The Consequences of Foreign Trade Policy and Currency Devaluation / Revaluation in Case of the Fixed Exchange Rate

A foreign trade policy is one of the instruments of the economic policy that allows influencing a macroeconomic balance by changing a volume and a structure of foreign trade by usage of tariff or non-tariff instruments. As an example let's examine the consequences of increase of custom duties on import (Fig. 8.10).

Limitation of imports as a result of increase of the custom duties leads to the growth of net export. Consumers buy less import goods and more domestic goods, and the aggregate demanded increases. The curve IS0 is shifted to the position of IS1 under the influence of these factors. In such case, a level of income increases (YO —> Yl), and the interest rate increases (r0 —> rl). The growth of net export shifts the curve BP0 to the right.

Influence of devaluation on a foreign trade balance in case of complete capital mobility

Figure 8.10. Influence of devaluation on a foreign trade balance in case of complete capital mobility

The state of both balance of payments accounts improves due to increase in custom duties and growth of an interest rate. So, there is a considerable positive balance of payments. As a result, demand for the national currency increases. As there is a surplus of the balance of payments in the point A, in order to maintain a fixed exchange rate the Central Bank buys up a foreign currency, thus increasing a money supply (LM0 —> LM1) and stimulating (still) the bigger growth of income. As a result, the interest rate will decrease that will lead to equilibration of the balance of payments and restitution of the external balance at the point C.

The influence of a foreign trade policy in case of complete capital mobility is almost the same as in case of limited capital mobility. The difference is in the depth of the balance of payments imbalance. In case of complete capital mobility the balance of payments will be higher, than in case of limited mobility, so it will be made the larger amount of interventions and increase of money supply. Therefore, the considerable increase of national income (Y0 to Y2) becomes a result of a protectionist foreign trade policy in case of the fixed exchange rate and high capital mobility as the effect of growth of net exports is complemented by the effect of increasing the money supply.

The effect of devaluation of national currency is similar to influence of a foreign trade policy on the open economy.

Let's examine its results in the model IS-LM-BP. The real exchange rate depreciates together with the nominal exchange rate as the internal prices don't react to the currency devaluation. Export from the country becomes more competitive in the world market while import relatively rises in price. As a result, the trade balance improves and the total demand increases for each level of interest rate. Thus, the curve IS shifts to the right (IS0 —> IS1), as it is shown in Fig. 8.10.

The growth of the exchange rate shifts the curve BP to the right. As it is observed a surplus of balance of payments in the point A, the Central Bank buys up foreign currency in order to maintain a fixed exchange rate, thus increasing a money supply (LMO —> LM1). The Central Bank will buy foreign currency that will increase the supply of national currency. As a result, the curve LM shifts to the right.

The balance will pass from the point E to the point C, where the curves IS, LM and BP are crossed. Thus, the total demand will increase. In this case, the devaluation is a measure of increase of aggregate demand, and in case of revaluation there is an opposite situation.

The Model IS-LM-BP in the Analysis of Economic Policy

The principle of usage of curves IS, LM, BP for the analysis of macroeconomic balance in case of the floating exchange rate practically does not differ from the analysis of balance in case of the fixed regime, but with one addition. In the IS-LM-BP model in case of the floating exchange rate the rate acts as a factor of rebalancing the economy and the money supply remains unchanged. The Central Bank doesn't interfere in trades at the foreign exchange market and the adjustment of the positive or negative balance of payments happens automatically.

And now let's examine two situations when in the country there are deviations in external balance. The first situation characterizes a possible balance of payments deficit (Fig. 8.11a), and the second situation characterizes a surplus (Fig. 8.11b). In the first case the point A indicates a balance of payments deficit, but as soon as the economy starts being under pressure of a deficit (on the economy), the change of the exchange rate leads to currency depreciation, the balance of payments is improved and the equilibrium shifts to a new point A which corresponds with a new level of income Y1 and an interest rate r1. Thus, the curve BP0 shifts to a position BP1.

Influence of the exchange rate on the balance of payments deficit

Figure 8.11a. Influence of the exchange rate on the balance of payments deficit

In the second situation it is observed a surplus in the point B. There is a rise in price of national currency, the curve BP0 shifts to BP2, and a new point of equilibrium B corresponds to a new level of income Y2, and an interest rate r2.

Influence of the exchange rate on the balance of payments surplus

Figure 8.11b. Influence of the exchange rate on the balance of payments surplus

So, in case of external imbalance in terms of the floating exchange rate there is its change and a shift of the curve BP, while in case of the fixed exchange rate there is a change in money supply and a shift of the curve LM.

As well as in case of the fixed rate, macroeconomic adjustment has a different character depending on the instruments of economic policy and the degree of capital mobility.

 
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