International Business Chapter 26 The Financial Account Influenced Such Phenomena The Foreign Interest Rate Expected Exchange

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CHAPTER 26

ECONOMIC POLICY IN THE OPEN ECONOMY

UNDER FLEXIBLE EXCHANGE RATES

Learning Objectives:

■ Analyze the impact of fiscal policy on income, trade, and exchange rates under flexible

exchange rates.

I. Outline

Introduction

– Movements to Flexible Rates

The Effects of Fiscal Policy under Flexible Exchange Rates with Different Capital

Mobility Assumptions

II. Special Chapter Features

Concept Box 1: Real and Financial Factors That Influence the BP Curve

III. Purpose of Chapter

The purpose of this chapter is to introduce students to the adjustment mechanisms under a

flexible exchange rate system and to make them aware of the implications of flexible exchange

rates for the use of domestic policy instruments.

IV. Teaching Tips

A. The opening paragraph sketches some choices that have been made by several different

countries regarding their exchange rate regimes. Students will be inclined to think that such

B. One of the keys to understanding the analysis in this chapter is grasping how changes in

the exchange rate, along with other variables, shift the BP curve back and forth. It is important

to review this (again) before you get into the content of the chapter.

C. The various assumptions regarding capital mobility are more critical under flexible rates

than under fixed rates. This point can be driven home in the case of fiscal policy actions that

D. We find it useful to emphasize strongly the effects of exogenous international shocks

such as relative price changes, foreign interest rate changes, etc., on the domestic economy. This

makes the students aware of the difficulty of carrying out economic policy when one has to deal

not only with domestic factors but also with events taking place in other countries.

E. As part of the comparative statics exercises, examine the impact of a change in domestic

V. Answers to End-of-Chapter Questions and Problems

1. If the intersection of the IS and LM curves is at a point below the BP curve, there will be

an incipient BOP deficit and depreciation of the home currency. Assuming that the Marshall-

2. The position of the BP curve is influenced by any factor other than domestic income and

the interest rate that impacts upon the capital/financial and current accounts in the balance of

payments. Therefore, foreign and domestic prices, expected prices, foreign and domestic tastes

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account is influenced by such phenomena as the foreign interest rate, expected exchange rates,

domestic and foreign rates of return on investment, foreign and domestic tax policy, foreign and

domestic financial reforms, and relative economic/political stability.

3. Fiscal policy is completely ineffective when capital is perfectly mobile. This result

occurs because the upward pressure on the domestic interest rate generated by expansionary

4. Under a fixed-rate system, the country is committed to maintain the exchange rate either

through unobstructed gold movements or by appropriately buying or selling foreign exchange.

As a result, the central bank loses control of the money supply as an instrument for meeting

5. Under a flexible-rate system, expansionary monetary policy puts downward pressure on

the interest rate which, in turn, puts downward pressure on the value of the home currency as

investors shift out of financial investments denominated in the home currency. Depreciation of

6. Expansionary monetary policy will increase exports and decrease imports (assuming that

the Marshall-Lerner condition is met) as downward pressure is put on the interest rate and,

7. Without additional information the precise impact of expansionary fiscal policy on the

exchange rate is ambiguous because it depends on the interest-responsiveness of short-term

capital internationally compared to the interest-responsiveness of the domestic money market

(i.e., is the BP curve flatter or steeper than the LM curve?). In the case where the BP curve is

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8. If there is a rise in the expected appreciation of the foreign currency, there will be an

incentive for investors to shift toward foreign currency-denominated financial assets. Thus, for

every level of income, it will now take a higher domestic interest rate to balance the balance of

9. Under a flexible-rate system, the foreign price increases in petroleum and food would

stimulate U.S. exports and reduce U.S. imports, leading to upward pressure on income and

interest rates and an appreciation of the currency. The stronger dollar offsets, at least in part, the

10. With the increase in interest rates in the EU, there will be an increase in demand for

foreign exchange (e.g., the euro or the British pound) to invest abroad in order to take advantage

of the higher earning potential (i.e., the BP curve will shift up, indicating that it will now take a

VI. Sample Exam Questions

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1. Under a flexible exchange rate system, changes in the foreign rate of interest will affect

2. If capital is imperfectly mobile (with BP flatter than LM), explain why governments find

fiscal policy less effective under flexible rates compared to fixed rates. Is fiscal policy ever

completely ineffective? If so, under what conditions? If not, why not?

3. Under flexible exchange rates, expansionary fiscal policy is less likely to lead to

4. It appears that the world is becoming more financially interdependent. How might you

incorporate this change, if necessary, in the IS/LM/BP model? What are the implications of this

change for macro policy in general and fiscal policy in particular?

5. The movement to more flexible exchange rates has made it necessary to more fully

6. Explain, using the IS/LM/BP model, how an increase in foreign interest rates can lead to

an increase in domestic interest rates.