Abstract
This paper examines policy responses to exchange-rate movements in a simple model of an open economy. The optimal response of monetary policy to an exchange-rate change depends on the source of the change: on whether the underlying shock is a shift in capital flows, manufactured exports, or commodity prices. The paper compares the model’s prescriptions to the policies of an actual central bank, the Bank of Canada. Finally, the paper considers the role of fiscal policy in an open economy. Coordinated fiscal and monetary responses to exchange-rate movements stabilize output at the sectoral as well as aggregate level.
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Notes
I do not explicitly model the behavior of inflation. One can add inflation to the model through a Phillips curve that relates changes in inflation to fluctuations in output. With this extension of the model, policies that stabilize output stabilize inflation as well. Therefore, these policies are appropriate for an inflation-targeting central bank, such as the Bank of Canada.
Future work should revisit the definition of sectors. In reality, some tradeable sectors, such as autos, are interest-rate sensitive, which is ruled out here. A richer model might have several sectors defined by varying combinations of interest-rate sensitivity and exchange-rate sensitivity.
To understand this approximation, let C* be the absolute level of commodity exports measured in foreign currency, and let e* be the level of the real exchange rate. Commodity exports in local currency are C*/e*. We can normalize C* and e* so their long run levels are both one. C and e are defined as deviations from these long run levels. A first-order approximation of C*/e* is \( {1} + \left( {{\hbox{C}} * - {1}} \right) - \left( {{\hbox{e}} * - {1}} \right) = {1} + {\hbox{C}} - {\hbox{e}} \). The deviation of C*/e* from its long run level is approximately C-e.
Again, this welfare argument could be formalized in a standard macro model with microfoundations.
Differentiating (18)-(19) yields \( {\hbox{dr}}/{\hbox{dc}} = \left[ {{{\hbox{D}}_{\rm{y}}}{{\hbox{M}}_{\rm{e}}}-{{\hbox{D}}_{\rm{y}}}{{\hbox{F}}_{\rm{e}}}-{{\hbox{M}}_{\rm{y}}}{{\hbox{F}}_{\rm{e}}}-{{\hbox{M}}_{\rm{e}}}} \right]/\left[ {{{\hbox{D}}_{\rm{r}}}\left( {{{\hbox{F}}_{\rm{e}}} - {{\hbox{M}}_{\rm{e}}} + {{\hbox{M}}_{\rm{y}}} + {1}} \right) - {{\hbox{F}}_{\rm{r}}}\left( {{{\hbox{M}}_{\rm{e}}} - {{\hbox{D}}_{\rm{y}}} - {{\hbox{M}}_{\rm{y}}}} \right)} \right] \). To see that this effect is ambiguous, note for example that it is positive if Dy = 1 and My = 0 and negative if Dy = My = 0.
More precisely, let \( {\hbox{M}}\left( {{\hbox{e}},{\hbox{Y}}} \right) = {\hbox{M}}\prime \left( {{\hbox{e}},{\hbox{Y}}} \right) + {\hbox{Z}} \), where the function M′(•) is fixed. One can show that \( {\hbox{dr}}/{\hbox{dZ}} > {\hbox{dr}}/{\hbox{dC}} \).
As in Section 6, we can extend the model to include taxes in the domestic demand function. In this case, a combination of fiscal and monetary policy can stabilize both manufactured exports and output in the domestic sector, while accommodating shifts in commodity exports. Once again, policy responds differently to shifts in M(•) and changes in C. When M(•) shifts up, sectoral output is stabilized by a combination of tighter monetary policy and looser fiscal policy. When C rises, fiscal policy tightens, and it is more likely that monetary policy loosens than when it is the only instrument.
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Ball, L. Policy Responses to Exchange-rate Movements. Open Econ Rev 21, 187–199 (2010). https://doi.org/10.1007/s11079-009-9160-6
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DOI: https://doi.org/10.1007/s11079-009-9160-6