Spending and the Exchange Rate in
the Keynesian Model
Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson
Course in International finance
International Master in Quantitative Finance
Outline
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Transmission of disturbances under different FX regimes
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Expenditure-switching and Expenditure-reducing policies
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–
•
Types of policies
SWAN diagram
Monetary factors
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IS-LM curve
Policy options: monetary expansion, fiscal expansion and/or devaluation
Transmission of Disturbances
Under Fixed Exchange Rates
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How changes in spending are transmitted from one country to another? What is the role of
the FX in that process?
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Internal disturbance in a small country:
Y
1

I s  m
–
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Multiplier is smaller than in the closed economy, due to import leak-out
External disturbance in a small country:
Y
1

X s  m
–
–
•
Shock in foreign aggregate demand transmitted to domestic income, through trade balance
Two-country model: spending multiplier would be a little higher (import leakage returns in the form of
exports). The same holds for export multiplier.
Under fixed FX regime, disturbances are generally transmitted positively from the country
of origin to the trading partners, via trade balance
Transmission of Disturbances
Under Floating Exchange Rates
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Assumptions: KA=0, no central bank interventions, so the FX adjusts automatically to ensure
BP=0 (TB=0)
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Fixed FX: internal disturbance (fall in Investment) causes decline in income, triggering trade
surplus (due to decline in imports)
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Floating FX: in response to TB surplus, the price of foreign currency falls (domestic currency
appreciates), thus stimulating imports and discouraging exports, until the TB is brought to
equilibrium (TB=0)
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Whatever the FX change, the TB remains at 0 (ΔTB=0)
TB  X  mY
X  mY
Transmission of Disturbances
Under Floating Exchange Rates
•
Downward shift in net export due to appreciation should be sufficient to offset derease in imports
due to lower income, so the change in income is as follows
Y 
•
I  X I  mY I


sm
sm
s
Internal disturbances have greater effect under floating exchange rates than under fixed rates
–
–
When exchange rate fluctuates to keep TB=0, it reproduces the effects of closed economy
All disturbances are bottled up inside the country rather than being partially transmitted abroad (change in
income by I
s
Transmission of Disturbances
Under Floating Exchange Rates
Transmission of Disturbances
Under Floating Exchange Rates
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External disturbance (decline in exports demand), triggers decrease in income and a trade deficit,
causing domestic currency depreciation, shifting net exports back upwards until the trade balance
is restored
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In this case the effect on income is eliminated (ΔY=0)
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The floating exchange rate insulates the economy against foreign disturbances
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Floating exchange rate restricts the effects of disturbances to the country of origin
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If shock originates from abroad, floating FX is preferred to fixed
If country is prone to domestic shocks, fixed FX is preferred
Expenditure-Switching and
Expenditure-Reducing Policies
Adjustment to a Current Account Deficit
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In case of a currenct account (CA) deficit, there are two choices: financing or adjustment
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How to reduce CA deficit: expenditure-reducing or expenditure-switching policies
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Expenditure-reducing policies: cut in government expenditure or rise in taxes (or monetary contraction),
triggers decline in imports demand (to some extent)
Expenditure-switching policies: switching expenditures away from foreign goods to domestic goods (e.g.
devaluation)
Expenditure-reducing policies reduce income and employment, while expenditure-switching
policies raise income and employment
Expenditure-Switching and
Expenditure-Reducing Policies
Types of Expenditure-Switching policies
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Price deflation
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Due to minimum wage laws, unions, contracts, etc. this option is usually rulled out
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Devaluation
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Direct trade controls (tarrifs or exports subsidies)
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Nontarrif barriers (quantitative restrictions or quotas)
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10% tarrifs + 10% exports subsidies = 10% devaluation (in terms of relative prices)
e.g. Smoot-Hawley tarrif in the USA in 1930s („beggar-thy-neighbour“ policies), which has triggered strategic
response of trade partners, leading to collapse of world trade. After WWII GATT was set to reduce the tarrifs
Tarrifs yield tax revenues, thus inducing expenditure-reducing effects, while quotas have only expenditureswitching effects, which is why tarrifs are more efficient
Advanced deposits on imports
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The same effect as tarrifs („tarrif“ equal to the interest on deposited money), thus triggering also
expenditure-reducing effects
Expenditure-Switching and
Expenditure-Reducing Policies
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The two-tier exchange rate
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Capital controls
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One exchange rate for current account transactions (fixed FX) and another one for capital-account
transactions (market-based FX)
Difficult to administer (spillover effects from current account to capital account FX market)
…keep capital from moving where it earnes a higher return. If the difference in returns faced by lender is a
difference in real social productivity, then there are social welfare costs
When the central bank is influencing the price of credit, the connection between the market price and social
productivity is no longer certain
Multiple exchange rates
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Using alternative exchange rate for imports of luxury goods
Expenditure-Switching and
Expenditure-Reducing Policies
THE SWAN DIAGRAM
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Two policy goals
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–
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external balance (TB=0)
Internal balance (output equal to full employemnt or to potential output)
Expansionary fiscal policy leads to internal balance, but triggers external balance
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The opposite holds for contractionary fiscal policy
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Devaluation raises output and improves trade balance
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–
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What determines the efficiency of fiscal policy in providing internal balance?
Revaluation leads to internal balance at the expense of external imbalance
Devaluation leads to external balance, but at the expense of internal imbalance
Two policy goals require two policy tools (Tinbergen; Meade, Mundell)
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Expenditure switching (devaluation), and
Expenditure reducing (government expenditure)
Expenditure-Switching and
Expenditure-Reducing Policies
Expenditure-Switching and
Expenditure-Reducing Policies
THE SWAN DIAGRAM: EXTERNAL IMBALANCE
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Another option – starting point is external and internal balance
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If government increases expenditures, it must devalue to maintain external imbalance
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If the economy is not in balance (e.g. any point off the BB line), E is to low or G is to high for
external balance (TB<0)
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–
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For TB=0, both G and E must vary together (BB upward sloping line)
It is necessary to cut G or to increase E, in order to restore external balance
The opposite holds if TB>0 (point S)
Only under floating FX regime will the economy be at the BB line, as the FX adjusts automatically
to maintain external balance
Policy Combinations That Give External
Balance
Expenditure-Switching and
Expenditure-Reducing Policies
THE SWAN DIAGRAM: INTERNAL IMBALANCE
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Starting from external and internal balance and than changing G, means that E must also change
in the reverse manner, to maintain balance
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–
–
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Rise in G implies the need for revaluation
Higher G must be accompanied by a lower E
Internal balance maintained at YY curve
If the economy is not in internal balance (e.g. any point off the YY line), E is to high or G is to low
for internal balance
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–
It is necessary to cut G or to reduce E (to decreasse foreign demand), in order to restore internal balance
The opposite holds if there is a missing demand
Policy Combinations That Give
Internal Balance
Expenditure-Switching and
Expenditure-Reducing Policies
THE SWAN DIAGRAM: EXTERNAL AND INTERNAL IMBALANCE
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Zone I: trade deficit and excess demand
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Zone II: deficit and unemployment
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Zone III: trade surplus and unemployment
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Zone IV: surplus and excess demand
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Only one equilibrium: point A
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What if the country is at the P1 point (trade deficit and unemployment)?
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It should cut expenditures and to devalue to attain internal and external balance simultaneously
P2 is almost the same case, but the correct strategy would be to raise expenditures and to devalue, to reach A
It is a matter of experimentation to discover the optimal strategy (i.e. to devalue and wait to see whether G
should be increased or decreased)
The Swan Diagram of Internal and External
Balance
Monetary Factors
Effect of a Fall in the Interest Rate, I
•
Money supply affects income, via interest
rates
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The lower the interest rates, the higher
investment and expenditure and the lower
saving
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Negative relationship between the interest rate
and income (IS curve)
Central bank sets the interest rate
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In the 1980s it was setting the money supply
Monetary Factors
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•
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Portfolio optimization: money vs other assets
Demand for money decreases as the real
return to alternative assets rises, represented
by the interest rate
Demand for real money is increasing function
of real income
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Positive relationship between the interest rate
and income (LM curve)
Intersection of IS and LM curve gives
equilibrium level of Y and I
There is unique level of income that implies
TB=0
Monetary Expansion
Monetary Factors
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IS-LM equilibrium at the point which implies TB=0
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Three policy options: monetary expansion, fiscal expansion and devaluation
MONETARY EXPANSION
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Monetary expansion shifts LM curve to the right (fall in interest rate and rise in Y), i.e. fall
in interest rate encourages investments and thus triggering rise in income
–
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New equilibrium is at point M
The higher level of expenditure induced by monetary expansion has shifted a country to the trade
deficit
Monetary Factors
FISCAL EXPANSION AND CROWDING-OUT
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G rises, shifting the IS curve to the right (rise
in trade deficit and income)
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By how much fiscal expansion shifts the IS
curve to the right? – Keynesian multiplier
Y 
•
1
G
sm
Increase in expenditure and income raises
money demand, forcing interest rate to go up,
thus discouraging private investment
–
New equilibrium at point F, i.e. income is still
higher than before fiscal expansion, but some
effects have been offset by the crowding-out of
investment
Fiscal Expansion with Crowding-Out of
Investment
Monetary Factors
LIQUIDITY TRAP AND JAPAN IN THE 1990s
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Keynesian model neglects the effects of fiscal expansion on inflation, interest rates and
rising public debt
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…but it showed to be relevant in the Japan crisis in 1990s
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Colapse of stock and real estate bubble triggering deflation, unemployment and slow growth, but
the goods prices did not decline enough to restore equilibrium
Bank of Japan reduced interest rate to zero: further increases in money supply absorbed by the
public withouth bringing reduction of the interest rate – liquidity trap
• LM curve became flat
Two important implications:
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Monetary policy becomes ineffective
Fiscal policy becomes more effective
•
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As LM curve is flat, fiscal expansion triggers no increase in the interest rate to crowd out private investment –
full mupltiplier shows up
In 1997 the government raised taxes to cut the deficit, which pushed the economy back to recession
Monetary Factors
DEVALUATION WITH CROWDING OUT
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Devaluation shifts the X-M line up, so the new equilibrium is at higher level of income (for
any interest rate)
•
By how much does the X-M curve shift to the right?
Y 
•
1
X
sm
If LM curve was flat, devaluation shifts the equilibrium to point L, thus improving the trade
balance by:
TB  X  mY  X  m
1
s
X
X 0
sm
sm
Monetary Factors
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The marginal propensity to import times the
increase in income is only a partial offset to
improvement in trade balance
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If LM has some slope change in income is less
due to crowding out
Income would not have increased in the first
place if devaluation did not stimulate trade
balance