D. Macroeconomic shocks and policies
2. Fixed exchange rates

Key results

(1) Independent monetary policy does not work

Example: Expansionary MP Step 1: Increase supply of money Step 2: Defend ER     To maintain targeted ER, Fed must sell FX and buy back $ --> offsetting contractionary MP     General property of fixed ERs: With fixed ERs and mobile assets, monetary policy does not work.     Intuition: MP can't serve 2 masters. When committed to defending ERs, can't be used to influence output at the same time.

    1979: Fed made a big deal about pegging the money supply instead of interest rates. That option was available only because the US was under floating ERs. With fixed ERs, Fed cannot choose its policy

    Not necessarily bad news: LDCs may lack confidence that CBs will be responsible or CBs may be subject to too much political pressure: Use fixed ERs. Keeps CB disciplined. Maintains stability and confidence. Avoids capital flight.

(2) Fixed ERs enhances the effectiveness of fiscal policy

Step 1: Increase G     Step 2: Defend ER with expansionary MP     Result: FP gets reinforced by automatically accommodating MP.     hG g matching hY instead of iNX Long run: Step 3: Inflation raises R.     hG g matching iNX

    Overall: fixed ERs with capital mobility make FP more powerful but MP useless.

(3) The long-run effects of policies are the same regardless of the ER arrangement

Ex: expansionary policies

E. Applications and current issues

1. Dutch disease at the macro level

    Recall Dutch disease at the micro level: the natural resource curse: discovery and development of a booming tradable sector puts upward pressure on wages, resulting in a cost squeeze and contraction of traditional exports, such as manufactures (natural gas versus wooden shoes in the Netherlands)

At the macro level: Dutch disease can arise from a surge of capital inflows     It's an external shock     Examples:     UK (1970s): Discovery of North Sea oil --> savers want to acquire British Petroleum stock     Philippines (2000s): Surge of remittances from emigrant labor NFI shifts left --> +R --> -NX --> -Y

2. Responding to external shocks

    Example1: the 1992 European financial crisis

    At the start of the 1990s, several members of the European Union, including Germany, France, and the United Kingdom maintained fixed exchange rates with each other as part of the European Monetary System (EMS).
    In 1992, due in part to the costs of German reunification, interest rates in Germany rose.

1992: i-rates increased in Germany     an external shock to other EMS members     France: stayed in the EMS and defended the franc ER (=> contMP)         result: +r --> -I --> -Y     UK: left the EMS and let the pound fall         result: -R --> +NX --> +Y