Download FE_04 - University of Hawaii

Monetary & Fiscal Policy
Efficacy of Traditional
Financial Tools
Tightened Monetary Policy


Exchange rates float; no capital
flows
Monetary policy is effective. The
currency appreciates; demand falls;
inflation declines; unemployment
up; interest rates rise. The current
account moves toward deficit due
to the exchange rate change, but
may be partly offset due to falling
inflation.
Tightened Monetary Policy
 ER
floats; capital free to flow
Monetary policy is strong.
 Currency appreciates.
 But higher interest rate draws capital
inflow.
 Currency appreciates even more.
 Demand contraction even greater.

Tightened Monetary Policy
Monetary policy, without controls on
exchange rates or capital flows is
strongest because it effectively
disperses spending decisions,
cuts, switches & expansions, to
cash balance holders, to the
public.
The strength of monetary policy
rests on floating exchange rates.
Capital flows reinforce the
Tightened Monetary Policy
ER pegged; Capital flows blocked.
 Monetary policy is ineffective.
 Inflation declines & interest rates
rise => improvement in current
account.
 Bank reserves accumulate
 The money supply eases again.

Tightened Monetary Policy
Note here that if the
government controls both
exchange rates and capital
flows, changes in spending
decisions resulting from
changes in monetary policy are
not made by the general public.
Tightened Monetary Policy
ER pegged; Capital free to flow.
 Monetary policy is ineffective.
 The increase in the interest rate
brings an immediate inflow of capital
which snuffs it out.
 There will be no deflation.
 Domestic demand and the current
account have no reason to change.

Tightened Monetary Policy
In these cases, monetary
policy is ineffective due to
pegged exchange rates.
Capital flows strengthen the
lack of movement.
Tightened Fiscal Policy




ER floating; capital flows blocked.
Fiscal policy is effective.
Tighter fiscal policy reduces overall
demand (G falls, or, through higher
tax rates, C, I and Im fall).
CA improves; the resulting decline
in demand for FX induces the home
currency to appreciate. Inflation is
down but unemployment is up.
Tightened Fiscal Policy






ER floats; capital free to move.
Fiscal policy is weak.
Interest rates decline => capital
departs. Hence, currency
depreciates.
The money supply is unchanged.
All changes are due to the change in
fiscal policy.
Overall demand declines; however,
CA rises which partly offsets the
decreases in domestic demand.
Tightened Fiscal Policy






ER pegged; Capital flows blocked.
Fiscal policy is ineffective.
Overall demand & inflation down.
CA rises (+ pegged ER) => rising R.
But ΔR => ΔM => increased
demand.
Hence, tight fiscal policy plus
expansionary monetary conditions
induce stalemate.
Tightened Fiscal Policy




ER pegged; Capital free to move.
Fiscal policy is strong.
Lower interest rate => capital
outflow. Declining reserves =>
falling M.
Tighter monetary policy plus the
assumed tighter fiscal policy gang
up to push the economy in the same
direction.
Bottom Lines
 If
exchange rates are flexible,
both fiscal and monetary policy
do what they are supposed to do.
 Monetary policy is more reliable.
 Fiscal policy at least works
weakly in the right direction.
Bottom Lines
 If
exchange rates are pegged,
monetary policy is not effective
at all, and fiscal policy works
only if capital flows freely.
 However, in this last case, the
resulting fiscal + monetary
change may prove too powerful
to control.
Bottom Lines
If capital flows freely, monetary policy
depends on floating exchange rates &
fiscal policy depends on pegged rates.
 Because capital does flow abundantly &
freely, financial authorities can either float
their exchange rates and depend on
monetary policy or peg their rates and
depend on fiscal policy.

Bottom Lines
Exchange rates become more volatile
with greater capital mobility.
Overshooting becomes ubiquitous.
Highly volatile exchange rates split
the global market into quasisegments.
 ER fixers regard this as too high a
cost to have to pay.
 Floaters think of volatility as a new &
positive instrument of policy,
independent of monetary policy.

Bottom Lines
But, monetary & exchange rate
policies are close to being one & the
same.
 A change in monetary policy (interest
rates) => changes in the exchange
rate.
 Pressure on exchange rates implies a
limited scope for interest rates.
 The three are tightly tied and are
independent of any influence from
the current account.
