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The Flexible Exchange Rate System: The Effect of Fiscal Policy

The above result depends upon the assumption that capital movement is perfect and the rate of interest is given by the world market. In this situation, monetary policy cannot be used as an independent policy because the fixed exchange rate has to be supported by the accommodated monetary policy. Monetary policy loses freedom of choice or its effect on the economy.

We now consider the flexible exchange rate system where the exchange rate is determined so as to attain equilibrium in the exchange market. In this instance, it is unnecessary to accommodate monetary policy. If an interest rate increases because of government spending, capital inflows occur in an open economy. Further, the excess demand for the home currency makes the home currency appreciate. As shown in Fig. 2.6, expansionary fiscal policy initially moves the IS curve upward and to the right to the IS0 curve.

We need to consider the impact of the appreciation of the home currency. In the IS/LM diagram, the exchange rate e is a shift parameter. Since e appears in the net export function, it may move the IS curve. Appreciation of the exchange rate (a decline of e) stimulates imports and depresses exports. This depresses aggregate demand in the home country; the IS curve then moves downward. Namely, an original upward movement of the IS curve because of expansionary government spending is offset by a downward movement of the IS curve because of the associated appreciation of the home currency, the yen.

The new equilibrium point is the same as the initial point, E0. This is because income does not change in the money market as long as the rate of interest and money supply do not change. The downward movement of the IS curve occurs so long as the rate of interest is higher than the world rate. Thus, the associated appreciation of the home currency completely offsets the initial expansionary effect of government spending. In other words, the multiplier of fiscal policy becomes zero here. Thus, The effect of fiscal policy in the flexible exchange rate regime

Fig. 2.6 The effect of fiscal policy in the flexible exchange rate regime

 
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