CFA Level 1

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.



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