Small Open Economies with Fixed Exchange Rates

Macroeconomics I

ECON222

Fall 2017

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Key Questions

How does a country x its exchange rate?

How do the impacts of monetary and scal policy change under xed
exchange rates?

What is the open economy trilemma?

Should Canada x its exchange rate with the US?

Macroeconomics I (ECON222) Open Economy IS-LM-FE Model Fall 2017 2 / 16

Fixing the exchange rate

In a xed-exchange-rate system, the value of the nominal exchange

rate is o cially set

An overvalued exchange rate is higher than its fundamental value

An undervalued exchange rate is lower than its fundamental value

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How to maintain an overvalued currency

Impose strong restrictions on international trade and nance

,! has signicant economic costs

Buy back currency in the foreign exchange market

,! the central bank uses foreign reserves to do this
,! cant do it for long because the amount of reserves is limited
,! eventually have to devalue

Fixed exchange rate regimes can end quickly due to speculative runs

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 Figure: An overvalued currency

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How to maintain an undervalued currency

Discourage foreign investment and exports

,! has signicant economic costs

Sell currency in foreign exchange market and accumulate foreign

reserves
,! cant do this forever as trading partnersforeign reserves are limited

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Monetary policy with xed exchange rates

An increase in M:
,! shifts the LM curve to the right so that r < rFor
,! Canadian assets become less desirable
,! the xed exchange rate is now overvalued
,! cannot be sustained for long
,! to avoid devaluation, must eventually decrease M again

Under a xed exchange rate the central bank cannot use

monetary policy to pursue macroeconomic stabilization goals.

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 Figure: Increase in M with xed exchange rates

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Fiscal policy under xed exchange rates
Short run

An increase in G:
,! shifts the IS curve to the right, so that r > rFor
,! Canadian asset become more desirable
,! the exchange rate is undervalued
,! to avoid revaluation, must eventually increase M
,! LM shifts to the right until r = rFor

The monetary expansion required to maintan the xed exchange rate

accommodates the scal expansion

Here scal policy is eective in adjusting domestic output in the

Keynesian short run.

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 Figure: Increase in G with xed exchange rates: short-run

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Fiscal policy under xed exchange rates
Long run

Since Y > Y , in the long run P increases

enom P
,! it follows that e = P For increases and NX falls
,! both LM and IS curves shift back until Y = Y

Eventually net exports are crowded out by the scal expansion

In the Classical model, P and e increase immediately

,! NX is immediately crowded out
,! no impact on Y = Y

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 Figure: Return to General Equilibrium

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Fixed vs. exible exchange rates

Benets of xed-exchange-rate systems:

,! less costly trade between countries, i.e. lower transaction costs
,! potential benets from increased trade and integration
,! promotes monetary policy discipline

The downside is inability to use monetary policy during recessions

,! a exible system is better for countries facing specic shocks that can
be oset with monetary policy.

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The open economy trilemma
In selecting an exchange rate system a country can choose only two
of three features:

1. free cross-border capital ows

2. a xed exchange rate
3. independent monetary policy

Under the Gold Standard (1870-1914) most economies chose 1 and 2

,! restored after WWI, but dropped during Great Depression

Under Bretton Woods system (1945-1973) most chose 2 and 3

,! hard to maintain capital controls in face of globalization

Since 1973, most economies have chosen 1 and 3

,! except for those in the EMS and EMU (since 1999)
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Currency unions

Sharing of a common currency by a group of countries

,! e.g the European Monetary Union

A currency union may reduce the costs and uncertainties of trading

and prevent speculative runs

However, monetary policies cannot be independent

,! there is a single European Central Bank (ECB)

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Summary

A small open economy has more sources of unexpected shocks

Flexible exchange rates provide a self-correcting mechanism

A exible exchange-rate system:

,! neutralizes the eects of both scal policy and shocks to the IS curve
,! monetary policy and shocks to the LM curve have a magnied impact

A xed exchange rate system:

,! neutralizes monetary policy and shocks to the LM curve and
,! magnies the eects of scal policy and shocks to the IS curve

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