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Chapter 18: II part - Coggle Diagram
Chapter 18: II part
Financial Crises and Capital Flight
Capital Flight
Capital rapidly leaves domestic economy → Financial capital shortage → investment ↓ (I ↓) → aggregate demand ↓ (D ↓) → output ↓ (Y ↓)
Investors rush to exchange domestic assets for foreign assets: Official reserves ↓ faster → balance of payments crisis worsens
Central Bank Response
Raise interest rates (R ↑) by reducing money supply (Ms ↓) through selling foreign/domestic assets
The goal is to attract investors to hold domestic assets
Crisis Trigger
Change in expectations about future exchange rate (self-fulling crisis)
Investors expect devaluation want foreign assets over domestic assets
Balance of Payments Crisis
Central bank lacks enough official international reserves to maintain fixed exchange rate
Must sell foreign assets to meet demand at fixed rate
Economic Consequences
High interest rates (R ↑) → Reduced money supply (Ms ↓) → Low aggregate demand and output (D ↓, Y ↓) → Low employment
Figure: Capital Flight, the Money Supply and the Interest Rate
Monetary Policy & Fixed Exchange Rates – Short Run
As a result cannot use monetary policy for other goals. Monetary policy becomes ineffective for
Influencing output
Reducing unemployment
Figure: Monetary Expansion is Ineffective under a Fixed Exchange Rate
Central bank intervenes to fix the exchange rate
Buys/sells foreign assets
Must keep R = R* (domestic interest rate = foreign interest rate)
Fiscal Policy & Fixed Exchange Rates – Short Run
Expansionary fiscal policy: ↑ Aggregate demand and Output (Y) → ↑ Demand for real money balances → R ↑ → Currency appreciates (E ↓)
To keep E fixed, the central bank buys foreign assets → ↑ Money supply (Ms) → ↓ Interest rate (R)
As a result fiscal policy is effective under fixed exchange rates
Figure: Fiscal Expansion under a Fixed Exchange Rate
Devaluation vs Revaluation (Fixed Exchange Rate)
Depreciation / Appreciation: Market-driven changes (Floating Regime)
Devaluation / Revaluation: Central Bank decision (Fixed Regime)
Devaluation: Central bank buys foreign assets (↑ Official international reserves (foreign bonds)) → ↑ Money supply (Ms) → ↓ Interest rate (R) → ↓ Return on domestic deposits → E ↑ Domestic currency loses value → Domestic goods become cheaper than foreign goods → ↑ Aggregate demand (AD) and Output /Y)
Figure: Effect of a Currency Devaluation in the Short Run
Abrupt Change Policy in Fixed Exchange Rate (Short Run)
E is set by the central bank, not by the market
Devaluation = ↑ E (domestic currency loses value)
Revaluation = ↓ E (domestic currency gains value)
The goal is to change the fixed value of E (exchange rate)
Fiscal Policy & Fixed Exchange Rates in the Long Run
Fixed E → No real appreciation in the short run
When Y > Y⁎ (above potential output) → in the long run ↑ Wages & Prices (P) → P ↑ makes Domestic goods more expensive → ↓ Competitiveness → Real appreciation → ↓ Aggregate demand (AD) & output (Y) and DD curve shifts left → Employment and Y fall back to natural levels → CB intervenes with ↑ Money supply → P ↑ proportionally → Real exchange rate ↓ (E fixed, P ↑) → AA curve shifts left
Long-Run Adjustments in Case of a Devaluation
Devaluation: Central bank buys foreign assets → Ms ↑ → Price level (P) ↑ proportionally → in the long run P ↑ ∝ E ↑ → Real variables (Y, real exchange rate) unchanged (devaluation is neutral in the long-run) → Same as a proportional Ms ↑ under floating rate. Result: Long-run neutrality: Nominal values ↑ and No change in Y or relative prices