MODULE 44 EXCHANGE RATES ANDMACROECONOMIC POLICY

MODULE 44 ESSENTIAL QUESTIONS

1. What is the meaning and purpose of devaluation and revaluation of a currency under a fixed exchange rate regime?

2. Why do open-economy considerations affect macroeconomic policy under floating exchange rates?

EXCHANGE RATES AND MACROECONOMIC POLICY• Why did Britain not adopt the euro?

• Independence from the rest of Europe • National identity• The rest of Europe is nuts (positive or

normative?)

• What trade-offs were faced? Increased trade vs managing their own monetary

policy

• What was the opportunity cost of this decision?

Britain gave up the ability to become more integrated with the European economy

DEVALUATION & REVALUATION OF FIXED EXCHANGE RATES

1. Adjusting a fixed exchange rate: China & USA for Example

2. Devaluation (depreciation) But WHY?

3. Revaluation (appreciation) But WHY? ?

4. Eliminating shortages and surpluses

5. Tool of macroeconomic policy

DEVALUATION & REVALUATION OF FIXED EXCHANGE RATES

1. Adjusting a fixed exchange rate: China & USA for Example

2. Devaluation (depreciation) But WHY? Devaluation would make American goods more expensive to consumers in China thus

reducing imports from America. China would also experience an increase in net exports to America; aggregate demand

would shift to the right, boosting their GDP. Bang!

3. Revaluation (appreciation) But WHY? ? Goods produced in China become more expensive for American

consumers but less expensive to consumers in China for American products thus increasing imports from America.

China would experience a decrease in net exports to America; aggregate demand would shift to the left, reducing inflation, and GDP.

4. Eliminating shortages and surpluses in FOREX

5. Tool of macroeconomic policy - reduce inflation & recession

MONETARY POLICY UNDER A FLOATING EXCHANGE RATE REGIME

• Ability to pursue independent monetary policy (no interference from other countries) http://en.wikipedia.org/wiki/File:Currency_Exchange_regimes.png

• Monetary policy results in changes in exchange rates and leads to other macroeconomic effects (Increases/decreases in Agg. Demand)

• Changes in interest rates have a direct effect in the exchange rates and influence net exports (draw this graph)

WHY CHINA DOES WHAT THEY DOThe main use of Monetary policy is to stabilize the economy.It can also have an impact on the foreign exchange market. Suppose the market for the Yuan is competitive and the exchange rate with the dollar is floating. What would happen if the central bank of China increased the money supply?1. Interest rates would f________.2. Domestic investment would i_____________.3. Aggregate demand would i________________.4. Foreign investors would seek o_____________ m______________to invest in

financial assets5. The demand for the Yuan would d_____________.6. Chinese citizens would seek nations with h______________ returns on

financial investments so the supply of Yuan would i_____________. 7. With both an i______________supply and d_____________demand, the

value of the Yuan will d_______________against the dollar.8. A depreciated currency will make products made in China l________

expensive to American consumers, thus there would be an i___________ in net exports and another increase in aggregate demand.

WHY CHINA DOES WHAT THEY DOThe main use of Monetary policy is to stabilize the economy.It can also have an impact on the foreign exchange market. Suppose the market for the Yuan is competitive and the exchange rate with the dollar is floating. What would happen if the central bank of China increased the money supply?1. Interest rates would fall2. Domestic investment would increase3. Aggregate demand would increase.4. Foreign investors would seek other nations to invest in financial assets5. The demand for the Yuan would decrease.6. Chinese citizens would seek nations with higher returns on financial

investments so the supply of Yuan would increase. 7. With both an increased supply and decreased demand, the value of the

Yuan will depreciate against the dollar.8. A depreciated currency will make products made in China less expensive to

American consumers, thus there would be an increase in net exports and another increase in aggregate demand.

INTERNATIONAL BUSINESS CYCLE•Shocks from abroad: a recession in Canada will cause a decrease in real GDP in the USA. WHY?

•Synchronized business cycles: Any wonder why the Great Recession was so far reaching? This chain of events is also affected by the exchange rate regime in the U.S.

•Floating exchange rates should lessen the impact of foreign shocks. HOW?1. A recession hits the Canadian economy.2. Canadians d____________ demand for goods made in America.3. This amounts to a d_____________in the demand for the U.S. dollar, and the U.S. dollar

d___________.4. A depreciating U.S. dollar means that goods made in America become more a____________

to Canadian consumers.5. Thus the depreciating U.S. dollar puts the brakes on the d_______________exports to

Canada and the negative impact on the U.S. economy is l_____________.

So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations.

INTERNATIONAL BUSINESS CYCLE

• Shocks from abroad: a recession in Canada will cause a decrease in real GDP in the USA. WHY? Canadians buy many goods made in America, so a recession in Canada means American firms will ship fewer products to Canadian customers. Exports will fall and aggregate demand will fall with it.

• Synchronized business cycles: Any wonder why the Great Recession was so far reaching? This chain of events is also affected by the exchange rate regime in the U.S.

• Floating exchange rates should lessen the impact of foreign shocks…1. A recession hits the Canadian economy.2. Canadians decrease demand for goods made in America.3. This amounts to a decrease in the demand for the U.S. dollar, and the U.S. dollar

depreciates.4. A depreciating U.S. dollar means that goods made in America become more affordable to

Canadian consumers.5. Thus the depreciating U.S. dollar puts the brakes on the diminished exports to Canada

and the negative impact on the U.S. economy is lessened.

So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations.

Review Module Questions p.

Read Module 45 p.

MODULE 45PUTTING IT ALL TOGETHER

WHAT YOU WILL LEARN

IN THIS MODULE:1. How to use macroeconomic models to conduct policy

analysis

2. How to approach free-response macroeconomics questions

A STRUCTURE FOR MACROECONOMIC ANALYSIS

1. A starting point

2. A pivotal event

3. Initial effects of the event

4. Secondary and long-run effects of the event

THE STARTING POINT

•AD/AS Model

• Long-run macroeconomic equilibrium

• A recessionary gap

• An inflationary gap

THE PIVOTAL EVENT

•Recession

•Inflation

•Expectations change

•Wealth change

•Supply shocks

THE INITIAL EFFECT OF THE EVENT• The effects of a curve shifting

SECONDARY AND LONG-RUN EFFECTS OF THE EVENT

•Secondary Effects

• Changes in the price level or real interest rate result in changes in some or all of the following:

• International Capital Flows

• Net Exports

• Investment

SECONDARY AND LONG-RUN EFFECTS

OF THE EVENT

•Long-run Effects

• Government budget

• "Crowding Out"

• Capital formation

• Economic growth