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Chapter 11
Economic Policy under Fixed
and Floating Exchange Rate
System
Macroeconomic Goals in an Open Economy

Inflation is an increase in the overall price
level in the economy.

Several measures could be used to indicate
the overall price level such as CPI, PPI, etc.

Price variations disturb economic activities
such as consumption and investment.

Deflation refers to the decrease in the
overall price level.

Unemployment is the proportion of workers
who are not employed or are looking for jobs.

Economic growth determines the growth in
living standards.

The three economic goals in an open economy
are internal balance, the overall balance in
domestic markets.

BOP equilibrium is the external balance.

The ultimate goal is to reach both internal
and external balance.
Monetary Policy, Fiscal Policy and Capital
Mobility

The target of monetary policy includes the
achievement of desired level of economic
growth, the domestic price level, the
exchange rate or balance of payments.

Open market operation, reserve ratio and
discount rate are three methods used by
central bank to control money supply.

Expansionary monetary policy includes:
purchase of securities in the open market
reduction of the reserve ratio
decrease in discount rate

Expansionary monetary policy worsens BOP
because of the higher income and lower
interest rate.

Contractionary monetary policy is used to
cool down the economy. It improves BOP.

Expansionary fiscal policy includes:
increase in government spending
decrease in tax rates

Its impact on BOP is ambiguous.

Contractionary fiscal policy is an important
tool for government to fight inflation.

Capital mobility refers to the extent to
which capital can shifted between nations.

Low capital mobility means it is not easy for
capital movements between nations because
of restrictions or barriers.

BP curve is steep with low capital mobility.

High capital mobility refers to the situation
that capital flows are relative free. BP curve
is thus flat.

Perfect capital mobility means there is no
restrictions on capital movements.
BP curve with low capital mobility
Interest rate (i)
BP
i1
B
A
i0
0
Y0
Y1
Y
BP curve with high capital mobility
Interest rate (i)
BP
B
i1
A
i0
0
Y0
Y1
Y
BP curve with perfect capital mobility
Interest rate (i)
id0 = if0
BP
id1
0
A
Y0
Y1
Y
The Effect of Policy Mix under Fixed Exchange
Rate System

Policy mix refers to the combination of
monetary and fiscal policies.

The two policies can be used in the same or
opposite direction.

For example, expansionary fiscal policy and
contractionary monetary policy increase
total output (income) and raise the interest
rate.
The effect of expansionary fiscal policy and
contractionary monetary policy under fixed rate system
with imperfect capital mobility
Interest rate (i)
BP
LM’
B
i1
C
LM
A
IS’
i0
IS
0
Y0 Y2 Y1
Y

The expansionary monetary policy has little
effect on the economy if the exchange rate is
not allowed to float.

The expansionary monetary policy increases
the money supply. Domestic currency has the
pressure to depreciate in the foreign
exchange market.

In order to defend the fixed parity, domestic
central bank must sell foreign currency and
buy domestic currency. The expansionary
monetary policy thus is offset.
The expansionary monetary policy under fixed rate system
with imperfect capital mobility
Interest rate (i)
BP
LM
LM’
i1
i0
A
IS
0
Y0
Y1
Y

Under the fixed exchange rate system, fiscal
policy is more powerful than monetary
policy in terms of affecting the aggregate
output and balance-of-payments status.

The capital mobility also influences the
effectiveness of the economic policy.

If the capital mobility is perfect, fiscal
policy exerts its largest feasible effects on
income.
The fixed rate system and perfect capital mobility
in a small country
Interest rate (i)
LM
LM’
A
B
i0
BP
IS’
IS
0
Y0
Y1
Y
The effects of foreign economic policy on
domestic economy

Under the fixed exchange rate system, the
policy of economic power such as the U.S.
influences small country’s economy.

The expansionary monetary policy has the
“locomotive effect” on foreign economy. That
is, the increase in domestic income leads to
the increase in foreign income.

The expansionary fiscal policy has the
“beggar-thy-neighbor” effect.
The locomotive effects of foreign expansionary
monetary policy

Interest rate (id)

Interest rate (if)
LMd
LMf
LMd’
id0
BPd
A
LMf’
if 0
BPf
A
B
B
BPd’
id1
BPf’
if 1
ISf ISf’
ISd
0
Yd0
Yd1
ISd’
Yd
Yf
0
Yf0
Yf1
The beggar-thy-neighbor effects of foreign
expansionary fiscal policy
Interest rate (id)
Interest rate (if)
LMd’
LMd
id1
LMf
BPd’
B
if 1
BPf’
B
A
id0
BPd
A
if 0
BPf
ISd’
ISf
ISf’
ISd
Yd
0
Yd1 Yd0
Yf
0
Yf0 Yf1
Economic policy under floating exchange
rate system

Floating exchange rate system means a
government has no obligation to defend the
parity between its domestic currency and
foreign currency.

The BOP disequilibrium causes the BP shift
right or left. The central bank has the
monetary policy autonomy.

Under floating exchange rate system,
monetary policy exerts a strong influence
over domestic aggregate output (income).

The effect of the fiscal policy on the
economy largely depends on the slope of the
BP curve.

The higher the capital mobility is, the
higher the interest rate level. The income
will be high but lower than the case of low
capital mobility.
The effects of expansionary monetary policy
under floating exchange rate system
Interest rate (i)
BP
LM
BP’
LM’
A
i0
i1
B
IS’
IS
0
Y0
Y1
Y
The effects of fiscal policy under floating
exchange rate system
Interest rate (i)
Interest rate (i)
BP
BP’
LM
i2
LM
C
BP’
B
i1
i1
i2
B
BP
C
A
i0
A
i0
IS’’
IS’
IS’
IS
IS’’
IS
0
Y
Y0
Y1
Y2
0
Y
Y0
Y2
Y1
The effects of domestic economic policy under floating
exchange rate system with perfect capital mobility
Interest rate (i)
Interest rate (i)
LM
LM
LM’
B
BP’
i1
A
C
A
i0
BP
i0
BP
B
BP’
i1
IS’
IS’
IS
IS
0
Y
Y0
Y1
Y2
0
Y
Y0
Y1
The effects of domestic economic policy on
foreign economy: a two-country model

Under the floating exchange rate system,
domestic expansionary monetary policy has
beggar-thy-neighbor effect on the foreign
economy.

On the other hand, expansionary fiscal policy
has the locomotive effect on the foreign
economy.
The effects of domestic expansionary monetary
policy on the foreign economy
Interest rate (id)
Interest rate (if)
LMd
LMd’
id0
A
B
LMf
BPd
if 0
C
B
BPd’
id1
BPf
A
BPf’
if 1
ISd’
ISd’’
ISf
ISf’
ISd
Yd
0
Yd0
Yd2 Yd1
ISf’’
Yf
0
Yf1 Yf0
The effects of domestic expansionary fiscal policy
on the foreign economy
Interest rate (id)
Interest rate (if)
LMd
id1
LMf
B
id2
BPd’
C
if 1
BPf’
B
A
id0
BPd
A
if 0
BPf
ISf’
ISd’
ISd’’
ISd
ISf
Yd
0
Yd0Yd2 Yd1
Yf
0
Yf0 Yf1