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Chapter 24
Floating Exchange Rates and Internal Balance
Overview
This chapter presents the analysis of the macroeconomy of a country that has a floating exchange
rate. If government officials allow the exchange rate to float cleanly, then the exchange rate
changes to achieve external balance.
With floating exchange rates monetary policy exerts strong influence on domestic product and
income. A change in monetary policy results in a change in the country's interest rates. Both the
current account and the financial account tend to change in the same direction. To keep the
overall payments in balance, the exchange rate must change. The exchange rate change results in
a change in international price competitiveness, assuming that it is larger or faster than any
change in the country's price level—overshooting. The change in price competitiveness results in
a change in net exports that reinforces the thrust of the change in monetary policy. We can
picture the change in monetary policy as a shift in the LM curve, and then a shift in the IS and
FE curves to a new triple intersection as the exchange rate and price competitiveness change.
With floating exchange rates the effect of a change in fiscal policy depends on how responsive
international capital flows are to changes in interest rates. If capital flows are sufficiently
responsive, then the exchange rate changes in the direction that counters the thrust of the fiscal
policy change—an effect sometimes called international crowding out. If capital flows are not
that responsive (or, as we enter into the longer time period when the capital flows have slowed),
the change in the current account dominates, so that the exchange rate changes in the direction
that reinforces the thrust of the fiscal policy change. Both cases are shown as a shift in the IS
curve, with the position of the intersection between the new IS curve and the LM curve being
above or below the initial FE curve, depending on how flat or steep the FE curve is. The
exchange rate change then shifts both the IS and FE curves toward a new triple intersection.
Domestic monetary shocks have strong effects on domestic product, with the exchange rate
change reinforcing the thrust of the shock. The effects of domestic spending shocks depend on
how responsive international capital flows are to changes in interest rates. International capital
flow shocks affect the domestic economy by changing the exchange rate and the country's
international price competitiveness. International trade shocks result in changes in the exchange
rate that mute the effects of these shocks on domestic product.
While a cleanly floating exchange rate ensures external balance, it does not ensure internal
balance, and changes in the floating exchange rate to achieve external balance can exacerbate an
internal imbalance. Government monetary or fiscal policies may be used to address internal
imbalances.
Changes in government policies adopted by one country can have spillover effects on other
countries. International macroeconomic policy coordination involves some degree of joint
determination of several countries' macroeconomic policies to improve joint performance.
Efforts at policy coordination in the late 1970s and 1980s include the agreement at the Bonn
Summit of 1978, the Plaza Agreement of 1985, and the Louvre Accord of 1987, but major efforts
at coordination are infrequent. Countries disagree about goals and about how the macroeconomy
works, and the benefits of coordination often are probably rather small.
The box on “Can Governments Manage the Float?” discusses whether selective intervention
which is often sterilized can have significant effects on floating exchange rates between the
major currencies. The conventional wisdom in the early 1980s was that sterilized intervention
was ineffective, but several studies in the early 1990s challenged that conclusion. Recent studies
use recently released data on daily intervention. The general conclusions are that intervention is
usually effective for a number of days, but often there is no effect one month later, and that larger
interventions and coordinated interventions tend to be more effective.
The chapter has the final two boxes in the series on the global financial and economic crisis. The
box “Liquidity Trap!” examines the challenge for monetary policy when the country’s short-term
nominal interest rate hits the lower bound, and the use of quantitative easing as an
unconventional monetary policy to try to escape the trap. The box “Central Bank Liquidity
Swaps” describes the coordinated efforts by central banks to use a new kind of swap line to
address dollar shortages in foreign financial systems that arose during the crisis. The U.S. Fed
essentially lends dollars to foreign central banks so they can lend these dollars to their banks.
Tips
This chapter is deliberately organized to parallel that of the previous Chapter 23 to the extent
possible. This allows for carryover of students' insights and capabilities through Chapters 22, 23,
and 24. It also results in clear contrasts between the behavior of a macroeconomy that has a fixed
exchange rate and one that has a floating exchange rate. The contrasts in the effects of shocks are
summarized in Figure 24.7, and other contrasts are reviewed in the next Chapter 25.
The method of analysis of policy changes and shocks used in the text is a bit mechanical, but it
does seem to assist students in grasping the implications of floating exchange rates. We
deliberately follow the same sequence for each change or shock: (1) the effects of the shock on
the economy if (hypothetically) the exchange rate were unchanged, (2) the resulting pressure that
causes a change in the floating exchange rate, and (3) the (additional) effects on the economy of
this exchange rate change.
In presenting this material one should probably offer cautions that the effects do not always play
out as suggested by the theory, because floating exchange rates do not always move in the
directions indicated. This may be due to changes in investors' expectations of future exchange
rates that are not captured by the approach, or it may be due to other shocks and news that are
also influencing exchange rates.
The box on “Why Are U.S. Trade Deficits So Big?” provides an application of the floating-rate
analysis to the macroeconomic experience of the United States since 1980. The box shows that
changes in the real exchange rate and changes in the trade deficit (with the expected lag) have
been closely correlated. Digging behind this relationship to examine saving and real investment,
it appears that the large U.S. trade deficits were the result of the government budget deficit in the
1980s, and were the result of a real investment boom in the late 1990s, with the fiscal deficit
again becoming important in the early 2000s.
Appendix G uses the aggregate demand-aggregate supply framework to examine the effects of
shocks, with the AD curve incorporating the effects of the induced change in the floating
exchange rate to maintain external balance.
