Previous installment is here. This one deals with international macro. However, the perspective is strictly textbook-ish. The bottom line:

From an international perspective, the notion of a liquidity trap becomes more doubtful. The central bank can always buy foreign bonds. This will depreciate the currency and reduce domestic real wage rates, achieving the goal of expansionary monetary policy.

International Macroeconomics

Macroeconomics looks a bit different if one takes an international perspective. We become interested in wage rates and interest rates in the rest of the world. We see a relationship between monetary policy and exchange-rate policy.

In what I call textbook domestic macroeconomics, the supply side of the economy is specified in terms of excess supply of labor and sticky nominal wage rates. As a result, an increase in prices results in lower real wages, more labor demand, and more output.

With the foreign trade sector included, this supply mechanism becomes even more potent. If prices of tradable goods rise relative to domestic wages, then both foreign and domestic producers have an incentive to shift production so as to employ more of our workers. Exports rise, imports fall, and our output increases.

In a closed economy, the central bank can manipulate the domestic interest rate. In a small open economy, the world interest rate is given. If the world interest rate is given, then monetary policy is just exchange-rate policy. If the central bank were to target a fixed exchange rate, then there really is no independent monetary policy. The central bank would have to increase the money supply whenever fiscal policy is expansionary, thus adding to the expansionary effect.

If the world interest rate is given and the exchange rate floats, then fiscal expansion will tend to be offset by an increase in the trade deficit, due to an appreciation of the exchange rate. Only if there is some monetary expansion will fiscal expansion work.

In open economy macroeconomics, a monetary expansion works by lowering the value of the domestic currency, thereby reducing real wage rates, which in turn causes exports to rise and imports to fall. If a country has a lot of unemployment and the central bank will not expand the money supply, then domestic wages have to fall in order to reduce the unemployment.

Suppose that we think of the real exchange rate as the rate at which an hour of domestic labor can be exchanged for an hour of equivalent foreign labor. That is, if you are an employer, the real exchange rate tells you whether it is cheaper to hire domestic workers or to engage in offshoring. If the domestic-currency wage rate is sticky in each country, then a change in the nominal exchange rate will affect the real exchange rate. Hence, a monetary expansion in our country can depreciate our currency in real terms.

Foreign exchange is traded in financial markets. Currency speculation is subject to the Efficient Markets Hypothesis, which can be states as TANSTAAFL for speculators. That is, there are no sure profits to be made by speculators using widely-available information.

The financial aspects of foreign-exchange trading suggest limited scope for central banks to manipulate exchange rates. A country that wants to maintain an undervalued currency will have to continually sell its currency and buy foreign assets, building up ever-larger reserves of foreign bonds. The opposite goal, of defending an overvalued currency, can be impossible to achieve, because the central bank has to sell foreign bonds, and eventually it will run out of foreign bonds to sell.

If a central bank tries to maintain an overvalued exchange rate, meaning one at which domestic real wages are too high to be competitive at full employment, it eventually will come under speculative attack. Speculators will come to the belief that the central bank cannot maintain the high exchange rate, and this belief will lead them to short the currency, which will force the central bank to use up more reserves, which will reinforce the belief among other speculators that the currency will eventually have to fall in value.

If the central bank sets an exchange rate target that is easy to defend, given its level of foreign currency reserves and given the relationship of domestic wages to world wages, then speculators are likely to assist the central bank in staying close to the target. However, if the central bank sets an exchange rate that is not easy to defend, eventually it will be subject to speculative attack.

From an international perspective, the notion of a liquidity trap becomes more doubtful. The central bank can always buy foreign bonds. This will depreciate the currency and reduce domestic real wage rates, achieving the goal of expansionary monetary policy.