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Macroeconomic policy and the exchange rate system


Our analysis of business cycles and economic growth has generally focused on policies in a closed economy. We analyzed the way that monetary and fiscal policies can help stabilize the business cycle, shaving the peaks off inflation and the troughs off output. How do macroeconomic policies change in an open economy? Surprisingly, the answer to this question depends crucially on whether the country has a fixed or flexible exchange rate.

Fixed Exchange Rates. The key feature of countries with fixed exchange rates and high capital mobility is that their interest rates must be very closely aligned. For example, if France and Germany have a fixed exchange rate and investors can easily move funds between French francs and German marks, the Replica Omega interest rates of the two countries must move together. Any interest-rate divergence will attract speculators who will sell one currency and buy the other until the interest rates are at the same level.

Consider a small country which pegs its exchange rate to a larger country. It could be Holland pegging to Germany. Because the small country’s interest rates are determined by the monetary policy of the large country, the small country no longer has an independent monetary policy. The small country’s monetary policy must be devoted to ensuring that its interest rates are aligned with its partner’s.

Macroeconomic policy in such a situation is therefore exactly the case described in our multiplier model above. From the small country’s point of view, investment is exogenous, because it is determined by world interest rates. Fiscal policy will be highly effective because there will be no monetary reaction to changes in G or T.

Flexible Exchange Rates. Surprisingly, macroeconomic policy with flexible exchange rates operates in quite a different way from the fixed exchange-rate case. Monetary policy becomes highly effective with a flexible exchange rate.

One of the best examples of the operation of macroeconomic policy with flexible exchange rates occurred when the Federal Reserve tightened money in the 1979-1982 periods. The monetary tightening raised U. S. interest rates, which attracted funds into dollar securities. This increase in demand for dollars drove up the foreign exchange rate on the dollar. At this point, the multiplier Omega Seamaster Replica mechanism swung into action. The high dollar exchange rate decreased net exports and contributed to the deep U. S. recession of 1981-1983. This had the impact of both lowering real GDP and lowering the rate of inflation.

Another example occurred in 1994-1997. During this period, the U. S. economy grew rapidly while Europe and Japan stagnated. Monetary policy in the United States was relatively tight, while Japanese short-term interest rates approached zero. As a result, the dollar appreciated sharply against European and Japanese currencies. This was what the macroeconomic doctor ordered, however, for the appreciation of the dollar retarded growth in the United States just as it was pushing against productive capacity while giving a boost to the depressed output in the other regions.

We see, then, that foreign trade actually opens up another link in the monetary transmission mechanism. Monetary policy affects net foreign investment (equal to net exports) as well as domestic investment. It is important to note that the foreign-investment impact reinforces the domestic investment: tight money lowers output and prices.

Realistic Complications. International trade opens new investment and consumption opportunities for a country, but it also complicates the life of economic policymakers. One complication occurs because the quantitative relationships between monetary policy, the exchange rate, foreign trade, and output and prices are extremely complex, particularly at the very first link. Current economic models cannot accurately predict the impact of monetary-policy changes on exchange rates. Further, even if we knew the exact money-exchange-rate relationship, the impact of exchange rates on net exports is complicated and difficult to predict. Moreover, exchange rates and trade flows will be simultaneously affected by the fiscal and monetary policies of other countries, so we cannot always disentangle the causes and effects of changes in trade flows. And the capital account may add further layers of complexity and unpredictability. When political conditions, tax laws, or the inflation outlook change, this may attract or repel investors’ funds, change the demand for a nation’s assets, and affect exchange rates. On balance, confidence in our ability to determine the best timing and likely effects of monetary policies has diminished in recent years as our economy has Omega Replica Watches become more open to trading and financial flows.

Foreign economic relations add another dimension to economic policy. Domestic policymakers must concern themselves with foreign repercussions of domestic policies. Rising interest rates at home change interest rates, exchange rates, and trade balances abroad, and these changes may be unwelcome.

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