332 Chapter 14 1G Tagg D fore &s = Keynesian multiplier process 27 income > = T money demand = T imports 3 Piterest rate Bof? deficit = Teapital inflows = Bof suplue SS net B of P surplus a™ Flexible exchange rates Fixed exchange rates = Texchange rate = T money supply =P imports, J exports = TageD forg & s = Lage fore &s = fiscal policy stronger fiscal policy weaker Figure 14.1. Reaction to Fiscal Policy ‘The flowchart shows the reaction of tae esonomy to an increase in government spending under both flexible and exchange rate systems ‘Sample Exam Question 14.3: “Economics students are taught about crowding out, But what about crowding in? Couldn't forces from the international sector strengthen fiscal policy?” Is this possible? If so, explain how it could come about, If not, explain why not. 144 International Influence on Monetary Policy ‘Under Flexible Exchange Rates ‘An increase in the money supply lowers the interes rate, and the lower interest rate stimu- lates aggregate demand and moves the economy (o a higher level of income. This rise in income increases imports, creating a balance of payments deficit, and the fallin the interest rate reduces capital inflows, thus augmenting this balance of payments deficit. Higher income may cause foreigners to invest more in our stock market, but this is not viewed as being strong enough to offset this balance of payments deficit, Under a flexible exchange rate system, the balance of payments deficit causes the ‘exchange rate to depreciate, This lower exchange rate increases exports—dixectly increas- ing demand for domestically produced goods and services. It also decreases imports—333 Policy in an Open Economy increasing demand for domestically produced goods and services that compete against imports. The rise in aggregate demand for domestically produced goods and services aug- ‘ments the impact on the economy of the stimulating dose of monetary policy, thus giving ‘greater strength to monetary policy in affecting the income level. This process is shown in figure 14.2 Under Fixed Exchange Rates ‘When the exchange rate is fixed, the balance of payments deficit created by a stimulating dose of monetary policy does not cause the exchange rate to fall, Instead, it causes a decrease in the money supply as the Fed buys dollars with foreign exchange to prevent the balance of payments deficit from lowering the exchange rate, The decrease in the money supply diminishes the stimulating effect of the policy dose, making monetary policy weaker in affecting the income level, This sequence of events is also shown in figure 14.2 ‘There is more to this story, however. An increase in the money supply ereated the balance of payments deficit, and an automatic decrease in the money supply is decreasing the deficit. So long as there is @ net increase in the money supply, there will be a balance mney supply = Fed buys bonds = 7 price of bonds = Limerest ate > > L capital inftows a TageD forg &s 3 Bol deficit => Keynesian mliplier process = Pimpors| = BofP deficit =) BofP deficit Flesible exchange rates Fixed exchange rates => Lexchange rate 9S money supply = Limports, 7 exports Lage D forg&es Page fore as = monetary poiey weaker =} monetary policy stronger but | money supply continues until criginal 7 money supply eliminated => monetary policy completely ineffective Figure 142. Reaction to Monetary Policy ‘This flowchart shows the reaction of the economy to an increase in money supply under both flexible and fixed exchange rate system,334 Chapter 14 of payments deficit. But so long as there is a balance of payments deficit, there will be a decreasing money supply. Consequently only when the original money supply increase hhas been completely wiped out will the deficit be eliminated. The economy will regain ‘equilibrium back where it started, so the end result of this monetary policy is no change. ‘This reflects an extremel important general result: under a fixed exchange rate, monetary policy is completely ineffective as a policy tool. Monetary policy implicitly is being used to fix the exchange rate, so is not available for other purposes. Sample Exam Question 14.4: “But adopting fixed exchange rates entails a step price, namely thatthe government is probibited from {o fight slumps. The upshot is a neat illustration of the “no-free-lunch” maxim so beloved by economists.” Fill in the blank. 145. Sterilization Policy ‘Monetary policy in the context of a fixed exchange rate is ineffective because an expan- sionary monetary policy creates a balance of payments deficit, which automatically decreases the money supply, offsetting and eventually eliminating the original increase in the money supply. What if, however, the monetary authorities take monetary action to ‘counteract the automatic change in the money supply, allowing the original monetary dose to be maintained? As the money supply decreases automatically in the preceding example, the monetary authorities could annually increase the money supply by exactly the same amount This policy is called a sterilization policy because it “sterilizes” the automatic money- supply change that results from an imbalance in international payments under fixed ‘exchange rates. Pursuing this policy maintains the original monetary policy dose and allows monetary policy to retain its effectiveness. Unfortunately, there is a catch: the sterilization policy maintains the imbalance in inter- national payments. In the example, the balance of payments deficit, which would normally disappear as it automatically decreased the money supply, now persists as this automatic ‘mechanism is “sterilized.” What are the implications of a continuing balance of payments deficit? Consider how the government, through its agent the central bank, deals withthe balance ‘of payments deficit, The deficit means that the supply of dollars on the foreign exchange market exceeds the demand, so those unable to obiain forcign exchange for their dollars {20 to the government to exchange them at the fixed rate, The government sells foreign ccurtency to them atthe fixed rate, as it has promised to do, and in return obtains domestic