Topic 6: Some Conclusions Regarding Monetary Policy
in a Small Open Economy

You should by now have realized that in a small open economy with flexible exchange rates, monetary policy is extremely effective. Equilibrium is determined at the the intersection of the LM curve and the ZZ line at the interest rate determined by world market conditions. If that intersection is at a level of output and income below full employment, the level of income and employment can be increased to the full-employment level by having the country's monetary authority simply expand the money supply. As the LM shifts to the right towards a full-employment equilibrium, the IS curve will follow it automatically as a result of a devaluation of the real and nominal exchange rates as domestic residents create an incipient balance of payments surplus by attempting to rebalance their portfolios by purchasing non-monetary assets from foreigners. The devaluation expands output, shifting the IS curve to the right by shifting world demand onto domestic goods.

In the long run under full-employment conditions the authorities, by adjusting the rate of monetary growth, control the domestic inflation rate. If inflation is too high the solution, which is not without cost, is to reduce the rate of money growth. This will shift the LM curve to the left, lead to an appreciation of the domestic real and nominal exchange rates and temporarily reduce the level of output and income below full-employment levels. Eventually the rate of growth of the price level will decline---its long-run rate of increase can be eventually reduced to a satisfactory level. At that point the LM and IS curves will both be shifting to the right in each period by an amount equal to the rightward shift of the levels of full-employment output and income. The nominal exchange rate will be rising or falling through time at a rate consistent with the new equilibrium domestic inflation rate together with any rate of change through time in the full-employment equilibrium real exchange rate as the economy grows through time.

You should now understand the above analysis by simply drawing the appropriate graphs in your mind or perhaps on a sheet of paper. If you need help along this line, simply click on and print out Figure 1 and Figure 2 for your reference. If you cannot draw the appropriate graphs on your own to analyse the above issues, you need to return to the beginning of this lesson and work through it again!

2. Monetary Policy Works by Changing Exchange Rates, not Interest Rates!

Conventional public discussions of monetary policy in newspapers and on radio and television, even in small countries, constantly refer to monetary policy as operating through central bank manipulation of interest rates. While there is some basis for this in large countries like the United States, it ignores the fact that the interest rates relevant for investment decisions in small open economies are determined by world market conditions over which the domestic central bank has no control. The only ways monetary authorities in small open economies could affect underlying domestic real interest rates is by talking more nonsense or less nonsense to attempt to change world asset holders' perceived risk of holding domestic assets, or by changing the money supply and consequently domestic nominal and real exchange rates with respect to other countries by so much as to make it predictable that movements in those rates in the near future will be in the opposite direction. The expectation of a rise in a country's real exchange rate carries with it an expected future increase in the world relative price of its output and hence in the world price of its capital stock relative to other countries' capital stocks. These expected capital gains will cause the current values of domestic assets to increase and the underlying domestic real interest rates to fall. This second avenue of control over real interest rates is ruled out by the fact that the best forecast of tomorrow's exchange rate turns out to be today's rate---upward and downward movements are equally likely. To date, economic research on predicting exchange rate movements has failed to successfully refute this result. Accordingly, the domestic central bank would have to force domestic exchange rates way out of line with normal variations to have any hope of exerting control over domestic real interest rates through this channel.

In years past textbooks used, and some still use today, an upward sloping curve that was frequently called the BB curve in place of the horizontal ZZ curve in the analysis presented here. The basis for that upward sloping curve was the argument that central bank induced falls in domestic interest rates cause capital to flow abroad and increases in domestic interest rates lead to increased capital inflows into the domestic economy. Only through a decline in domestic interest rates would asset holders be induced to purchase assets from foreigners and vice versa. A rise in the domestic interest rate through the imposition of tight money, it was argued, will result in sales of domestic assets abroad, creating a domestic balance of payments surplus and requiring an increase in domestic income to increase imports and thereby maintain balance of payments equilibrium---hence the upward slope of the BP, or balance-of-payments-equilibrium curve, which replaces our ZZ curve.

The above argument involves a fallacy of composition---what is true for each individual acting alone is not true for all individuals acting together. Anyone will understand that if the domestic interest rates rise relative to foreign rates it makes sense to reallocate some of one's investment portfolio from foreign to domestic assets to take advantage of the higher return. Hence the seemingly sensible argument that capital flows respond to interest rate differentials. The problem with this conclusion is that when everyone tries to sell foreign assets and buy domestic ones they bid up the prices of domestic assets relative to the prices of assets abroad. This will cause the domestic interest rate to return to levels at which such a portfolio shift is no longer profitable. That is, at every point in time world asset holders will bid the price of every asset up or down to the point at which they are, in the aggregate, just willing to hold the existing stock. Asset prices and interest rates are determined by the willingness of investors to hold the existing stocks. Prices will continually adjust until people in the aggregate are no longer willing to trade. Of course, those who think an asset's price is going to fall will sell that asset to someone else who thinks its price is going to rise. But interest rates will at all times move to the levels at which investors as a group are just willing to hold the existing asset stocks. So interest differentials are determined by existing capital stocks and not by current flows---except, of course, to the extent that current aggregate investment flows result in miniscule relative changes in overall stocks.

3. Real Shocks do not Affect Income and Price Levels when Exchange Rates are Flexible!

Although major discussion of this issue is postponed to the lesson covering fiscal policy, you have probably realized that real shocks cannot affect output, employment and prices when the exchange rate is flexible. The levels of output and income are determined by the point at which the LM curve crosses the ZZ curve. The nominal and real exchange rates will adjust to ensure that the IS curve also passes through that point. Any exogenous real shock that shifts the IS curve will bring about a change in the real exchange rate sufficient to drive that curve back to its original level.

Suppose, for example, that the government by manipulating its expenditures and taxes induces a rightward shift of the IS curve designed to increase output and employment. This will cause income to rise and thereby increase people's desired money holdings. In order to add to their money balances they will try to sell assets to foreigners. The resulting excess demand for the domestic currency on the foreign exchange market will cause the domestic nominal and real exchange rates to increase. As the relative price of domestic output in terms of foreign output thereby rises, world expenditure on domestic output will fall---by the same amount, it turns out, as the additional expenditure induced by government fiscal policy. The IS curve will thereby be prevented from shifting to the right and output, income and employment will remain unchanged.

There is, of course, an avenue through which the central bank can make the fiscal policy effective. It can increase the money supply sufficiently to keep the domestic real exchange rate from rising and shifting the IS curve back to its original position. But this is really monetary policy---the LM curve shifts to the right and the fiscal efforts of the government shift the IS curve to the right by the same amount, making a devaluation of the real exchange rate in response to the monetary expansion unnecessary.

It is time for the last test in this Lesson. As usual, be sure and think up your own answers before looking at the ones provided.

Question 1
Question 2
Question 3