Fiscal and Monetary Policy Under Fixed & Flexible Exchange Rates
Fiscal and Monetary Policy Under Fixed and Flexible Exchange Rates
Perfect Capital Mobility and Flexible Exchange Rates
Fiscal Policy
Under perfect capital mobility and flexible exchange rates, expansionary fiscal policy aimed at increasing aggregate demand through higher production can face challenges. If domestic interest rates rise above international rates, it attracts capital inflows, leading to currency appreciation. This appreciation can harm export competitiveness and reduce foreign demand, ultimately making the fiscal policy ineffective in boosting GDP. Instead, it may only alter the composition of aggregate demand by substituting exports with domestic consumption.
This phenomenon is known as the ‘crowding out’ effect, where higher interest rates can reduce private consumption and investment. While the increased demand for money initially raises interest rates, the inflow of foreign capital eventually brings them back down. However, the initial appreciation of the domestic currency can negatively impact the competitiveness of the economy.
Monetary Policy
With flexible exchange rates, expansionary monetary policy can be effective in the short run. By increasing the money supply, it can lower interest rates and stimulate aggregate demand. This leads to a depreciation of the domestic currency, making exports more competitive and boosting external demand. As a result, production increases, and the policy is considered effective in the short term.
Fixed Exchange Rates
Fiscal Policy
Under fixed exchange rates, fiscal policy can be more effective in influencing GDP. Expansionary fiscal policy can increase aggregate demand and output. However, monetary policy becomes dependent on maintaining the fixed exchange rate. If domestic interest rates rise, it can attract capital inflows, putting upward pressure on the exchange rate. To maintain the fixed rate, the central bank may need to intervene by selling domestic currency and buying foreign currency, which can offset the expansionary effects of the fiscal policy.
Monetary Policy
Monetary policy under fixed exchange rates is generally ineffective. If the central bank tries to expand the money supply, it can lead to lower interest rates. This can cause capital outflows and put downward pressure on the exchange rate. To maintain the fixed rate, the central bank would need to intervene by buying domestic currency and selling foreign currency, which would reduce the money supply and offset the initial expansionary effect.
Credit Restrictions and Capital Controls
In some cases, countries with fixed exchange rates may resort to credit restrictions and capital controls to make monetary policy more effective. By limiting access to credit and controlling capital movements, the central bank can influence domestic interest rates and manage the exchange rate. This is particularly relevant for smaller economies within a currency union, where maintaining the fixed exchange rate is crucial.
Economy Adjustment to External Shocks
The effectiveness of fiscal and monetary policies in response to external shocks depends on the exchange rate regime. Under fixed exchange rates, external shocks can have a more significant impact on the domestic economy. For example, a rise in international interest rates can lead to capital outflows and a decrease in domestic production. However, under flexible exchange rates, the exchange rate can adjust to absorb the shock. A rise in international interest rates may lead to a depreciation of the domestic currency, which can boost exports and mitigate the negative impact on output.
Conclusion
The choice of exchange rate regime and the effectiveness of fiscal and monetary policies depend on various factors, including the degree of capital mobility, the size and openness of the economy, and the nature of external shocks. Understanding these interactions is crucial for policymakers to design appropriate macroeconomic policies to achieve their objectives.