International Finance: Theory and Policy, v. 1.0

by Steve Suranovic

10.2 Monetary Policy with Floating Exchange Rates

Learning Objectives

1. Learn how changes in monetary policy affect GNP, the value of the exchange rate, and the current account balance in a floating exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the foreign exchange market, and the G&S market.

In this section, we use the AA-DD model to assess the effects of monetary policy in a floating exchange rate system. Recall from Chapter 7 "Interest Rate Determination" that the money supply is effectively controlled by a country’s central bank. In the case of the United States, this is the Federal Reserve Board, or the Fed for short. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in Chapter 7 "Interest Rate Determination", Section 7.5 "Controlling the Money Supply".

Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate (E$/£). This moves the economy downward, back to the A′A′ curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A′A′ curve, as shown in the figure. Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram. Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 9 "The AA-DD Model", Section 9.8 "AA-DD and the Current Account Balance", the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise. Contractionary Monetary Policy Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise. The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, E$/£, implying an appreciation of the U.S. dollar and a decrease in the current account balance.

Key Takeaways

• The U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.
• Contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate (E\$/£), implying an appreciation of the U.S. dollar and a decrease in the current account balance.

Exercises

1. Use the AA-DD model (not necessarily the diagram) to explain the sequential short-run adjustment process of an increase in the money supply on the following economic variables under floating exchange rates. (In other words, first answer how the money supply increase immediately affects the interest rate. Next, answer how the previous economic variable—i.e., the interest rate—affects the nominal exchange rate. Continue this process through investment.)

1. The interest rate
2. The nominal exchange rate
3. The real exchange rate
4. The current account balance
5. GNP
6. Disposable income
7. Consumption
8. Saving
9. Investment
2. Repeat the exercise above assuming a decrease in the money supply.
3. Suppose a country with floating exchange rates has a current account deficit that its government considers too large. Use an AA-DD diagram to show how monetary policy could be used to reduce the current account deficit. Does this action help or hinder its goal of maintaining low unemployment? Explain.