Global Economic Analysis - Effect of Monetary Policy

Unanticipated changes in monetary policy will produce both price (substitution) and income
effects. For example, suppose monetary authorities begin a program of expansionary (easy)
monetary policy.

We would then expect the following sequence of events to occur with regard to the price effect:

·Real interest rates will be reduced.

·As real interest rates are reduced, domestic financial and capital assets become less attractive as
a result of their lower real rates of return. Foreigners will reduce their positions in domestic
bonds, real estate, stocks and other assets. The financial account (or balance on capital account)
will deteriorate as a result of foreigners holding fewer domestic assets. Domestic investors will
be more likely to invest overseas in the pursuit of higher rates of return.
·The reduction in domestic investment by foreigners and the country's citizens will decrease the
demand for the nation's currency and increase the demand for the currency of foreign countries.
The exchange rate of the nation's currency will tend to decline.
·With no government intervention, the financial account and the current account must sum to
zero. As the financial account declines, the current account will be expected to improve by an
equal amount. In other words, the balance of trade should improve. The country's export will
have become relatively cheaper and imports will be relatively more expensive.

The effect of an expansionary monetary policy is to lower the exchange rate, weaken the
financial account and strengthen the current account. A restrictive monetary policy would be
expected to result in the opposite: a higher exchange rate, a stronger financial account and a
weaker current account (a more negative, or a less positive balance of trade).

With a program of expansionary (easy) monetary policy, the following sequence of events would
be expected to occur with regard to the income effect:

·The domestic GDP will rise.

·The rise in domestic GDP will tend to increase the demand for imports. The increase in imports
will cause the current account to deteriorate.
·The increase in imports purchased will increase the need to convert domestic to foreign
currency. As a result, the exchange rate of the domestic currency will decrease.
·With no government intervention, the financial account must now move toward a surplus as the
financial and current account must sum to zero. Due to the increase in imports, foreigners will
now have a surplus of the nation's currency. If foreigners do not use that currency to purchase the
country's exports (which would improve the current account balance), they will ultimately need
to invest that currency in the assets of the domestic country. This explains why countries such as
China and Japan invest large sums in assets such as U.S. Treasuries. The holders of the U.S.
currency must put it to work somewhere! Note that foreign investors are often getting better rates
of return than what might be readily apparent because the value of the domestic currency is
falling relative to their own currency.

In summary, the income effect of expansionary monetary policy tends to lower the domestic
currency exchange rate, weaken the current account and work to improve the financial account.
A restrictive monetary policy tends to cause the opposite due to the income effect. The domestic
currency exchange rate increases, the current account improves and the financial account
weakens.

As both price and the income effects of monetary policy move in the same direction regarding
their impact on the exchange rate, it is clear that expansionary (restrictive) monetary policy will
lower (raise) the country's exchange rate. The effect of monetary policy on the current and
financial accounts is not so clear because the price and income effects move in opposite
directions. For example, the price effect of easy money on the current account tends to
strengthen it, while the income effect tends to weaken the current account. Since the effects
move in opposite directions, it is not immediately clear what the ultimate impact will be.

We should note that investors can buy and sell financial assets such as stocks and bonds more
quickly than producers and consumers can sell and buy physical goods. So initially, interest rate
(substitution) effects would be expected to dominate. An unanticipated increase in the money
supply will cause the exchange rate to go down, the financial account to weaken and current
account to gain strength. Over time, the income effect will come into play. A rising GDP will
cause both the trade balance and financial account to weaken.

Some argue that for an economy with a foreign sector, monetary policy can create cyclical
movements that tend to destabilize an economy. Unanticipated expansionary monetary policy
initially causes the trade balance to improve, but as time progresses, it causes the trade balance to
become more negative. It initially causes the capital account to weaken due to lower interest
rates, but then later tends to improve it. In the long run, the main effect of the expansionary
monetary policy is a lowering of the nation's currency exchange rate, which is the international
equivalent to the long-run effect of expansionary monetary policy, inflation. Empirical evidence
indicates that countries with high rates of monetary supply growth experience both inflation and
declining currency exchange rates. An important point to consider is the exchange rates of two
countries - their relative rates of money supply growth will help determine how the exchange
rate changes.

Fiscal policy changes will produce both price (substitution) and income effects for exchange
rates and balance of payments. Suppose government policymakers enact a program of
unanticipated fiscal stimulus. This would be expected to cause the following sequence of events
to occur with regard to the price effect:

·Greater government budget deficits caused by tax cuts and/or increased spending will increase
the demand for investable funds, which will cause interest rates to rise.
·The increase in interest rates will cause capital inflows (foreigners will purchase more domestic
financial assets). As a result, the capital account will strengthen (become more positive or less
negative).
·Foreign investors will need to exchange their currency for the domestic currency. The increased
demand for the domestic currency will cause its exchange rate to increase.
·If there is no government intervention with the balance-of-payments, the current account will
need to become more negative (or less positive). The trade balance will weaken as imports
increase and/or exports decrease. This makes sense because the strengthening of the nation's
currency will make its exports relatively less attractive to foreigners and imports will be less
expensive relative to the country's consumers and domestic businesses.

To summarize, the price effect of a stimulative fiscal policy is to raise the value of the domestic
currency, strengthen the capital account and weaken the current account. A restrictive fiscal
policy would have the opposite effects: a weaker domestic currency, a weaker capital account
(there would be net capital outflows) and a stronger current account.

With a program of fiscal stimulus, the following sequence of events would be expected to occur
with regard to the income effect:

·The tax cuts and/or increase in government spending associated with the fiscal policy, and the
associated multiplier effect, will increase GDP.
·The rise in GDP will cause the demand for imports to increase and the current account will be
weakened (become more negative or less positive).
·More domestic currency will need to be converted into foreign currencies to purchase the
increased quantity of imports. The increased supply of domestic currency on the international
markets will cause the exchange rate to decline.
·With no government intervention, the financial account will need to become more positive (or
less negative) in order to compensate for the weakening of the current account. Foreigners will
be holding more of the domestic currency and are therefore in a position to purchase more of the
nation's financial assets. Also, as the domestic economy is improving, they may find it more
attractive as a place to invest.

To summarize, the income effect associated with fiscal stimulus will tend to lower the exchange
rate of the country's currency, weaken the current account (trade balance) and strengthen the
financial account.

Fiscal policy price and income effects move in the same direction with regard to their impact on
the financial and current accounts. Stimulating fiscal policy will clearly weaken the current
account (balance of trade) and strengthen the capital account. Restrictive fiscal policy will
strengthen the current account (balance of trade) and weaken the capital account.

The impact of fiscal policy on exchange rates is not so clear because the price and income effects
work in opposite directions. The income effect tends to weaken the currency exchange rate,
while the price effect will tend to strengthen the currency exchange rate. Because foreign
investors can trade financial assets (such as stocks and bonds) more quickly and easily than
consumers and producers can alter the purchase and sale of physical assets, the price effect
would be expected to have the larger initial effect. Over time, the income effect will increasingly
come into play.

So initially, the fiscal stimulus should cause the domestic currency to appreciate. Over time, as
the demand for imports is stimulated, the domestic currency will weaken. If the fiscal stimulus is
associated with inflation, there will be a further weakening of the domestic currency. Note that
the fiscal stimulus will also have the effect of worsening the balance of trade and increasing the
financial account in both the short and long run.

A stimulative fiscal policy is good for the economy when it is operating below full employment
levels. There are a couple of factors that will mitigate the positive effects. One factor is that
government deficits will work to increase interest rates, which can crowd out private investment.
Another factor is that after foreign capital comes in (due to higher interest rates), the domestic
currency exchange rate rises. This leads to a rise in imports, which reduces GDP. These two
factors lessen the positive effects of fiscal policy stimulus.

Global Economic Analysis - Currency Appreciation and

Depreciation

Current and Financial Account Surpluses and Deficits

Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly affect
an economy. In fact, these deficits (surpluses) are actually the result of what is occurring in an
economy, instead of being the cause. Trade deficits often occur when a nation's economy is
growing faster than the economies of its trading partners. Rapid domestic growth increases the
demand for imports, while slow or no growth with foreign economies can cause a decline in
demand for the country's exports.

Trade balances are also affected by capital flows. If a nation's economy offers investment
opportunities that are relatively better than other nations, then capital will flow into the country.
With flexible exchange rates, this capital inflow will tend to increase the value of the nation's
currency.

Economic statistics support the hypothesis that trade deficits are associated with investment
opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant
economic growth for the U.S., trade deficits and net foreign investment were fairly small. As the
U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly increased.
During the recession of the early 1990s, capital inflow greatly decreased and the current account
was actually slightly positive during one of those years. The time between 1993 and 2000 was
one of substantial economic growth; net capital inflows greatly increased, which caused the U.S.
dollar to appreciate and the current account ran large deficits.

Budget deficits and trade deficits tend to be linked

An increase in the U.S. government budget deficit will cause an increase in the real interest rate,
which causes additional foreign capital to flow into the country. The inflow of foreign currencies
will cause the value of the U.S. dollar to increase in relation to other currencies. The increase in
value of the U.S. dollar will make U.S. exports relatively less attractive to foreigners and imports
into the U.S. will be relatively less expensive; therefore, net exports will go down. The increase
in the budget deficit leads to an increase in the trade deficit.

Causes of a Nation's Currency Appreciation or Depreciation

Factors that can cause a nation's currency to appreciate or depreciate include:
·Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy
those goods. In order to buy those goods, they will need to buy the nation's currency. Countries
with the lowest price levels will tend to have the strongest currencies (those currencies will be
appreciating).

·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the
supply of their currencies, which will cause the currency to depreciate. Those countries with
restrictive (hard) monetary policies will be decreasing the supply of their currency and the
currency should appreciate. Note that exchange rates involve the currencies of two countries. If a
nation's central bank is pursuing an expansionary monetary policy while its trading partners are
pursuing monetary policies that are even more expansionary, the currency of that nation is
expected to appreciate relative to the currencies of its trading partners.

·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation

(appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of its
trading partners remain relatively stable. U.S. goods will seem very expensive to foreigners,
while U.S. citizens will increase their purchase of relatively cheap foreign goods. The U.S. dollar
will depreciate as a result. If the U.S. inflation rate is lower than that of its trading partners, the
U.S. dollar is expected to appreciate. Note that exchange rate adjustments permit nations with
relatively high inflation rates to maintain trade relations with countries that have low inflation
rates.

·Income Changes - Suppose that the income of a major trading partner with the U.S., such as
Great Britain, greatly increases. Greater domestic income is associated with an increased
consumption of imported goods. As British consumers purchase more U.S. goods, the quantity of
U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will appreciate.

Global Economic Analysis - International Finance

Law of Demand for Foreign Exchange

The law of demand for foreign exchange states that, all other factors remaining equal, the
quantity demanded of a particular currency will decrease (increase) as the exchange rate goes
higher (lower). Demand for a country's currency is derived from the goods or services produced
by that country. The purchase of a Japanese car by an American consumer will necessitate the
conversion of dollars to Japanese yen. As the exchange rate rises (in terms of Japanese yen),
Japanese cars will become more expensive to American consumers, who will in turn buy fewer
Japanese cars. The lower demand for Japanese cars will lead to a decreased demand for the yen.
If the exchange rate for the yen vs. the dollar goes down, Japanese goods will be cheaper for
American consumers. As a result, more Japanese goods will be purchased and more dollars will
be exchanged for yen.

Law of Supply for Foreign Exchange

The law of supply for foreign exchange states that, all other factors remaining equal, the supplied
quantity of a particular currency will increase (decrease) as the exchange rate goes higher
(lower). U.S. citizens supply U.S. dollars to the foreign currency market when they buy foreign
goods or services, or when they purchase foreign assets such as real estate or stocks. As the
exchange rate increases (e.g. the price of a U.S. dollar in terms of Japanese yen goes from 100
yen per dollar to 110 yen per dollar), more U.S. dollars will be supplied as U.S. citizens get more
value for their "buck".

Factors Affecting the Quantity of Demand and Supply for Currency

There are two main factors that affect the quantities demanded and supplied for a particular
currency:

·Relative interest rates

·Expectations concerning future exchange rates

If, for example, interest rates in the United States are higher than those of other countries,
foreigners will want to convert their currencies to dollars in order to earn a higher rate of return.
Their actions will cause a reduction in the supply of dollars.

Expectations about future exchange rates will also impact current quantities demanded and
supplied for currencies. For example, suppose the current exchange rate for euros and dollars is
$1.20 per euro and an importer of European goods expects the euro to depreciate next month to
$1.1 per euro. That importer will hold off on converting dollars to euros thereby decreasing the
current quantity demanded for euros and the quantity supplied for dollars.

How is the Exchange Rate Influenced by Supply and Demand

If the demand for a currency increases (decreases) while the supply remains the same, the
exchange rate will rise (decline) to achieve market equilibrium. If the supply of a currency
increases (decreases) while demand remains the same, the exchange rate will decline (rise).
Exchange rates can be volatile because supply and demand are affected by common factors, such
as interest rate differentials and expectations.

Global Economic Analysis - Fixed vs. Pegged Exchange

Rate Systems
A fixed exchange rate system maintains fixed exchange rates between currencies; those rates are
referred to as official parity. A nation with fixed exchange rates must enforce those rates. An
early form of fixed exchange rates was to specify the value of a nation's currency in terms of
gold (the "gold standard").

The Gold Standard

The gold standard system worked reasonably well during the 1800s, but it was gradually
disbanded during the twentieth century. In 1944, leading non-communist nations agreed on a
fixed exchange rate system (the Bretton Woods System) whereby the value of the U.S. dollar
was pegged at $35 per ounce and other nations then fixed the value of their currencies in relation
to the U.S. dollar. Private individuals could not acquire gold at that price; only governments
traded gold at that price. During the 1960s, the U.S. government pursued an expansionary
monetary policy in an attempt to finance the Vietnam War and increase domestic entitlement
programs ("guns and butter") without raising taxes. The inflationary monetary policy induced
nations to begin a run on U.S. gold, and the U.S. was forced to stop redeeming dollars for gold
and break the fixed exchange rate system that had been started in 1944.

Read more on the Gold Standard's rise and fall in the following article:
The Gold Standard Revisited

A nation operating under a fixed exchange rate system (pegged to the dollar) that experiences a
balance of payments deficit will be forced to finance the deficit out of its dollar reserves. As the
number of dollars declines, the nation's money supply is reduced. This causes prices to drop and
interest rates to increase. The price drops make the nation's goods more competitive
internationally; the higher interest rates also cause more capital to flow into the country. These
forces help the nation to achieve equilibrium with its balance of payments.

The advantages of fixed exchange rate systems include the elimination of exchange rate risk, at
least in the short run. They also bring discipline to government monetary and fiscal policies.
Disadvantages include lack of monetary independence and increases in currency speculation
regarding possible revaluations.

Pegged Exchange Rate System

A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes.
Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to a
basket of currencies. The choice of the currency (or basket of currencies) is affected by the
currencies in which the country's external debt is denominated and the extent to which the
country's trade is concentrated with particular trading partners. The case for pegging to a single
currency is made stronger if the peg is to the currency of a principal trading partner. If much of
the country's debt is denominated in other currencies, the choice of which currency to peg it to
becomes more complicated.

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual
exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given
changes in economic fundamentals, the target exchange rate may be modified.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they
may need to resort to central bank intervention, the imposition of tariffs or quotas, or the
placement of restrictions on capital flow. If the pegged exchange rate is too far from the actual
market rate, it will be costly to defend and it will probably not last. Currency speculators may
benefit from such a situation.Advantages of pegged exchange rates include a reduction in the
volatility of the exchange rate (at least in the short-run) and the imposition of some discipline on
government policies. One disadvantage is that it can introduce currency speculation.