Lecture 18
MONETARY POLICY

1. Floating Exchange Rates

• Suppose the central bank buys govt securities (domestic assets) on the open market

• M^s increases

• Interest rate falls

• Consumption and Investment will rise

• The AE-line shifts up

• Eqbm GNP rises

• The decrease in R leads to:
  Greater capital outflows leading to ...
  depreciation of the domestic currency which causes ...
  net exports to rise causing ...
  the AE-line to shift up yet again and...
  GNP to rise further

• Results:
  • The increase in GNP is magnified (why?)
  • Lower interest rates
  • A weaker currency
  • Decrease in capital account surplus and current account deficit
  • Smaller budget deficit
  • Higher investment

2. Fixed Exchange Rates

• Suppose the central bank buys domestic assets (govt. securities) on the open market

• Decrease in interest rates

• Decrease in R leads to capital outflows

• Domestic currency will tend to depreciate ...
  
  But since the exchange rate is fixed ...
  ... the central bank must prevent the incipient depreciation by ...
  ... selling foreign-exchange reserves

• Domestic money supply falls back to original level

• Interest rate rises (to original level, R₀)

• Since R has not changed, AE is unaffected ...
  ... implying that GNP remains the same!

• Results:
  • Monetary policy is ineffective at raising GNP
  • No change in interest rates
  • Increase in the central bank's holdings of domestic assets is exactly offset by decrease in holdings of foreign reserve assets

Conclusion: Monetary policy is ineffective under fixed exchange rates.