 curve>

The overbar over i* indicates that the foreign interest rate is taken as given (or exogenous). Notice that the slope of this curve is positive (m/κ), and that anything that changes the autonomous components of exports, imports and financial flows ( , , ) will shift the position of the schedule. So too will changes in q. The BP=0 schedule is the combination of all points for which the trade balance and financial flows are such that the overall balance of payments (in an economic sense) equals zero, so that official foreign exchange reserves do not change. The slope of the BP=0 schedule is positive because higher income is associated with higher imports and a lower trade balance; hence financial inflows must be higher, and this occurs when the interest rate is higher, holding foreign interest rates constant. The IS and LM and BP=0 schedules are all shown in Figure 12.5. The figure is drawn assuming equilibrium internally and externally, with equilibrium at i0 interest rate and Y0 income level. This model combining the IS-LM model and an external balance condition is also called the Mundell-Fleming model.5

5 The original references are Mundell (1961) and Fleming (1962).

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Figure 12.5: IS-LM-BP=0 in equilibrium 12.4 Fiscal Policy under Fixed Exchange Rates We now examine the implications of the model when policymakers fix the exchange rate. In the fixed exchange rate situation, q does not change unless the government devalues or revalues the currency.6 To denote the fact that the real exchange rate is controlled by the central bank, and is changed exogenously, we will put a bar over q, hence . Shifts in the IS and LM curves occur for the same reasons as before. Consider what happens if one increases government spending, as shown in Figure 12.6. The IS curve shifts out (denoted by the gray arrow).

6 In reality the central bank sets the nominal exchange rate, S. If the price level is fixed at home and abroad, then the real exchange rate is fixed.

Y0 Y

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Figure 12.6: Expansionary fiscal policy under fixed exchange rates, high capital mobility In this case, the equilibrium income and interest rate rises. Notice that the equilibrium interest rate i1 is higher than that consistent with external equilibrium (i.e., BP=0). As a consequence, the balance of payments is in surplus, so ORT < 0, and foreign exchange reserves are increasing. What happens next depends critically on the actions of the central bank. The increase in foreign exchange reserves implies an increase in currency or bank reserves (i.e., money), unless some offsetting action is undertaken. That offsetting action is termed sterilization. In the absence of sterilized intervention, the LM curve will shift out to the new LM (white arrows), setting income at level Y’1). However, if the central bank sterilizes the inflow, then the LM curve remains at Y1. To show why a net financial inflow causes an LM shift in the absence of sterilization, we have to digress in order to examine the workings of the central bank. A central bank purchases domestic assets (such as government bonds) and foreign exchange, and pays by issuing currency and crediting private banks with bank reserves. The central bank balance sheet, in Table 12.1, reflects the cumulative effect of these operations:

Central Bank

Balance Sheet

Assets Liabilities Domestic Assets (DA)

Currency (CU)

Foreign exchange reserves (FXRes)

Bank reserves (Res)

Y0 YY1

iBP=0|Y

(higher gov’t spending)

(money supply due to foreign exchange reserve accumulation)

Y’1

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Table 12.1: Central Bank Balance Sheet The sum of central bank liabilities (currency and bank reserves) is termed the money base. This is different from the money supply, which determines the position of the LM curve. For our purposes, we will just assume that when the money base increases, the money supply increases.7 The central bank increases or decreases the money supply typically by conducting “open market operations”. For instance, in Section 12.1, the central bank would increase the money supply by buying domestic assets (DA, e.g. government bonds) from the private banks, and paying with currency. Suppose that there is a financial inflow that more than offsets a trade deficit; then foreign exchange reserves (FXRes) would rise. Notice that when FXRes rises on asset side of the balance sheet, then the money base also rises. Suppose the FXRes rises by the equivalent of 1 billion Chinese yuan.

Central Bank Balance Sheet

Assets Liabilities

+1 CNY (CU)

+1 CNY (FXRes)

Table 12.2: Change in Balance Sheet due to Unsterilized Balance of Payments Surplus The resulting increase in the money supply leads to the outward shift in the LM shown in Figure 12.6. In the sterilization case, the central bank keeps the money supply constant by selling DA in exchange for currency. The process of exactly offsetting the increase in FXRes with a decrease in DA is termed a “sterilization of reserve accumulation”. This is shown in Table 12.3

Central Bank Balance Sheet

7 The money supply is composed of currency and checking deposits; the former is a liability of the central bank, while the latter is a liability of the private banking system. If banks are forced to hold a minimum amount of bank reserves as a share of total checking deposits (say 10%, so $100 deposits requires $10 bank reserves), then there will be a fixed relationship between money supply and money base. (This assumes the private banks do not hold any reserves above the required minimum.)

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Assets Liabilities

‐1 CNY (DA)

+1 CNY ‐1 CNY (CU)

+1 CNY (FXRes)

Table 12.3: Change in Balance Sheet due to Sterilized Balance of Payments Surplus If the inflow is sterilized, then the LM curve does not shift out in Figure 12.6. In Figure 12.6, the BP=0 curve is drawn flatter than the LM curve; this flat BP=0 curve arises because κ is large relative to m. This situation is often characterized as a case of high capital mobility: financial flows respond strongly to small changes in the domestic interest rates (or, to interest differentials, since the foreign interest rate is assumed fixed). There is nothing that guarantees that the BP=0 line is flatter than the LM curve. Recall the slope of the LM curve is (k/h), while that of the BP=0 curve is (m/κ), and one can imagine that for a small, developing country, international investors might not wish to place their financial capital in the country without a very high rate of return; in other words financial flows might not be very sensitive to interest differentials, so that κ is small. Then the slope of the BP=0 curve will be steep, perhaps steeper than the LM curve. As depicted below in Figure 12.7, the fiscal expansion shifts out the IS curve (gray arrow), output and interest rates rise as before. Now, however, the equilibrium interest rate is not as high as that required for external equilibrium. Hence, BP < 0, ORT > 0, and foreign exchange reserves decline. If the central bank does not sterilize the foreign reserves decline, then the LM curve will shift in, until external equilibrium is restored. If the central bank does sterilize, then the LM remains where it was. Of course, this must come to an end when foreign exchange reserves are depleted.

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Figure 12.7: Expansionary fiscal policy under fixed exchange rates, low capital mobility Since the expansionary fiscal policy induces a trade deficit, then FXRes will decline over time. In the absence of offsetting increases in DA (sterilization), then the money base will decline, reducing the money supply (ΔM < 0), and shifting the LM curve in, until the original level of income is restored. However, if the central bank does sterilize the inflow, then the LM remains shifted out, and income at Y1 – at least until foreign exchange reserves are exhausted. 12.5 Monetary Policy under Fixed Exchange Rates Now we consider monetary policy. We examine the case of high capital mobility in Figure 12.8 (the low capital mobility case yields the same result). The LM curve shifts out, driving the interest rate down to i1.

Figure 12.8: Expansionary monetary policy under fixed exchange rates, high capital mobility

Y0 YY1

iBP|Y1

(higher gov’t spending)

Y0 YY1

(increased money supply)

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

In this case, the resulting equilibrium interest rate i1 is less than required for external equilibrium. As a consequence, there is a balance of payments deficit, ORT > 0, and foreign exchange reserves are run down. In the absence of offsetting sterilization by the central bank, the money supply shrinks, and the LM curve shifts back (white arrows). This process stops only when the interest rate is back at i0. In other words, the monetary policy is undone. This happens because monetary policy is subordinated to the pegging of the exchange rate. Notice that if the central bank were to reduce the money supply, shifting back the LM curve, then the reverse process would occur. The resulting higher interest rate would draw in financial flows in amounts exceeding what is needed to maintain foreign exchange reserve levels. The increase in foreign exchange reserves would result in a corresponding increase in the amount of domestic currency circulating, thereby increasing the money supply. That process undoes the initial monetary policy. The fact that monetary policy is undone by the response of capital flows is a demonstration of the loss of a country’s monetary autonomy when it enters into a fixed exchange rate system. Since the loss of foreign exchange reserves is faster when capital mobility is high, then the higher the degree of capital mobility, the greater the loss in monetary. (This applies when countries use market forces to set the equilibrium exchange rate at the official pegged rate; sometimes countries also use capital controls and other exchange restrictions to set the rate at the official rate, as in the case of China). As noted above, this process can be delayed by sterilization. However, sterilization of capital outflows can continue only as long as the central bank possesses foreign exchange reserves. Once reserves are exhausted, sterilization is no longer feasible, and the money supply will once again be out of the central bank’s control. Sterilization of capital inflows does not face the constraint of foreign exchange reserves; in principle reserves could increase without bounds. However, the stock of domestic assets the central bank holds is not infinite. Recall, in order to maintain the money base so as to keep the money supply constant, the central bank has to sell domestic assets as the stock of foreign exchange increases. Once the stock of domestic assets is exhausted sterilization is no longer feasible, and the money supply increases. The greater the degree of capital mobility, the less the scope for monetary autonomy. At the limit, when capital mobility is infinite ( ∞), there is no monetary autonomy under fixed exchange rates. Under this condition, policymakers have to choose between a fixed exchange rate with no monetary autonomy versus monetary autonomy and a freely floating exchange rate. This choice is part of the International Trilemma discussed at further length in Section 13.7. 12.6 Exchange Rate Policy under Fixed Rates: Devaluation and the Interest Rate Defense In this model, the government exerts control over the economy through three levers: fiscal policy, monetary policy, and the value of the currency. By changing the value of the currency (by altering the value of the currency the central bank commits to exchanging home currency for foreign), the government can affect the level of economic activity, primarily by changing the relative price of home and foreign goods.

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Suppose a country faces a balance of payments deficit, as shown in Figure 12.9. Notice that initially, the equilibrium interest rate is below that consistent with equilibrium. Under these conditions, a devaluation could be a particularly useful policy. Notice that q enters into the BP=0 equation and in the IS equation; hence a devaluation would shift both curves (gray arrows).

Figure 12.9: Devaluation from an initial balance of payments deficit At the new equilibrium, the balance of payments is now in surplus, since the interest rate i1 is greater than iBP|Y1. The balance of payments problem has been remedied, and in fact foreign exchange reserves will now accumulate. The balance of payments surplus will be undone over time if the central bank does not sterilize the reserve accumulation. As foreign exchange reserves rise, the money base increases, shifting out the LM curve. Eventually, the interest rate will fall to the level consistent with external balance, and reserve accumulation ceases. Now, let’s return to the question raised at the beginning of the chapter. Why would raising the interest rate – what is called an interest rate defense -- remedy a balance of payments deficit? We start with the same conditions as in Figure 12.9, but now the central bank raises the interest rate by tightening monetary policy so the LM curve shifts inward (gray arrow).

Y0 Y

iBP|Yi

(devalued exchange rate)

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Figure 12.10: Interest rate defense in a balance of payments deficit The resulting equilibrium is sustainable in terms of the balance of payments, but, as depicted in Figure 12.9, would result in a lower level of income. Hence, the interest rate defense brings with it serious costs. Rarely do countries pursue solely one policy or another. In 2014, Russia implemented a combination of both policies – raising interest rates and allowing the currency to weaken. 12.7 Application: China’s Surpluses and Reserve Accumulation One of the best illustrations of the impact of the fixed exchange rate is China. Beginning in 2004, China began running significant current account surpluses. These surpluses arose from a variety of factors, including the accession of China to the World Trade Organization that could be interpreted as an exogenous increase in net exports.

Y0 Y

(contractionary monetary policy)

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Chart 12.1: Log trade weighted value of the Chinese yuan (blue, left scale), and 12 month moving average of Chinese trade balance, in billions of USD. In addition, rapid productivity growth can be interpreted as a depreciation in the real exchange rate. Both of these effects result in an outward shift in the IS curve and a downward shift in the BP=0 curve. The resulting equilibrium is illustrated in Figure 12.11. Notice that the equilibrium interest rate i0 exceeded that necessary for external equilibrium, iBP|Y0.

-.5

-.4

-.3

-.2

-.1

-5

1994 1996 1998 2000 2002 2004 2006 2008 2010

Log trade weighted real CNY [left axis]

trade balance (bn USD, 12 mo mov. avg.) [right axis]

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Figure 12.11: China 2004-05. In the next two years, the current account surplus increased, resulting in accelerating reserve accumulation. Notice that in order to prevent the LM shifting out (which would have increased GDP and reduced the current account), the central bank had to sterilize the reserve accumulation. Instead of selling Chinese government bonds (reducing DA on the central bank balance sheet), the People’s Bank of China (PBoC) relied mostly upon forcing the banking sector to hold more bank reserves. This served to reduce the money supply relative to what it otherwise would have been. In the years leading up to 2005, the PBoC tried to offset the expansionary effect of a weak currency by tightening money policy (gray arrow). This shifted the LM curve upward, raising the interest rate, and widening the gap between the equilibrium interest rate i1 and the interest rate consistent with external balance, iBP|Y1. In other words, government policy exacerbated reserve accumulation. Chinese foreign exchange reserves surge starting in 2004, as shown in Chart 12.2.

Y0 Y

iBP=0|Y0

(monetary tightening)

iBP=0|Y1

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

Chart 12.2: International reserves, in millions of USD. Source: IMF, International Financial Statistics. A much more reasonable approach would have been to revalue the Chinese currency, the yuan. This would have shifted the IS curve inward (achieving the goal of reducing GDP) and shifted up the BP=0 curve (shown as gray arrows). This policy is shown in Figure 12.12.

Figure 12.12: China, 2005-2008.

Y0 Y

iBP=0|Y0

(revaluation)

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

96 98 00 02 04 06 08 10 12 14 16

Chinese international reserves, mn USD

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

A currency revaluation could have accomplished the dual aims of cooling off the economy, and reducing the current account surplus and pace of reserve accumulation. This is essentially the policy China finally undertook, under pressure from the international community, since China went off its de facto peg against the US dollar in July 2005. By June 2015, after years of yuan appreciation, Chinese foreign exchange reserves peaked, at over $4 trillion. Since then, financial outflows have increased so that, when combined with foreign exchange intervention, China’s reserves have declined by nearly a trillion dollars by early 2017. 12.8 Conclusion This chapter develops a model of the economy that incorporates a role for money and interest rates. Monetary policy affects output by changing interest rates, thereby affecting the interest sensitive components of aggregate demand – investment in this model. Fiscal policy retains influence, albeit diminished, by virtue of the crowding out effect: when output rises with an increase in government spending, the rising demand for money induces an elevated interest rate that reduces investment and output somewhat. This framework is termed the IS-LM model. External equilibrium is defined as the case where foreign exchange reserves are stable; this occurs when a trade deficit is financed by financial capital inflows, or a trade surplus finances financial capital outflows. Combining this external balance condition with the IS-LM model results in the Mundell-Fleming model. When the exchange rate is fixed by the central bank, then monetary policy is not autonomous in the long term. Monetary policy has to accommodate fiscal policy, and is unable to undertake independent measures. Over the short term, if changes in foreign exchange reserves are offset, or “sterilized”, monetary policy can independently affect output over some time frame. In the next chapter, we examine the opposite case, where the exchange rate is allowed to move freely so that the balance of payments is always in equilibrium, so that official reserves transactions are essentially fixed at zero. In that case, monetary policy will have greater scope for independent action, and fiscal policy correspondingly less. Summary Points

1. A model that dichotomizes the economy into real and financial sides is developed. The real side is linked to the financial side by way of investment sensitivity to interest rates.

2. Fiscal policy is less powerful than in the simple Keynesian model, because higher income induces higher interest rates that depress investment.

3. Monetary policy works by changing interest rates, thereby affecting investment and total aggregate demand.

4. In an economy on a fixed exchange rate, the central bank is committed to buying and

Chinn/Irwin International Economics, Chapter 12 (draft 6/29/2017) © Menzie Chinn

selling foreign exchange to peg the currency at a certain value.

5. Both monetary and fiscal policy are effective in affecting output, but they are only effective over time if foreign exchange changes are sterilized.

6. The degree of capital mobility is important to determining the effectiveness of either

fiscal or monetary policy, when foreign exchange changes are sterilized. Key Concepts

Bank reserves

Bonds

BP=0 curve

Capital controls

Capital mobility

Currency

Current account

Crowding out

Devaluation

Domestic assets

Financial account

Foreign exchange reserves

Interest rate defense

IS curve

LM curve

Monetary autonomy

Money

Money base

Money demand

Money supply

Mundell-Fleming model

Official reserves transactions

Open market operations

Revaluation

Sterilization

Exercises

1. In the IS-LM model, is it true that the interest rate is determined solely in the financial sector.

2. Assume one doesn’t have to consider the external balance condition. What is the size of

the government spending multiplier, compared to that in Chapter 11, if investment spending does not depend on the interest rate?

3. Monetary policy works by changing the money supply so as to affect the interest rate. How can the central bank can change the money supply?

4. Consider fiscal policy in an economy described by the following equations: (1) (2) (3) ̅ (4) (5) ̅ (6) ̅ (7) (8)

(9) M

d s



(10)

(11) M

P kY hi

 

For now, ignore the external balance condition. 4.1 Solve for the IS curve, with Y on the left hand side. 4.2 Solve for the LM curve, with i on the left hand side. 4.3 Graph the IS and LM curves on a single graph. Show the vertical intercepts, the slopes,

and the intersection. 4.4 Solve for equilibrium income. Show your work. 4.5 Calculate the change in income resulting from a given increase in government spending,

ΔG. 4.6 Show graphically what happens when government spending is increased. Clearly indicate

the distance of the curve shifts, and the amount of the income change. 4.7 Is the effect of government spending on income greater or less in this model, as compared

to the simple Keynesian model? Explain why the difference occurs, in words. 4.8 Answer 4.7 again, if the interest sensitivity of money demand were infinite. Explain why

this is true. 4.9 Answer 4.7 again, if the interest sensitivity of investment were infinite. Explain why this

is true.

5. Consider the same economy described in Problem 4. 5.1 Calculate the change in income for a given change in money supply, ( / )M P . Assume

the price level P is fixed at 1. 5.2 Show graphically what happens when the real money stock is increased. Clearly indicate

the distance of the curve shifts and the amount of the income change. 5.3 Suppose the interest sensitivity of investment is extremely high. Show graphically the

effect upon output and interest rates that result from an increase of the real money stock. Clearly indicate the size of the change in income.

5.4 Suppose the interest sensitivity of money demand was infinite. Show graphically the

effect upon output and interest rates that result from an increase of the real money stock. Clearly indicate the size of the change in income.

6. Suppose the economy is described by the following set of equations, as in the Mundell- Fleming model. (1) ̅ <IS curve>

(1’) ̅

(2) <LM curve>

(3) ∗ <BP=0 curve>

6.1 Draw a graph of initial equilibrium, where the goods and money markets are in

equilibrium, as is the balance of payments. Assume that m/κ < k/h. 6.2 Show what happens if government spending is increased, both immediately, and over

time, assuming no sterilization. 6.3 At the new equilibrium, what is true about (i) the level of output; (ii) the level of

investment; (iii) the real exchange rate; and (iv) the trade balance? 6.4 Redraw 6.1, and show the impact of a monetary contraction, both immediately and over

time. Assume over time, financial flows are sterilized. 6.5.Explain why the process you lay out in 6.4 occurs. 6.6 Answer 6.4 if financial flows are not sterilized. 6.7 Does your answer to 6.5 change if m/κ > k/h?

7. Consider the same economy described in Problem 6, with m/κ < k/h.

7.1 Assume the economy begins in equilibrium. Show what happens in the short term if the foreign interest rate rises exogenously.

7.2 Assume the central bank sterilizes inflows/outflows. Is the balance of payments in surplus, deficit or equal to zero?

7.3 Suppose the central bank wishes to re-establish balance of payments equilibrium. What policies can it implement in order to achieve that goal?

8. In the same economy examined in Problem 7, show the impact in the short term of a revaluation of the currency. What happens to output, the interest rate and the balance of payments?

9. Suppose a country is running a balance of payments deficit. What are the policy options for remedying the deficit?

Worked Exercise

4.1 Solve for the IS curve, with Y on the left hand side. Substitute equations (2) through (8) into equation (1):

̅ ̅ ̅

Collecting terms:

̅ ̅ ̅ ̅

Rearranging:

1 ̅

1 1

4.2 Solve for the LM curve, with i on the left hand side.

Substitute equations (10) and (11) into equation (9):

Rearrange:

Divide both sides by –h:

4.3 Graph the IS and LM curves on a single graph. Show the vertical intercepts, the slopes,

and the intersection.

4.4 Solve for equilibrium income. Show your work. Substitute the LM curve into the IS curve:

1 1

̅ ⟨ 1

⟩

Rearrange:

1 ̅

1 / ̅

1 ̅

4.5 Calculate the change in income resulting from a given increase in government spending,

ΔG. Take the total differential of the answer to 4.4:

Y0 Y

Slope = k/h

Δ Δ Δ Δ Δ Δ

Since

̅ ≡ ̅ ̅ ̅ ∆ ∆ ∆ ∆ ∆

Assuming only government spending changes, then: Δ Δ Δ

Or:

Δ Δ

4.6 Show graphically what happens when government spending is increased. Clearly indicate

the distance of the curve shifts, and the amount of the income change.

4.7 Is the effect of government spending on income greater or less in this model, as compared

to the simple Keynesian model? Explain why the difference occurs, in words.

The effect is less in absolute value, because of crowding out of investment. As income

Y1 Y

Y’0

rises, demand for money rises. Since the money supply is fixed, the equilibrating interest rate in the money market must rise. As a consequence, investment falls, and this decreases aggregate demand and output relative to what it would have been if interest rates remain unchanged. As a consequence, output rises by only, GY  ̂ rather than

GY   .

4.8 Answer 4.7 again, if the interest sensitivity of money demand were infinite. Explain why this is true.

If the interest sensitivity of money demand were infinite, then the LM curve would be perfectly flat. Then the shift inward is the same as the reduction in income. Notice that when h=∞,  ˆ .

4.9 Answer 4.7 again, if the interest sensitivity of investment were infinite. Explain why this

is true.

If the interest sensitivity of investment were infinite, then the IS curve is horizontal, and does not shift down as lump sum taxes are reduced.

Y0 Y

References

Fleming, J. Marcus, 1962, "Domestic Financial Policies under Fixed and under Floating Exchange Rates," Staff Papers-International Monetary Fund 9(3): 369-380.

Mundell, Robert A., 1963, “Capital mobility and stabilization policy under fixed and flexible exchange rates,” Canadian Journal of Economic and Political Science 29(4): 475–485.

Y0 Y