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mand shift is the dominant influence. The evidence strongly

Price Level
suggests that aggregate demand shifts are usually larger, so we A
expect GDP to rise. Hence:
A currency depreciation is inflationary and probably also

The intuitive explanation for this result is clear. When the D1
dollar falls, foreign goods become more expensive to S0
Americans. That effect is directly inflationary. At the same
time, aggregate demand in the United States is stimulated by
rising net exports. As long as the expansion of demand out- Real GDP
weighs the adverse shift of the aggregate supply curve
brought on by currency depreciation, real GDP should rise.
But wait. By this reasoning, the massive depreciations of several Southeast Asian curren-
cies in 1997 and 1998 should have given these economies tremendous boosts. But instead, the
so-called Asian Tigers suffered horrific slumps”as did Mexico when the peso tumbled in
1995. Why? The answer is that our simple analysis of aggregate supply and demand omits a
detail that, while unimportant for the United States, is critical in many developing nations.
Countries that borrow in foreign currency will see their debts increase whenever their
currency values decline. For example, an Indonesian business that borrowed $1,000 in July
1997, when $1 was worth 2,500 rupiah, thought it owed 2.5 million rupiah. But when the
dollar suddenly became worth 10,000 rupiah, the company™s debt skyrocketed to 10 million
rupiah. Many businesses found themselves unable to cope with their crushing debt burdens
and simply went bankrupt. So although currency depreciation is expansionary in the
F I GU R E 5
United States, it was sharply contractionary in Indonesia.
The Effects of a
Returning to rich countries such as the United States,
Currency Appreciation
let™s now reverse direction and look at what happens
when the currency appreciates. In this case, net exports fall,
so the aggregate demand curve shifts inward. At the same
time, imported inputs become cheaper, so the aggregate S0
supply curve shifts outward. Both of these shifts are shown D0
in Figure 5. Once again, as the diagram shows, we can be
sure of the movement of the price level: It falls. Output
also falls if the demand shift is larger than the supply
Price Level

shift, as is likely. Thus:
A currency appreciation is disinflationary and probably
also contractionary.
This analysis explains why many economists and finan-
cial experts cringed a bit when the yen and the euro appre- D0
ciated relative to the dollar in 2002“2004 and then again in D2
2007. Japan, in particular, was just emerging from defla-
tion, and growth there was mediocre. The last thing it Real GDP
needed, they argued, was a decrease in aggregate demand.

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Part 4
384 The United States in the World Economy

Interest Rates and International Capital Flows
One important piece of our international economic puzzle is still missing. We have ana-
lyzed international trade in goods and services in some detail, but we have ignored inter-
national movements of capital up to now.
For some nations, this omission is inconsequential because they rarely receive or lend
international capital. But things are quite different for the United States because the vast
majority of international financial flows involve either buying or selling assets whose val-
ues are stated in U.S. dollars. In addition, we cannot hope to understand the origins of the
various international financial crises of the 1990s and 2000s without incorporating capital
flows into our analysis. Fortunately, given what we have just learned about the effects of
exchange rates, this omission is easily rectified.
Recall from the previous chapter that interest rate differentials and capital flows are
typically the most important determinants of exchange rate movements. Specifically, sup-
pose interest rates in the United States rise while foreign interest rates are unchanged. We
learned in the previous chapter that this change in relative interest rates will attract capi-
tal to the United States and cause the dollar to appreciate. This chapter has just taught us
that an appreciating dollar will, in turn, reduce net exports, prices, and output in the
United States”as indicated in Figure 5. Thus:
A rise in interest rates tends to contract the economy by appreciating the currency and
reducing net exports.
Notice that this conclusion has a familiar ring. When we studied monetary policy in
Chapter 13, we observed that higher interest rates deter investment spending and hence
reduce the I component of C 1 I 1 G 1 (X 2 IM). Now, in studying an open economy with
international capital flows, we see that higher interest rates also reduce the X 2 IM com-
International capital
flows are purchases and ponent. Thus, international capital flows strengthen the negative effects of interest rates on
sales of financial assets aggregate demand.
across national borders. If interest rates fall in the United States, or rise abroad, everything we have just said is
turned in the opposite direction. The conclusion is
A decline in interest rates tends to expand the economy by depreciating the currency
and raising net exports.

Exercise Provide the reasoning behind this conclusion.

We are now ready to use our model to analyze how fiscal and monetary policies work when
capital is internationally mobile and the exchange rate floats. Doing so will teach us how in-
ternational economic relations modify the effects of stabilization policies that we learned
about in earlier chapters. Fortunately, no new theoretical apparatus is necessary; we need
merely remember what we have learned in the chapter up to this point. Specifically:
• A rise in the domestic interest rate leads to capital inflows, which make the ex-
change rate appreciate. A currency appreciation reduces aggregate demand and
raises aggregate supply (see Figure 5).
• A fall in the domestic interest rate leads to capital outflows, which make the
exchange rate depreciate. A currency depreciation raises aggregate demand and
reduces aggregate supply (see Figure 4).

Fiscal Policy Revisited
With these points in mind, suppose the government cuts taxes or raises spending. Aggre-
gate demand increases, which pushes up both real GDP and the price level in the usual
manner. This effect is shown as the shift from D0D0 to the blue line D1D1 in Figure 6. In a

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Chapter 19 385
Exchange Rates and the Macroeconomy

closed economy, that is the end of the story. But in an open economy with international A closed economy is one
that does not trade with
capital flows, we must add in the macroeconomic effects that work through the exchange
other nations in either
rate. We do this by answering two questions.
goods or assets.
First, what will happen to the exchange rate? We know from earlier chapters that a fis-
cal expansion pushes up interest rates. At higher interest rates, American securities be-
come more attractive to foreign investors, who go to the foreign-exchange markets to buy
dollars with which to purchase them. This buying pressure drives up the value of the dol-
F I GU R E 6
lar. Thus, at least for a rich country that can easily sell its bonds on the world market,
A Fiscal Expansion in
A fiscal expansion normally makes the exchange rate appreciate.
an Open Economy
Second, what are the effects of a higher dollar? We
know that when the dollar rises in value, American goods
become more expensive abroad and foreign goods be- D1
come cheaper here. So exports fall and imports rise, driv- D2
ing down the X 2 IM component of aggregate demand. D0
The fiscal expansion thus winds up increasing both S0

Price Level
America™s capital account surplus (by attracting foreign cap-
ital) and its current account deficit (by reducing net exports). B
In fact, the two must rise by equal amounts because,
under floating exchange rates, it is always true that 2 A
Current account surplus 1 Capital account surplus 5 0 C D1
Because a fiscal expansion leads in this way to a trade D2
deficit, many economists believe that the large U.S. trade S2 D0
deficits of the 1980s were a side effect of the large tax
cuts made early in the decade”and that the tax cuts of Real GDP
2001“2003 once again pushed the trade deficit up. We
will return to that issue shortly.
For now, note that the induced rise in the dollar will shift the aggregate supply curve
outward and the aggregate demand curve inward, as we saw in Figure 5. Figure 6 adds
these two shifts (in brick-colored lines) to the effect of the original fiscal expansion (in
blue). The final equilibrium in an open economy is point C, whereas in a closed economy
it would be point B. By comparing points B and C, we can see how international linkages
change the picture of fiscal policy that we painted earlier in the book.
Two main differences arise. First, a higher exchange rate makes imports cheaper and
thereby offsets part of the inflationary effect of a fiscal expansion. Second, a higher ex-
change rate reduces the expansionary effect on real GDP by reducing X 2 IM. Here we
have a new kind of “crowding out,” different from the one we studied in Chapter 15.
There we learned that an increase in G will crowd out some private investment spending
by raising interest rates. Here an increase in G, by raising both interest rates and the
exchange rate, crowds out net exports. But the effect is the same: The fiscal multiplier is
reduced. Thus, we conclude that
International capital flows reduce the power of fiscal policy.
Table 2, which shows actual U.S. data, suggests that this new in- TA BL E 2
ternational variety of crowding out was much more important Percentage Shares of Real GDP in the United
than the traditional type of crowding out during the huge fiscal ex- States, 1981 and 1986
pansion of the 1980s. Between 1981 and 1986, the share of invest-
C I G X 2 IM
ment in GDP barely changed despite the rise in the shares of both
1981 64.5% 14.3% 20.5% 0.2%
consumer spending and government purchases. Only the share of
1986 67.3 14.5 21.2 22.8
net exports, X 2 IM, fell”from 10.2 percent to 22.8 percent.
Change 12.8 10.2 10.7 23.0
American economists thus learned an important lesson. In 1981,
many economists worried that large government budget deficits NOTE: Totals do not add up because of rounding and deflation.

If you need review, turn back to Chapter 18, page 370.

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Licensed to:
Part 4
386 The United States in the World Economy

would crowd out private investment. By the end of the decade, most were more
concerned that deficits were crowding out net exports and producing a massive trade

Monetary Policy Revisited
Now let us consider how monetary policy works in an open economy with floating ex-
F I GU R E 7
change rates and international capital mobility. To remain consistent with the history of
A Monetary
the 1980s, we consider a tightening, rather than a loosening, of monetary policy.
Contraction in an
As we know from earlier chapters, contractionary mon-
Open Economy
etary policy reduces aggregate demand, which lowers both
real GDP and prices. This situation is shown in Figure 7 by
the shift from D0D0 to the blue line D1D1, and it looks like
the exact opposite of a fiscal expansion. Without interna-
tional capital flows, that would be the end of the story.
But in the presence of internationally mobile capital,
we must also think through the consequences for interest
Price Level

rates and exchange rates. As we know from previous
chapters, a monetary contraction raises interest rates”just
like a fiscal expansion. Hence, tighter money attracts for-
eign capital into the United States in search of higher rates
of return. The exchange rate therefore rises. The appreci-
ating dollar encourages imports and discourages exports;
so X 2 IM falls. America therefore winds up with an
D2 inflow of capital and an increase in its trade deficit. In


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