D. Macroeconomic shocks and policies
1. Internal shocks
b. Fiscal policy (FP)

    Note1: The ER appreciates more in the SR than in the LR. Exchange rate overshooting occurs: the tendency of an adjusting ER to initially go beyond its new long-run equilibrium level.
    (Dornbusch--Journal of Political Economy 84(12/76), 1161-1176: predicted before it was observed)

    Notice how it occurs becuase NX is less elastic in the SR than in the LR
    Helps explain the excessive variability of ERs and =>
    It takes awhile for foreign suppliers to satisfy all of the economy's credit needs
    In the meantime, the currency is overvalued and domestic i-rates are above i-rates abroad
    (speculative bubbles can reinforce overshooting. Example: Appreciating $. Since ER appreciates beyond its LR level at first, there are profits to be made initially by banking on its appreciation rather than its subsequent depreciation. This expectation makes $ a great currency to hold, so speculators bid for it. But the act of buying $ becomes self-fulfilling. Buying $ in the expectation of $ appr. causes the appr. Referred to as a bandwagon effect. Can really augment currency swings. The problem is that the bubble eventually bursts.)

    Note2: In the LR, crowding out of tradables replaces crowding out of investment and can completely offset the FP stimulus.
    (IS shifts all the way back to its original position)
    Example: US: Reaganomics: 1980s versus 1970s:
    Budget deficit rose by 2.0% of GDP
    CAB fell by 2.3% of GDP.
    (shares of GDP, 1971-80 vs 1981-90: (G-T): 2.2% vs 4.2%. CAB: +0.2% vs -2.1%)

    Note: the locomotive effect: foreign sector spreads FP effects to other countries:
    +G --> -NX => +NX*
    Example: +Gus = 1% --> +Yus=1.5%, +Ycanada = 0.7%

    Overall: floating ERs make MP more powerful but FP less powerful.

    Special case: It is possible for NXSR to slope up instead of down. This causes a phenomenon called the "J-curve."

    Return to example of expansionary MP

Growth of money supply R NX ($billion) a. 1991 4.8% 86.5 -29 b. 1992 11.4% 83.4 -39       It is still the case that as elasticities rise over time, the situation reverses and the trade balance rises.

What causes a J-curve?
Very inelastic demands for exports and imports

    Example: suppose Qx and Qm don't change: depreciation will increase TEm but not TRx, so NX falls instead of rises
    How TR and TE change with price (in this case, R), depends on elasticity.

    Recall from Econ101 how price and TR move in the same direction if demand is inelastic (e<1) and in opposite directions if demand is elastic (e>1).
    The same applies to NX, but we have to consider both TR from Xs and TE on Ms.
    The Marshall-Lerner condition does this:

    The combined quantity effects must exceed the price effect
    Note: if either elasticity > 1 we're O.K.
    Example: For OPEC: can't determine the effect of an ER change by looking only at the elasticity of demand for OPEC oil. Need to know OPEC elasticity of demand for imports too. Their short-run demand for our goods rose only a little with their new-found wealth.

    EX: UK: LR elasticities:
    eX by ROW = 0.48 and eM by UK = 0.65
    eX + eM = 0.48 + 0.65 = 1.13, but lower in short run

    See: Devaluation case studies handout

2. Policy making with fixed exchange rates

    A fixed ER is a nominal ER that isn't allowed to move around, outside of a very narrow range called the band.
    The government of a country with fixed ERs pledges to defend the targeted nominal ER (Eo = the "peg").
    Central banks (CBs) must intervene as necessary to prevent currency appreciation and depreciation
    The clue to exchange rate stabilization activity is:
    official reserve transactions (ORT) do not = 0
    => CBs are buying and selling currencies as necessary to try to maintain targeted values

    Who should adopt a fixed ER?
    --The whole world has tried in before:
    Gold-standard: 1880-1914
    Gold-exchange standard: 1945-1973

    --Some economists would like to return to global fixed ERs: Laffer and Mundell want a return to gold standard as part of supply side econ.

    But most large countries or country blocks use floating ERs today.
    A floating ER gives countries macroeconomic independence
    But if it is always best then why not have floating ERs for states or cities too?
    For at least some areas, fixed ERs make more sense

    --2 reasons to choose fixed ERs:
    (1) You fit into an optimal currency area: Members are so dependent on each other for transactions that it is too disruptive to allow daily ER fluctuations
    Especially important because I/T take longer than domestic trans. 3-6 months even for standard Ms and Xs.
    Examples: EU / small trade-dependent countries
    (2) You suffer from hyperinflation due to "irresponsible" Central Banks
    Example: Argentina -- fixed ER = nominal anchor for the country's money supply

Basic setup
    With fixed ERs, traders (CA) and savers (KA) do not have to compete with each other for FX.
    They can behave independently, just turning to Central Banks to fill gaps in FX availability at the stated rates.

    With floating ERs, ERs freely adjust to clear the CA and KA => ORT = 0
    With fixed rates, ERs aren't allowed to clear the CA and KA, so not surprising when CA and KA get out of balance and CBs have to step in
    CBs intervene as necessary to keep E at its peg (Eo)

    CB intervention for stabilization --> "official reserve transactions" which are fundamentally the same as regular MP

    ORT by CBs = MP, but not autonomous.
    CBs must defend E, and MP is the result

    Note1: Impossible to fix ER with all trading partners simultaneously
        Fixed only against the peg itself. If peg appreciates, so do you
        Example: Argentina pegging to the $ (2000: <12% of Xs to US)

    Note2: The peg is nominal, not real: R = Eo^.Pdom/Pfor
        Example: domestic price inflation can still cause real appreciation

    So calling ERs fixed is a bit of misnomer.
    The main result is how the commitment affects policy.