• Increase money supply to stimulate output. ⇒ Exchange rate is under depreciation pressure. ⇒ Money supply must be reduced to its original level. Fiscal Policy
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International Monetary Theory and Policy, EC247/347
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Fixing the Exchange Rate to Escape from Liquidity Trap • Liquidity trap ◦ Monetary policy cannot stimulate the economy by incrasing the money supply (liquidity). ◦ Example: nominal interest rate already zero (it cannot be negative) ⇒ Further increase in money supply has no effect on the interest rate. ⇒ If output is lower than its natural level, monetary policy cannot effect it. • Interest parity condition with R = 0 Ee − E ∗ 0=R=R + E e E ⇒ E= 1 − R∗ • Escaping from liquidity trap ◦ Monetary expansion has no effect on output (output is trapped). ◦ Central bank has to peg the exchange rate at a level higher than E e. ⇒ Currency depreciates. ⇒ World demand for domestic goods rises.
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• Key fact 1: ◦ Monetary policy is an ineffective tool of stabilization whereas fiscal policy is an effective one under fixed exchange rate regime.
AA2
Stabilization Policies with a Fixed Exchange Rate
• How can the government stabilize output and maintain fixed exchange rate at the same time? ◦ Previously we looked at how the government can stabilize output if the exchange rate is flexible.
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Monetary Policy
Output, Y
Fiscal Expansion Under Fixed Exchange Rate DD1
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Exchange rate, E
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Output, Y
International Monetary Theory and Policy, EC247/347
Internal Balance: Full Employment and Price-Level Stability • Over- or underemployment of resources are costly. • Inflation is costly. ◦ Predictable changes in prices are less costly. ◦ Unpredictable changes in prices are costly. External Balance: The Optimal Level of Current Account • Gains from trade: ◦ Intertemporal gain ⇒ some times CA deficit and some times CA surplus is desirable. • Problems with excessive CA deficit: ◦ Deficit is financed with borrowing that has to be repaid. • Problems with excessive CA surplus: ◦ Low domestic investment. ◦ Lending risk.
International Monetary Theory and Policy, EC247/347
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International Monetary Theory and Policy, EC247/347

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Monetary Expansion is Ineffective Under a Fixed Exchange Rate DD
Macroeconomic Policy Goals in an Open Economy
• Internal balance: ◦ Full employment of a country’s resources, ◦ Domestic price level stability. • External Balance: ◦ No excessive the current account surplus, ◦ No Excessive the current account deficit.
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International Monetary Theory and Policy, EC247/347
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E 1 − R∗
Ee 1 − R∗
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International Monetary Theory and Policy, EC247/347
Week 10, Autumn 2003
Fixing Exchange Rate to Restore Full Employment
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Output, Y
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A Low-Output Liquidity Trap
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Exchange rate, E
Ee 1 − R∗
Exchange rate, E 0
Exchange rate, E
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International Monetary Theory and Policy, EC247/347
Week 10, Autumn 2003
International Monetary Theory and Policy, EC247/347
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The International Monetary System, 1870-1973
• Our analysis so far: ◦ How a country’s fiscal and monetary policy can affect its output and employment given the macroeconomic conditions in the rest of the world. • Open economies are interdependent ◦ Channels of interdependence depend on monetary and exchange rate arrangements. ⇒ International Monetary System.
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AA2 AA1
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• Fiscal expansion ⇒ ⇒ ⇒ ⇒ Aggregate demand increases at any E , Output rises, Excess demand for money, Upward pressure on R, and downward pressure on E , ⇒ Central bank increases money supply to keep E = E 0.