Question

How does expansionary monetary policy abroad affect r, CF, e, NX, and Y in the short-run, under floating exchange rates in a large open economy?

Answer 1

• Expansionary monetary policy (↑M^S) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short run.
• Contractionary monetary policy (↓M^S) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run.
• Expansionary fiscal policy (↑G, ↑TR, or ↓T) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policy (↓G, ↓TR, or ↑T) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.
• In the long run, once inflation effects are included, expansionary monetary policy (↑M^S) in a full employment economy causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls.
• A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response.
• A central bank can influence the exchange rate with direct Forex interventions (buying or selling domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.
• A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and their effect on interest rates.
• Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.

• It is important to recognize that these results are what “would” happen under the full set of assumptions that describes the AA-DD model; they may or may not accurately describe actual outcomes in actual economies.

1. Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the short run if government spending decreases in the AA-DD model with floating exchange rates.
2. Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the short run if government spending decreases in the AA-DD model with floating exchange rates.
3. Of increase, decrease, or stay the same, this is the effect on the foreign currency value (vis-à-vis the domestic) in the short run if domestic government spending decreases in the AA-DD model with floating exchange rates.
4. Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the short run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
5. Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the short run if the nominal money supply decreases in the AA-DD model with floating exchange rates.
6. Of increase, decrease, or stay the same, this is the effect on equilibrium GNP in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates.
7. Of increase, decrease, or stay the same, this is the effect on the domestic currency value in the long run if the nominal money supply increases in the AA-DD model with floating exchange rates.

8. When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average U.S. interest rates, which in turn will result in a lower U.S. rate of return in the Forex market. Since RoR_$ < ROR_£ now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (E_$/£) rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher U.S. money supply. Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new A′A′ curve for very long.

   Step 2: Now that the exchange rate has risen to E_$/£¹′, the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G.

   Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate (E_$/£). This moves the economy downward, back to the A′A′ curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A′A′ curve, as shown in the figure.

   Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.

   Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 9 "The AA-DD Model", Section 9.8 "AA-DD and the Current Account Balance", the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.

   Contractionary Monetary Policy

   Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.

   The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, E_$/£, implying an appreciation of the U.S. dollar and a decrease in the current account balance.