The Chinese currency for Macro econ Class

Mr.Garcia

chapter13_nm_2.pdf

Home >Business & Finance homework help >Economics homework help >The Chinese currency for Macro econ Class

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

13 Income and Interest Rates under Floating Exchange Rates, and the International Trilemma

Overview

In this chapter, we learn:

●●● How exchange rates adjust under floating exchange rates to restore external equilibrium

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

●●● How fiscal and monetary policy effectiveness differ under floating and fixed rates.

●●● How a liquidity trap will prevent expansionary monetary policy from increasing output.

●●● How effective fiscal and monetary policies are when capital mobility is perfect under different exchange rate regimes

●●● The International Trilemma means that an economy can only simultaneously achieve two of three goals of exchange rate stability, monetary independence and financial integration

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

''It's a bleak picture,'' said Charles W. Bartsch, a policy analyst with the Northeast-Midwest Institute, a Washington-based center for economic and environmental research. ''Many of these towns aren't going to make it. They're going to have to go through bankruptcy and let the chips fall where they may.'' The municipalities' financial problems grow out of the severe depression that in recent years has savaged the country's steel industry, idling more than 700,000 workers in this once prosperous region. … Hammered by the strength of the dollar, which made imported steel less expensive, and bypassed by the economic recovery, steel companies have closed one mill after another. Once the backbone of the region's economy, the mills are now silent, soot-stained monuments to another era.

From, Lindsay Gruson, New York Times, October 6, 1985.

This news article from the 1980’s is perplexing. The economic recovery was well underway by 1985, and yet the industrial heartland was suffering with high unemployment and shuttered factories. How can a strong dollar be blamed for this outcome? In fact, the dollar was a key reason for the rapid decline in the industrial Midwest, and surging imports was part of the story. How and why motivates the development of this model with a freely floating exchange rate. In contrast to the model presented in Chapter 12, the central bank in this model is no longer committed to exchanging home currency for foreign currency at a designated exchange rate. Rather, the central bank eschews foreign exchange intervention, and thus gains monetary policy autonomy. In terms of the model, foreign exchange reserves no longer change in response to changes in interest rates and trade flows. Instead, the exchange rate freely adjusts in response to market forces so as to keep foreign exchange reserves constant. Because of this switch in what variable is free to move and what is not, the model’s predictions differ substantially from those obtained in Chapter 12. 13.1 The Model We retain the IS, LM and BP=0 schedules as described in the previous chapter. One seemingly minor -- but critical – distinction is that the q variable no longer has a bar over it, indicating it is no longer a fixed constant.

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

(13.1)  biqvnMIXAY  )( <IS curve>

(13.2) <LM curve>

(13.3) ∗ <BP=0 curve>

In the fixed exchange rate case, q is treated as a constant, changed only when the central bank decides to devalue or revalue the currency. In a floating exchange rate case, q is an endogenous variable, free to move in response to other forces. When the equilibrium interest rate is above (below) that consistent with external equilibrium, the currency appreciates (depreciates) so as to maintain the BP=0 condition. When the economy is at external equilibrium (as below in Figure 13.1), then there is no tendency for q to change.

Figure 13.1: IS-LM-BP=0 in equilibrium This graph is indistinguishable from Figure 12.1. The differences from the fixed exchange rate situation become apparent when one examines the implications of fiscal and monetary policy. 13.2 Fiscal Policy under Floating Exchange Rates We’ll examine fiscal and monetary policies in turn. First, consider what happens if one increases government spending.

0BP

Y0 Y

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Figure 13.2: Expansionary fiscal policy under floating exchange rates, high capital mobility The IS curve shifts out (dark gray arrow). Output initially rises to Y1 and interest rates to i1. However, now the equilibrium interest rate is greater than that consistent with external equilibrium; this means financial inflows exceed that necessary to offset the trade balance. In the fixed exchange rate system, this would mean increases in official reserves. However, under the floating exchange rate system, the home currency appreciates, i.e., q falls. As q falls, this affects two curves: the IS and the BP=0 schedules. Inspecting equation (13.1), one sees that a fall in q shifts in the IS curve. Now examine equation (13.3); a fall in q shifts up the BP=0 curve. These two shifts are depicted in Figure 13.2 (light gray arrows). Notice then that equilibrium income falls to Y2 and interest rates to i2 (although both of these are higher relative to the initial starting values of Y0 and i0). Why do these shifts occur? As q falls (appreciates), exports fall and imports increase and hence aggregate demand declines and the IS shifts in. As exports decrease and imports increase for any given income level with an appreciated currency, financial inflows must be higher for any given income level in order for external balance to hold. This can only be accomplished by a higher interest rate. This is the same as saying the BP=0 curve is shifted higher. In the end, in an open economy, some of the fiscal expansion is offset by reduced “net exports” (exports minus imports). Another way of thinking about this phenomenon is that there is now an additional channel for crowding out. There are now two interest rate sensitive components of aggregate demand: investment spending and net exports. Net exports are not literally interest sensitive, but to the extent that they depend upon the exchange rate and the exchange rate is in turn dependent upon interest rates, they are in effect interest sensitive. 13.3 Monetary Policy under Floating Exchange Rates Now we consider what happens if a monetary expansion is undertaken. In this case, we examine

'IS (increased gov’t spending)

0BP

Y0 Y Y1

i1 '0BP (appreciated currency)

"IS (increased gov’t spending, appreciated currency

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

only the high capital mobility case, as the qualitative results do not depend on the degree of financial openness. In Figure 13.3 below, the monetary expansion shifts out the LM curve (dark gray arrow). The resulting equilibrium interest rate ii is less than required for external equilibrium. As a consequence, there is an incipient balance of payments deficit and the exchange rate depreciates. The depreciated exchange rate results in increased net exports, so the required interest rate for external equilibrium falls (the BP=0 curve shifts downward). The increase in net exports also means that domestic aggregate demand rises, and the IS curve shifts out. The equilibrium settles at income level Y2 and interest rate i2.

Figure 13.3: Expansionary monetary policy under floating exchange rates, high capital mobility Notice that monetary policy is relatively powerful. The increase in the money supply decreases the interest rate and hence spurs investment, thereby increasing output. The lower interest rates also puts negative pressure on the balance of payments, and under a free float, this manifests itself in a depreciation of the home currency. This shifts out the BP=0 curve (light gray arrow) This depreciation spurs exports and discourages imports, so the expansionary monetary policy “crowds in” net exports, as well as investment. This result highlights the fact that in an open economy under a floating exchange rate regime, monetary policy is generally more powerful than in the case of a closed economy. That is because monetary policy can now exert its influence through two channels – the investment channel and the net exports channel. That is even more true the greater the degree of financial capital mobility. The impact of monetary policy in this example highlights the following fact that: although in a fully floating exchange rate regime, market conditions determine the currency’s value, that does not mean the central bank (and the government) cannot influence that value. In particular, the

'LM (monetary expansion)

Y0 Y Y2

'IS (depreciated currency)

0BP

'0BP (depreciated currency)

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

central bank can, by affecting the interest rate, affect the market conditions that underlie the exchange rate’s level. 13.4 Application: The Dollar and Deficits during the 1980’s At the beginning of the Chapter, the problems of the industrial heartland of America during the mid-1980’s were recounted – declining manufacturing and high unemployment. This experience can be readily explained using the model we’ve just described. When President Reagan came to office in January 1981, he proposed increases in defense spending and tax cuts which, along with the recession, caused a large budget deficit. The budget balance, when there is an income tax, is given by equation (13.4): (13.4)

≡ ̅

The official measure of the budget balance is a not a “pure” measure of the stance of fiscal policy, since tax receipts fall and spending on transfers such as unemployment insurance rise during recessions. A more exogenous measure of fiscal policy is provided by the budget balance evaluated at full employment, sometimes called the cyclically adjusted budget balance. This measure, along with the cyclically adjusted, normalized by GDP and full employment GDP (YFE), is shown in Chart 13.1.

Chart 13.1: Actual budget balance to GDP ratio (blue), cyclically adjusted budget balance ratio (red) and cyclically adjusted budget balance to potential GDP (green). Source: Congressional Budget Office, Budget and Economic Outlook, August 2011.

-.10

-.08

-.06

-.04

-.02

.00

.02

.04

70 75 80 85 90 95 00 05 10

Actual

Cyclically adjusted

Cyclically adjusted to Potential GDP

Federal budget balance to GDP

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

The increase in the cyclically adjusted budget deficit – increased spending and decreased taxes – by about 3 percentage points of GDP stimulated the economy. In Figure 13.4, this effect is represented by an outward shift in the IS curve (dark gray arrow). At the same time, the Federal Reserve under the leadership of Chairman Paul Volcker, embarked upon a policy of squeezing inflation out of the economy through contractionary monetary policy. In terms of our model, this results in the LM curve shifting inward (black arrow), so that the interest rate rises to i1. Assuming high capital mobility this leads to an appreciation of the currency, which, as shown in Figure 13.4 leads to shifts of the BP=0 and IS curves (light gray arrows).

Figure 13.4: Expansionary fiscal policy and contractionary monetary policy under flexible exchange rates, high capital mobility The economy settles at income level Y2, interest rate i2. The income level exceeds the starting level at Y0, but not by as much as would have been the case if monetary policy had been less contractionary. In this sense, the collision of expansionary fiscal policy and contractionary monetary policy is like stepping on the gas and brake pedals at the same time. The model also implies the resulting interest rate increase should appreciate dollar. And that is exactly what happened.

'IS (increased gov’t spending)

0BP

Y0 Y

'0BP (appreciated currency)

"IS (increased gov’t spending, appreciated currency)

'LM (contractionary monetary policy)

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Chart 13.2: Real interest rate (left scale) and log real value of US dollar (1973M01=0). Real interest rate calculated as difference between one year Treasury yield and one year ex post inflation. Source: Federal Reserve Board, and BLS. From President Reagan’s inauguration to the dollar’s peak in March 1985, the real value of the currency rose by 35%. Then, as shown in Chart 13.3, starting in 1982, the US began running a massive trade deficit, unprecedented in the post-War era, largely because of the appreciated dollar. Instead of fiscal policy crowding out investment, as would have occurred in the closed economy model, net exports were crowded out.

-8

-4

-.3

-.2

-.1

1975 1980 1985 1990 1995 2000 2005 2010

Real interest rate [left scale]

Log real value of US dollar [right scale]

Reagan

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

-.4

-.3

-.2

-.1

-.06

-.05

-.04

-.03

-.02

-.01

.00

.01

.02

1975 1980 1985 1990 1995 2000 2005 2010

Net exports

to GDP ratio

[right scale]

Log real value

of US dollar

[left scale]

Chart 13.3: Log real value of US dollar (1973M1=0), and net exports as a share of GDP. Source: Federal Reserve Board, and BEA. The closely timed onset of deterioration in the budget and trade balances led to the term “Twin Deficits”, discussed in Chapter 9. In words, the appreciation of the dollar made US exports relatively uncompetitive in markets overseas, while it made foreign made goods relative cheap to American consumers and firms. As a consequence, manufacturers were hit hard by the combination of recession and then increased import competition. The industrial cities of the Midwest suffered so strongly that this experience led to the coining of yet another term: “the Rustbelt”. Starting toward the end of 1984, Fed policy loosened considerably. Combined with tax increases, the US interest differential relative to other countries declined, and so too did the dollar. With a lag of a couple years (as shown in Chart 13.3), US net exports responded to the dollar decline, so that by 1986, the trade deficit shrank as a share of GDP. 13.5 Interest Rate Shocks So far we have examined the effects of domestic policies. However, the model is also quite useful for examining how events in the rest of the world can affect exchange rates and income at home. For instance, mid-2014, expectations of a US interest rate relative to that in the euro area led to a depreciation of the euro against the US dollar. We can analyze this event in the model from the perspective of the euro area. Consider the increase in the US interest rate as a rise in *i . Notice that in Equation 13.3, *i enters in one-

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

for-one in the determination of the interest rate that equilibrates the balance of payments. If the foreign (US) interest rate rises (exogenously) by one percentage point, then the BP=0 curve will shift up one percentage point. The outcome in the high capital mobility case is depicted below in Figure 13.5.

Figure 13.5: RoW interest rate rises under floating exchange rates As the foreign interest rate rises (dark arrow), the euro area interest rate rises above what is consistent with external balance. The euro thus depreciates to q’ shifting down the BP=0 curve, and shifting out the IS curve (light arrows). In the end, the euro area interest rate rises in response to the foreign interest rate increase, although not one-for-one. To stabilize the exchange rate, the monetary authority (in this case the European Central Bank) could raise euro area interest rates. In Figure 13.5, this would entail a shift backwards of the LM curve. In other words, the country could maintain the exchange rate at a given level, at the cost of losing control over output. In this case, the country would undergo a recession. Since the euro area was experiencing slow growth, the ECB did not tighten monetary policy. This episode illustrates the trade-offs that policymakers make. While it might be provi desirable stabilize the currency’s value, that has to be weighed against the benefits of maintaining the level of output. 13.6 Summarizing Effects under Fixed and Floating Exchange Rates Our examination of the effects of different policies, as well as developments abroad, has yielded a large number of outcomes, depending on exchange rate regime, degree of capital mobility, and whether the central bank sterilizes financial capital flows. The following table summarizes these many results, assuming relatively high capital mobility.

Y0 Y

'IS (depreciated currency)

i1 0BP

'0BP (higher foreign interest rate)

"0BP (higher foreign interest rate, depreciated currency)

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Exchange rate regime Income

Interest rate

Real exchange rate

Trade balance

Foreign Exchange Reserves

Government spending

Fixed (w/sterilization) Increase Increase No change Decrease Increase

Fixed Increase Increase No change Decrease Increase

Floating Increase Increase Appreciation Decrease No change

Real money supply

Fixed (w/sterilization) Increase Decrease No change Decrease Decrease

Fixed No change No change No change No change Decrease

Floating Increase Decrease Depreciation Increase No change Real exchange rate

Fixed (w/sterilization) Increase Increase Devaluation Increase Increase

Fixed Increase Increase Devaluation Increase Increase

Floating nr nr nr nr nr

Foreign interest rate

Fixed (w/sterilization) No change No change No change No change Decrease

Fixed Decrease Increase No change Increase Decrease

Floating Increase Increase Depreciation Depreciation No change Table 13.1: The Impact of Policies and Foreign Developments. Notes: Responses of each variable in the column to a change in the indicated variable in left column, under fixed exchange rate regime with sterilization, without sterilization, and free floating. Entries in bold face italics indicate relatively large changes. “nr” denotes “not relevant”.

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Box 13.1: Empirical Estimates of Policy Effects

Theory provides insights into the effectiveness of fiscal, monetary and exchange rate policies in open economies. Under fixed exchange rates, fiscal policy should be relatively effective, monetary policy relatively ineffective (particularly in the longer term). The reverse is true under floating exchange rates: fiscal policy should be less effective, and monetary policy more effective, holding all else constant. How well do these predictions hold in real world data? One way to answer this question is to compile data on a number of economies, and examine how changes in government spending affect output, the real exchange rate, and the current account. Ethan Ilzetzki, Enrique Mendoza and Carlos Vegh estimated the response of these variables to an unexpected amount of government spending equal to one percent of GDP. In contrast to the Mundell-Fleming model we’ve examined, these estimates allow the central bank to react to the fiscal policy. Hence, the responses estimated do not exactly correspond to the examples examined in the text, where monetary policy is held fixed (either by sterilization in fixed rates, or under floating). In the Chart below, the response of each variable over 20 quarters is shown. The left side presents the impact for economies operating under fixed exchange rate regimes, while the right side presents for those operating under floating exchange rate regimes. The blue lines indicate the estimated effect, while the red lines show the 90% confidence intervals for these estimates. What to look for is the red lines differing from the zero line; that indicates that the effect is statistically significant. (Note that the real effective exchange rate (reer) is defined opposite of how it is in the model; a rise is an appreciation of the currency.) Under fixed exchange rates, GDP increases, with peak effect about a year after the government spending shock. Over time, the impact tails off toward zero (which matches up with theory outlined in Chapter 14). Within three years of the government spending increase, the impact on GDP is not statistically significant. The current account and the real exchange rate deviate from zero by a statistically insignificant amount. The policy rate is the rate set by the central bank, rather than the market rate discussed in the model. In the estimates, the policy rate deviates by an economically and statistically insignificant amount. To the extent it moves, it falls (i.e., monetary policy is accommodative).

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Notes: Impulse responses to a 1% shock to government consumption in episodes of fixed exchange rates (left panels) and flexible exchange rates (right panels). Impulses from top to bottom: government consumption; gross domestic product; current account as a percentage of GDP; the real effective exchange rate; policy interest rate of the central bank. Dotted lines represent 90% confidence intervals based on Monte Carlo simulations.

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Under floating exchange rate regimes, GDP does not respond in a statistically significant manner. The fact that the response under floating is less than under fixed is consistent with the Mundell-Fleming model. The real exchange rate appreciates upon impact, and then reverts back to zero within year. The policy rate rises slightly in response to the fiscal policy. The current account, which approximately equals the trade balance, responds somewhat counter-intuitively. Instead of declining as it should under flexible rates, it rises (erratically) in the 0th and 2nd quarter after the government spending occurs. Why this result is obtained is a hard question to answer, partly because the predictions are clear if everything else is held constant. In reality, the degree of openness to international trade, the degree of capital mobility, and the degree of capital openness all vary.1 The data from the real-world confirms the key conclusion that fiscal policy is less effective under flexible rates than fixed.

13.7 Another Limit to Monetary Policy Effectiveness In the cases we’ve examined thus far, monetary policy has been able to spur output by dropping the interest rate, and hence affect investment and net exports. For most of the post-War era, this was the case. However as shown in Chart 13.4, beginning in 2008, as central banks sought to stimulate economic growth, they encountered a constraint: namely the zero lower bound. This phenomenon is shown in Chart 13.4.

1 This anomalous result might arise because developing countries, which account for a large number of floating exchange rate regimes, exhibit this behavior. For those countries, a government spending increase results in an increase in the current account, something that is not predicted by any particular theory.

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

-4

1975 1980 1985 1990 1995 2000 2005 2010

CAD

EUR

JPY

USD

CHF

GBP

Policy rates, %

Chart 13.4: Monetary policy interest rates in US (black), Canada (blue), euro area (red), Japan (green), Britain (purple) and Switzerland (teal). Source: IMF, International Monetary Fund. The zero lower bound arises because it is very difficult to charge interest rates below 0%. Because at zero interest rates, money and bonds become perfect substitutes, the LM curve is flat for a certain portion. A flat LM is termed a liquidity trap, because in such cases, monetary policy might be ineffective even under floating exchange rates. This situation is shown in Figure 13.6. For the sake of illustration, we ignore the BP=0 schedule to begin with. The money supply is sufficiently large so that the IS curve intersects the LM on the flat portion. An increase in the money supply (gray arrow) only drives down interest rates in the portion of the LM curve that is above zero interest rates.

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Figure 13.6: Monetary policy in the liquidity trap Since the equilibrium interest rate cannot be driven down, then investment cannot be spurred, and so the link between monetary policy and economic activity is severed. In order to examine how the presence of a liquidity trap affects the effectiveness of monetary policy in the open economy, we re-introduce the BP=0 schedule, as shown in Figure 13.7.

Y0 Y

i0=0

LM’

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

Figure 13.7: Non-adjustment in a liquidity trap

Notice that the equilibrium interest rate is above the rate that equilibrates the balance of payments. As a consequence, the currency appreciates, shifting up the BP=0 schedule, and shifting in the IS curve. Output falls to Y1. Interestingly, not only is monetary policy ineffective in boosting output. Over time, the adjustment process leads to a reduction of output. For this reason, the presence of a liquidity trap poses an especially difficult challenge to stimulating the economy in the face of an economic contraction. This challenge arises because of the placement of the BP=0 schedule. The BP=0 schedule could be placed higher; in that case, the equilibrium interest rate would be below that necessary for external balance. The currency would depreciate, shifting out the IS curve, and down the BP=0 curve. Then equilibrium would be re-established by the adjustment process. Which situation is more likely to prevail? As shown in Chart 13.3, advanced country interest rates were fairly low, if not effectively zero, from 2008 onward. During this period, monetary policy working through the short term interest rate was ineffective, exactly because the situation illustrated in Figure 13.7 prevailed. Notice that expansionary fiscal policy could be effective in raising output. Appreciation of the currency, arising from the higher interest rate, would tend to offset some of the expansion, but overall, output would increase.

i0=0

LM’(increased money supply)

BP=0

iBP=0|Y0

IS (appreciated currency) BP=0 (appreciated

currency)

iBP=0|Y1

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

13.8 The Implications of Perfect Capital Mobility The examples we have examined have typically presumed that financial flows are highly sensitive to differentials in returns -- in the context of the model, m/κ < k/h. This assumption makes sense particularly when analyzing the advanced economies, such as the euro area, or Japan, which have largely removed legal and regulatory barriers to the cross-border movement of funds. Under specific conditions, where perfect capital mobility holds, extreme results occur when either monetary or fiscal policies are implemented. In the context of the model, perfect capital mobility is defined as the situation where capital is infinitely sensitive to interest differentials. Since the slope of the BP=0 schedule is m/κ, then the slope is as shown in Figure 13.8.

Figure 13.8: Perfect capital mobility, with expansionary fiscal policy under floating rates If expansionary fiscal policy is implemented, then the IS curve would shift out, as shown in Figure 13.8. The interest rate would rise above the foreign interest rate, inducing an infinitely large financial inflow that would appreciate the home currency, pulling back in the IS curve. As long as the interest rate is above the foreign, infinite amounts of capital would continue to flow in, appreciating the currency. Hence, the only possibility is that the currency is appreciated sufficiently to pull the IS back to its original starting point. Fiscal policy is completely ineffective in affecting output because of complete crowding out of net exports. A completely opposite result is obtained for monetary policy, as shown in Figure 13.9. Expansionary monetary policy shifts out the LM curve (dark gray arrow), resulting in an interest rate below the foreign interest rate. This would cause an infinite financial outflow, which in turn depreciates the home currency, spurring net exports. As a consequence, the IS curve shifts out (light gray arrow). However, as long as the IS curve shifts out less than the amount necessary to bring the interest rate up to the foreign interest rate, then financial outflows continue, weakening the currency. Only when the IS curve has shifted out sufficiently to set the home interest rate

0BPiRoW=i0

Y0 Y

'IS (higher gov’t spending)

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

equal to the foreign does the process end. Then output will have increased substantially, from Y0 to Y1; in this case monetary policy is perfectly effective.

Figure 13.9: Perfect capital mobility, with expansionary monetary policy under floating rates Interestingly, these results are in turn exactly reversed if the economy is under a fixed exchange rate regime. Then fiscal policy is completely effective (because interest changes would induce infinite financial inflows or outflows that cannot be sterilized, and hence change the money base until the original interest rate is restored). Monetary policy is completely ineffective because any move shift the LM curve induces an interest rate change and either infinite financial inflows or outflows, that undo the original money base change. Is there an example of a completely fixed exchange rate regime, combined with completely open financial accounts, by which to assess whether an independent monetary policy is possible in such circumstances? The euro area countries, which gave up their own currencies, constitute an extreme example. A less extreme case, where the country retains its own currency, is Denmark, which from approximately 1988 onward had no cross-border capital controls. As shown in Chart 13.5, when the exchange rate is not pegged, the Danish interest rate can deviate from the German. When Denmark pegs to first the Deutsche mark and then euro, the interest differential becomes essentially a constant at zero.

0BPiRoW=i0

Y0 Y

'LM (expansionary monetary policy)

'IS (depreciated currency)

Chinn/Irwin International Economics, Chapter 13 (draft 7/6/2017) © Menzie Chinn

-4

-2

0.76

0.80

0.84

0.88

0.92

0.96

1.00

1.04

1.08

1.12

80 82 84 86 88 90 92 94 96 98 00 02 04 06

Danish-German interest rate, % [left scale]

DKR/DEM 1999M01=1 [right scale]

DKR/EUR, 1999M01=1 [right scale]

Chart 13.5: Danish money market interest rate minus German money market interest rate, in percent (blue, left scale), and Danish Krone per Deutsche Mark (red) and Danish Krone per euro (green), both 1999M01=1 (right scale). Vertical dashed line at 1999M01, inception of the euro. Source: IMF, International Financial Statistics, and Federal Reserve System. Notice the interest differential is not exactly zero to begin with; that’s because at the beginning, there is some expected probability of devaluation of the krone. Remember the expected depreciation is what the interest differential should equal under uncovered interest parity (when financial capital is perfectly mobile). This pattern of results can be summarized in the following table: Regime Policy Floating Fixed

Fiscal Perfectly ineffective

Perfectly effective

Monetary Perfectly effective

Perfectly ineffective

Table 13.2: Policy effectiveness matrix

13.9 The International Trilemma The “International Trilemma” is a hypothesis that states that a country simultaneously may choose any two, but not all, of the three goals of monetary independence, exchange rate stability, and financial integration.2 This conclusion leaps out from our discussion of perfect capital mobility in the previous section. Because a country cannot simultaneously attain all three goals, this is also sometimes called “the Impossible Trinity”. The trilemma is illustrated in Figure 13.10.

Monetary Independence

Exchange Rate Stability

Financial Integration

Floating Exchange Rate Monetary Union or

Currency Board e.g. Euro system

Closed Financial Markets and Pegged Exchange Rate e.g. Bretton Woods system

Figure 13.10: The International Trilemma

Each of the three sides – representing monetary independence, exchange rate stability, and financial integration – depicts a potentially desirable goal, yet it is not possible to be simultaneously on all three sides of the triangle. The top vertex, labeled “closed capital markets”, is, for example, associated with monetary policy autonomy and a fixed exchange rate regime, but not financial integration.

Throughout history, different international financial arrangements have attempted to achieve combinations of two out of the three policy goals. The Bretton Woods system, which prevailed in the post-War period, sacrificed capital mobility for monetary autonomy and exchange rate stability, and is shown at the top vertex. Until a couple of decades ago, developing countries pursued monetary independence and exchange rate stability, but largely kept their financial markets closed to foreign investors, as in the case of China recounted in Chapter 12. The Euro system is built upon the fixed exchange rate arrangement and free capital mobility, but abandoned monetary autonomy of the member countries, and hence is shown at the lower right vertex. The freely floating exchange rate regime most closely conforms to the United States, the euro area, to the extent that policymakers in these economies do not systematically intervene in foreign exchange markets to manage their currencies.

2 The term “international trilemma” was first coined by Obstfeld and Taylor (1997).

Monetary independence means the monetary authorities of an economy to have some autonomy over its macroeconomic management. An economy with a high degree of monetary independence can stabilize the economy through monetary policy without being subject to other economies’ macroeconomic management. Hence, monetary independence can in principle allow countries to stabilize output in the face of developments in the rest of the world economy.

Exchange rate stability – at the extreme, keeping the nominal value of a currency fixed against a specific foreign currency -- is a means of providing a nominal anchor. One of the potential benefits of such an anchor is that enhanced price stability. In addition, during times of an economic stress, a pegged exchange rate could enhance the credibility of policy makers and thereby minimize the effects of investor anxieties. However, greater levels of exchange rate fixity deprives the economy of the use of the exchange rate as a shock absorber.

Financial liberalization allows more efficient resource allocation, mitigating information asymmetry, enhancing and/or supplementing domestic savings, but subjects the economy to the whims of volatile cross-border financial flows. “Sudden stops” – dramatic reversals of financial flows -- have led to boom-bust cycles in numerous, smaller, economies, particularly in the past three decades. This point is discussed at further length in Chapter 16.

Does the concept of the Trilemma hold up in the real world? In order to answer this question, each of the three concepts has to be measured. Joshua Aizenman, Menzie Chinn and Hiro Ito have constructed measures of each of these variables for a large set of countries, over the 1970- 2014 period. The monetary independence variable is measured as the correlation of interest rates with that in a major country. For example, if a country’s interest rate moves percentage point for percentage point with that in a reference country, say the United States, then the degree of monetary independence is zero. If on the other hand, there is zero correlation, then there is full monetary independence. The exchange rate stability indicator is measured as the volatility of the exchange rate. Suppose the standard deviation of month to month changes in the exchange rate against a reference currency – for instance the US dollar – is zero; then exchange rate stability is full. Finally, the capital mobility measure is represented by an index based on the legal restrictions on cross-border transactions, as reported by each country to the International Monetary Fund. Chinn and Ito calculate an index of financial openness which takes on a value of one if there are no restrictions, and a value of zero if there are very tight restrictions. The Aizenman, Chinn and Ito find that countries do face a trade-off between these indices. As one of the goals is favored, one or the other or both other goals have to be sacrificed.3

3 Michael Klein and Jay Shambaugh (2013) have documented that central banks are freer to set their interest rates the more flexible the exchange rate regime or more stringent restrictions on financial capital flows (using a slightly different measure of control).

Chart 13.6: Monetary independence (mi), exchange rate stability (ers), and capital mobility (kaopen) indices, averages for all industrial countries. The evolution of the three indices, averaged over the industrial countries, is shown in Chart 13.6. The patterns in the chart demonstrate that since the breakdown of the Bretton Woods system in 1971, the industrial countries have loosened the constraints on the free flow of financial capital, while stabilizing exchange rates, and abdicating monetary autonomy. Some of the movement that occurs in 2000 is due to the advent of Economic and Monetary Union (EMU), popularly known as the creation of the euro. EMU entailed the surrender of independent currencies, and hence the abandonment of independent monetary policies. In sum, the theoretical framework laid out in Chapter 12 and this chapter are verified in the real world. When exchange rates are fixed, monetary autonomy is limited for countries with high capital mobility (as in the Denmark example). As in the case of China discussed in Chapter 12, when impediments to financial flows are high, it’s possible for countries to retain both rigid exchange rates and an independent monetary policy. 13.10 Conclusion When an economy operates under a floating exchange rate regime, the central bank commits to allowing market conditions fully determine the value of the currency. An implication of this is that the central bank’s stock of foreign exchange reserves should be constant, while the exchange rate adjusts in response to changes in exogenous variables, like government spending, the money supply, and foreign income and interest rates.

.2 .4

.6 .8

1970 1980 1990 2000 2010 year

mi_idc ers_idc ka_open_idc

Under flexible exchange rates, fiscal policy loses effectiveness in terms of affecting output, while monetary policy increases effectiveness. In the case of fiscal policy, there are now two channels of crowding out: higher interest rates reduce investment, and – by increasing interest rates and appreciating the currency – net exports. Conversely, monetary policy has enhanced effectiveness. That occurs because expansionary monetary policy, by changing the interest rate, now affect two components of aggregate demand: investment and net exports. As the degree of capital mobility increases, each of these characterizations become more and more pronounced. At the limit, when capital mobility is perfect, so that infinite financial capital flows respond to the smallest of interest differentials, then fiscal policy becomes completely ineffective and monetary policy perfectly effective. The International Trilemma is an implication of the Mundell-Fleming model. If financial integration is complete, then a country can pursue monetary autonomy with floating rates, or it can pursue fixed rates while giving up monetary independence. On the other hand, by giving up financial integration, a country could pursue fixed exchange rates and monetary independence. What is not possible is achieving simultaneously all three goals of exchange rate stability, monetary autonomy and financial integration. Summary Points

1. In a flexible exchange rate regime, the exchange rate adjusts so changes in foreign exchange reserves are zero.

2. Under a flexible exchange rate regime, when financial capital mobility is relatively high,

fiscal policy is relatively less effective and monetary policy more effective, as compared to a fixed rate regime.

3. When a country faces higher foreign interest rate, a higher rate of expected currency

depreciation, or an exogenously lower amount of financial inflows, the exchange rate will tend to depreciate, in the absence of a tightening monetary policy.

4. If monetary policy is tightened in response to a balance of payments deficit, the economy

will tend to contract.

5. When the economy is in a liquidity trap, monetary policy will be completely ineffective in increasing output.

6. Under full capital mobility, and with a fixed (flexible) exchange rate regime, monetary

policy is completely ineffective (effective), and fiscal policy completely effective (ineffective).

7. The international trilemma, also known as the impossible trinity, states that an economy can only fully achieve two out of the three goals of financial openness, exchange rate stability and monetary policy autonomy.

Key Concepts

Budget balance

Cyclically adjusted budget balance

Economic and Monetary Union

Exchange rate stability

Financial integration

Monetary independence

Perfect capital mobility

Impossible Trinity

International Trilemma

Liquidity trap

Zero lower bound

Exercises

1. Under a pure floating exchange rate regime, official reserves transactions are always zero, so that the economy is always on the BP=0 schedule. What variable or variables adjust(s) in order to insure this condition holds? 2. 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>

2.1 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. 2.2 Show what happens if government spending is decreased, both immediately, and over

time. You might wish to break up the answer into two steps. 2.3 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?

3. Consider the economy discussed in Exercise 2.

3.1 Draw a graph of initial equilibrium, where the goods and money markets are in equilibrium, as is the balance of payments. Show the impact of a monetary contraction, both immediately and over time.

3.2 Explain why the process you lay out in 3.1 occurs. 3.3 Does your answer to 3.2 change if m/κ > k/h?

4. Consider the same economy described in Exercise 2.

3.1 Assume the economy begins in equilibrium. Show what happens in the short term if the foreign interest rate falls exogenously. What happens to output, the interest rate and the exchange rate?

3.2 Suppose the central bank wishes to maintain output at pre-shock levels. What policies can it implement to achieve that goal?

5. Consider the same economy described in Exercise 2.

5.1 Assume the government wishes to reduce the trade deficit by imposing tariffs to decrease the amount of autonomous imports, . Graphically show the impact on output and interest rates.

5.2 Does the trade balance improve by the amount that autonomous imports decrease? 6. Consider a closed version of the economy in Exercise 2. Exports and imports are both zero, and no financial capital flows cross the border.

6.1 Suppose the economy is in a liquidity trap. Show the impact of a decrease in government spending. Is fiscal policy effective in changing output?

6.2 Suppose the economy is in a liquidity trap. Show the impact of a decrease in the money supply, if the resulting interest rate is positive. Is monetary policy effective in changing output?

7. Consider the economy described in Section 3.7, with the equilibrium interest rate below the interest rate consistent with balance of payments equilibrium.

7.1 Illustrate the initial equilibrium. 7.2 Show how the economy adjusts over time.

8. Consider the Mundell-Fleming model where capital mobility is infinite. Show, using a diagram:

8.1 The impact of contractionary fiscal policy under fixed exchange rates. 8.2 The impact of contractionary monetary policy under floating exchange rates. 8.3 The impact of contractionary fiscal policy under floating exchange rates. 8.4 The impact of contractionary monetary policy under fixed exchange rates.

9. Is it possible to conduct an independent monetary policy if the exchange rate is fixed, but the degree of capital mobility is zero? 10. Suppose capital mobility is infinite. Can a country simultaneously pursue a fixed exchange rate regime and an independent monetary policy?

References Aizenman, Joshua, Menzie Chinn and Hiro Ito, 2010, “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma's Configurations,” Journal of International Money and Finance 29: 615-641. Chinn, Menzie and Hiro Ito, 2006, “What Matters for Financial Development? Capital Controls, Institutions and Interactions,” Journal of Development Economics 61(1): 163-192. Ilzetzki, Ethan, Enrique G. Mendoza, and Carlos A. Végh, 2013, "How big (small?) are fiscal multipliers?." Journal of monetary economics 60(2): 239-254. Klein, Michael W., and Jay C. Shambaugh, 2013, “Rounding the Corners of the Policy Trilemma: Sources of Monetary Policy Autonomy,” NBER Working Papers No. 19461. Obstfeld, Maurice and Alan M. Taylor, 1997, “The Great Depression as a Watershed: International Capital Mobility in the Long Run,” NBER Working Papers No. 5960 (March).