Exchange Rates Flashcards
Floating rate
○ the exchange rate is determined by market forces
○ It adjusts freely in response to changing market conditions
Fixed rate
x ○ The central bank announces a target for the exchange rate and maintains/”defends” it by intervening in the foreign exchange (FX) market
○ It is usually fixed against one specific foreign currency
○ There are sometimes infrequent adjustments to the peg – this is known as devaluation or revaluation. Recall that appreciation and depreciation are caused by market forces, while devaluation and revaluation are caused by direct intervention
Managed Rate
The exchange rate may also fluctuate within a band – where the central bank sets an upper and lower bound to the rate and allows the rate to flow between those bounds
3 Aspects of Mundell Fleming Model
trade across countries, capital flows across countries, small open economy with free capital flows
free capital flows
§ Capital flows freely between countries without any transaction costs or costly legal restrictions in investing abroad
§ Domestic and foreign assets are considered perfect substitutes
No-Arbitrage Condition
the yield on a long-term bond must equal an average of the policy rates expected over the lifetime of the bond. In this, investors should see no difference between buying a bond or depositing in a bank
Explain the process of how an increase in government spending through fiscal policy leads to exchange rate appreciation but no change in national income
The government increases spending, and through the Keynesian multiplier, this causes income to rise. Consumers have higher income, want to spend more, ad so demand more money, causing the MD curve in the money market to shift right, MD and MS are out of equilibrium and the interest rate rises to clear the money market. However, since this is an open economy, the interest rate must tend towards the world rate. The higher domestic rate causes capital inflows, causing the supply of loanable funds to shift right and bring r back to r*. The inflows also cause an increase in demand of the domestic currency in the forex market, causing the exchange rate to appreciate. This causes NX to fall and perfectly offset other GDP increases – crowding out occurs, meaning income remains the same, while e has appreciated. This means that in a small open economy, fiscal policy is totally ineffective
Why is fiscal policy different in a closed than in an open economy?
In a closed economy, the government can increase GDP without an opposing force from NX, while in an open economy the fall in NX crowds out government attempts to stimulate the economy
The Exchange Rate Channel of Monetary Policy
An increase in the money supply of a small open economy causes the LM* curve to shift right. When the money supply increases, MS exceeds MD and the interest rate falls to clear the money market. There is a corresponding shift left of the LM curve. The fall in the interest rate induces capital outflows and the supply of loanable funds falls, bringing the interest rate back to the world rate. The outflows cause the demand of the currency on the forex market to fall, causing depreciation, which causes NX to rise, and income to rise as well.
How do the exchange rate and interest rate channels of monetary policy differ?
the exchange rate channel occurs in a small open economy, where monetary expansion results in currency depreciation, increasing NX and therefore income. the interest rate channel occurs in a closed economy, where the interest rate does not tend to r*, meaning that an increase in MS caused r to fall, inducing a rise in investment spending, and therefore in GDP
Is fiscal policy effective in a small open economy?
Yes and no –it is not effective in a floating rate regime, since NX would crowd out any fiscal effects. It is effective in a fixed regime, since the rightward shift of the IS* curve would be matched by an increase in the money supply and rightward shift of the LM* curve to preserve the exchange rate – income would rise
Is monetary policy effective in a small open economy
Yes and no – it is effective in a floating rate regime, as e would depreciate and Y would increase. It is ineffective and pointless in a fixed regime, since as soon as the CB launched monetary expansion, it would need to reverse it, so it’s totally pointless
