Module 44 exchange rates and macroeconomic policy

• 1. EXCHANGE RATES ANDMACROECONOMICPOLICY MODULE 44

2. EXCHANGE RATES AND MACROECONOMIC POLICYThere are three policy issues raise by open-economy macroeconomics 3. DEVALUATION AND REVALUATION OFFIXED EXCHANGE RATESA reduction in the value of a currency that is set under a fixed exchange rate regime is called devaluationRemember that depreciation is a downward move in the value of a currency.So devaluation is a depreciation that is due to a revision in a fixed exchange rate target. 4. DEVALUATION AND REVALUATION OFFIXED EXCHANGE RATESA devaluation makes domestic goods cheaper in terms of a foreign currency, which will lead to higher exports.At the same time, it makes foreign goods more expensive in terms of domestic currency, and reduces imports.The effect of devaluation is to increase the balance of payments on the current account. 5. DEVALUATION AND REVALUATION OFFIXED EXCHANGE RATESAn increase in the value of a currency that is set under a fixed exchange rate regime is called a revaluation.A revaluation makes domestic goods more expensive in terms of foreign currency, which reduces exports, and makes foreign goods cheaper in domestic currency, which increases imports.So revaluation reduces the balance of payments on the current account. 6. DEVALUATION AND REVALUATION OFFIXED EXCHANGE RATESDevaluations and revaluations serve twopurposes, under a fixed exchange rateregime.1. First, they can be used to eliminate shortages or surpluses in the foreign exchange market.2. Second, devaluation and revaluation can be used as tools of macroeconomic policy. 7. DEVALUATION AND REVALUATION OFFIXED EXCHANGE RATESA devaluation, by increasing exports and reducing imports, increases aggregate demand; so a devaluation can be used to reduce or eliminate a recessionary gap.A revaluation, by decreasing exports and increasing imports, decreases aggregate demand; so a revaluation can be used to reduce or eliminate an inflationary gap. 8. MONETARY POLICY UNDER A FLOATING EXCHANGE RATE REGIMEWith a floating exchange rate regime, a countrys central bank retains its ability to pursue independent monetary policy, and can increase aggregate demand by cutting the interest rate, or decrease aggregate demand by raising the interest rate.However, the exchange rate adds another dimension to the effects of monetary policy. 9. MONETARY POLICY UNDER A FLOATING EXCHANGE RATE REGIME A lower interest rate leads to higher investmentand consumer spending. However, with a lower interest rate, foreignershas less incentive to move funds into thecountry, as they will receive a lower rate of returnon their loans. The demand for the currency falls. At the same time, residents have more incentiveto move funds abroad because the rate of returnin foreign countries is relatively higher than athome. Thus, the supply of the currency increases. 10. MONETARY POLICY UNDER AFLOATING EXCHANGE RATE REGIMEThe decrease in demand and increase in supply for the currency causes the exchange rate to fall, and the currency depreciates.This depreciation in the currency increases aggregate demand, increasing the amount of exports and reducing imports. 11. MONETARY POLICY UNDER AFLOATING EXCHANGE RATE REGIMEIn a closed economy, a reduction in the interest rate increases investment and consumer spending.In an open economy with a floating exchange rate, a reduction in the interest rate leads not only to increased investment and consumer spending, but to an increase in net exports, which further increases AD. 12. INTERNATIONAL BUSINESS CYCLESNot all demand changes or shocks originate from the domestic economy.Economies sometimes face shocks coming from abroad.The key point is that changes in AD affect the demand of goods and services produced abroad as well as at home. 13. INTERNATIONAL BUSINESS CYCLESOther things equal, a recession leads to a fall in imports and an expansion leads to a rise in imports.Since one countrys imports are another countrys exports, so there is a link between aggregate demand in different national economies.This is one reason business cycles in different countries sometimes seem to be sinchronized. 14. INTERNATIONAL BUSINESS CYCLESThe extent of this link depends on the exchange rate regime.If a recession abroad reduces the demand for a countrys exports, this is also a reduction in the demand for the countrys currency in the foreign exchange market.If the country has a fixed exchange rate, it responds with exchange market intervention. 15. INTERNATIONAL BUSINESS CYCLESHowever, if the country has a floating exchange rate, the currency depreciates.Because now the countys goods and services are relatively cheaper to foreigners when the demand for exports falls, the quantity of goods and services exported doesnt fall by as much as it would under a fixed rate. 16. INTERNATIONAL BUSINESS CYCLESAt the same time, the fall in the currency makes imports more expensive to the citizens of the country, leading to a fall in imports.Both effects limit the decline in the countrys aggregate demand compared to what it would have been under a fixed exchange rate regime. 17. INTERNATIONAL BUSINESS CYCLESOne of the advantages of a floating exchange rates is that it helps insulate countries from the recessions originating abroad. 18. SOME COUNTRIES WITH FIXED EXCHANGERATESAntarctican dollar Central African CFA Macanese patacaAruban florinfranc Maldivian rufiyaaBahamian dollarComorian francMoroccan dirham Cook Islands dollar Namibian dollarBahraini dinar Cuban convertible pesoNepalese rupeeBarbadian dollar Danish kroneNetherlands AntilleanBelarusian ruble guilder Djiboutian francBelize dollarNew Caledonian franc East Caribbean dollarBermudian dollar Falkland Islands poundOmani rialBhutanese ngultrum French Polynesian franc Panamanian balboaBosnia and Gibraltar pound Qatari riyalHerzegovinaGuernsey poundSaudi riyalconvertible mark Swazi lilangeni Hong Kong dollarBulgarian levJordanian dinar Trinidad and TobagoCaribbean guilderLebanese pounddollarCayman Islands dollarLithuanian litasUnited Arab Emirates dirham Venezuelan bolvar