Chapter 25 Flashcards
Internal policy objectives
objectives relating solely to the domestic economy.
External policy objectives
objectives relating to the economy’s international economic relationships.
Internal balance
this is where the economy is at the potential level of national income. In the Keynesian model, it is where the economy is at the full-employment level of national income.
External balance
where the current account of the balance of payments is in balance (floating exchange rates)/ where there is a total currency flow balance at a given exchange rate (fixed exchange rate).
The Exchange rate regime
the system under which the government allows the exchange rate to be determined.
A nominal exchange rate
This is simply the rate at which one currency exchanges for another.
Real exchange rate
This is the exchange rate index adjusted for changes in the prices of imports and exports. If a country’s prices rise (fall) relative to those if its trading partners, its real exchange rate will rise (fall) relative to the nominal exchange rate.
Two extreme regimes:
Totally fixed exchange rate
Freely floating exchange rate
Totally fixed exchange rate
where the government takes whatever measures are necessary to maintain the exchange rate at some stated level.
Freely floating exchange rate
where the exchange rate is determined entirely by the forces of demand and supply in the foreign exchange market with no government intervention whatsoever.
Sterilization
where the government uses open-market operations or other monetary measures to neutralize the effects of balance of payments deficits or surpluses on the money supply.
expenditure switching
were contractionary policies lead to a reduction in inflation and thus cause a switch in expenditure away from imports and towards exports.
The amount that the exchange rate has to change depends on:
The amount that the curves shift.
The elasticity of the curves.
There are a number of possible intermediate systems between the two extremes of totally fixed and completely free-floating exchange rates:
Adjustable peg
Managed floating
Joint float
Exchange rate band
Adjustable peg
This is a system whereby exchange rates are fixed for a period of time but may be devalued (revalued) if a deficit (or surplus) becomes substantial.
In the short and medium term, correction is the same as with a totally fixed system. In the long term the currency can be repegged at a lower or higher rate.
Devaluation = adjusting the peg downwards.
Revaluation = adjusting the peg upwards.
Managed floating
This is a system of flexible exchange rates, but where the government intervenes to prevent excessive fluctuations or even to achieve an unofficial target exchange rate.
The crawling peg is midway between managed floating and the adjustable peg system. It is a system whereby the government allows a gradual adjustment of the exchange rate.
Joint float
This is where a group of currencies pegged to each other jointly against other currencies.
Exchange rate band
This is where a currency is allowed to float between an upper and lower exchange rate but is not allowed to move outside this band.
Three causes of long-term shifts in demand in supply of imports and exports:
Different rates of inflation between countries
Different rates of growth between countries
Income elasticity of demand for imports higher than for exports
Different rates of inflation between countries
if a country has persistently higher rates of inflation than the countries with which it trades, its imports will tend to grow faster than its exports.
Different rates of growth between countries
In a country grows faster than the countries with which it trades, its imports will tend to grow faster than its exports.
Income elasticity of demand for imports higher than for exports –
if the income elasticity of demand for imports is relatively high, and the income elasticity of demand for exports is relatively low, then as world incomes grow, the country’s imports will grow faster than its exports.
LR structural changes
Trading blocs can emerge.
Countries may exercise monopoly power to a greater extent than previously.
Countries may develop import substitutes.
The nature and quality of a country’s products may change.
Advantages of fixed exchange rates:
Certainty – with fixed exchange rates, international trade and investment become much less risky, since profits are not affected by movements in the exchange rate.
Little or no speculation – provided the rate is absolutely fixed there is no point in speculating.
Automatic correction of monetary errors – if the central bank allows the money supply to expand too fast, the resulting extra demand and lower interest rates will lead to a balance of payments deficit. This will force the central bank to intervene to support the exchange rate.
Preventing governments pursuing irresponsible macroeconomic policies – if a government deliberately and excessively expands AD the resulting balance of payments deficit will force it to constrain demand again.
Disadvantages of fixes exchange rates:
Fixed exchange rates make monetary policy ineffective – interest rates must be used to ensure that the overall balance of payments balances. As a result, money supply must be allowed to vary with the demand for money in order to keep interest rates at the necessary level. Thus, monetary policy cannot be used for domestic purposes.
Fixed rates contradict the objective of having free markets.
international liquidity
the supply of currencies in the world acceptable for financing international trade and investment.
Purchasing-power parity theory
the theory that the exchange rate will adjust so as to offset differences in countries’ inflation rates, with the result that the same quantity of internationally traded goods can be bought at home as abroad with a given amount of the domestic currency.
carry trade
borrowing at low interest rates and then using it to buy assets that earn higher rates. In foreign exchange markets, the carry trade involves borrowing money in a currency of a country where interest rates are low and exchanging if for another currency where the country pays higher interest rates.
Speculators seeing the exchange rate falling can react in two ways
Stabilizing speculation
Destabilizing speculation
Stabilizing speculation
occurs when speculators believe that any exchange rate change will soon be reversed.
The action of speculators prevents excessively large exchange rate changes. In general, stabilizing speculation occurs whenever speculators believe that the exchange rate has overreacted to the current economic decision.
Destabilizing speculation
occurs when speculators believe that exchange rate movements will continue in the same direction. The destabilizing speculation could cause overshooting with the exchange rate falling well below the purchasing-power parity rate. At this point speculators, believing that the rate will rise again will start buying pounds again. This causes the exchange rate to rise.
Overshooting
where a fall (or rise) in the long-run equilibrium exchange rate causes the actual exchange rate to fall (or rise) by a greater amount before eventually moving back to the new long-run equilibrium level.
Advantages of a free-floating exchange rate:
Automatic correction
No problem of international liquidity and reserves.
Insulation from external economic events.
Governments are free to choose their domestic policy – under a fixed rate, a government may have to deflate the economy even when there is high unemployment. Under a floating rate, the government can choose whatever level of domestic demand it considers appropriate, and simply leave exchange rate movements to take care of any balance of payments effect.
Disadvantages of a free-floating exchange rate:
Speculation
Uncertainty for traders and investors
Lack of discipline on the domestic economy
Speculation
SR instability can be lessened by stabilizing speculation, thus making speculation advantageous. If, due to SR inelasticity of demand, a deficit causes a very large depreciation, speculators will buy pounds, knowing that in the LR the exchange rate will appreciate again. Their action therefore helps to lessen the SR fall in the exchange rate.
Uncertainty for traders and investors
the uncertainty caused by currency fluctuations can discourage international trade and investment. The problem can be overcome by using the forward exchange market. Which is where contracts are made today for the price at which a currency will be exchanged at some specified future date
Lack of discipline on the domestic economy
governments may pursue irresponsibly inflationary policies.
