Monetary & Fiscal Policy Efficacy of Traditional Financial Tools

Tightened Monetary Policy Exchange rates float; no capital flows 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. 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 ER floats; capital free to flow Monetary policy is strong. Monetary policy is strong. Currency appreciates. Currency appreciates. But higher interest rate draws capital inflow. But higher interest rate draws capital inflow. Currency appreciates even more. Currency appreciates even more. Demand contraction even greater. 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 changes.

Tightened Monetary Policy ER pegged; Capital flows blocked. ER pegged; Capital flows blocked. Monetary policy is ineffective. Monetary policy is ineffective. Inflation declines & interest rates rise => improvement in current account. Inflation declines & interest rates rise => improvement in current account. Bank reserves accumulate Bank reserves accumulate The money supply eases again. 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. ER pegged; Capital free to flow. Monetary policy is ineffective. Monetary policy is ineffective. The increase in the interest rate brings an immediate inflow of capital which snuffs it out. The increase in the interest rate brings an immediate inflow of capital which snuffs it out. There will be no deflation. There will be no deflation. Domestic demand and the current account have no reason to change. 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. ER floating; capital flows blocked. Fiscal policy is effective. Fiscal policy is effective. Tighter fiscal policy reduces overall demand (G falls, or, through higher tax rates, C, I and Im fall). 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. 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. ER floats; capital free to move. Fiscal policy is weak. Fiscal policy is weak. Interest rates decline => capital departs. Hence, currency depreciates. Interest rates decline => capital departs. Hence, currency depreciates. The money supply is unchanged. The money supply is unchanged. All changes are due to the change in fiscal policy. All changes are due to the change in fiscal policy. Overall demand declines; however, CA rises which partly offsets the decreases in domestic demand. Overall demand declines; however, CA rises which partly offsets the decreases in domestic demand.

Tightened Fiscal Policy ER pegged; Capital flows blocked. ER pegged; Capital flows blocked. Fiscal policy is ineffective. Fiscal policy is ineffective. Overall demand & inflation down. Overall demand & inflation down. CA rises (+ pegged ER) => rising R. CA rises (+ pegged ER) => rising R. But ΔR => ΔM => increased demand. But ΔR => ΔM => increased demand. Hence, tight fiscal policy plus expansionary monetary conditions induce stalemate. Hence, tight fiscal policy plus expansionary monetary conditions induce stalemate.

Tightened Fiscal Policy ER pegged; Capital free to move. ER pegged; Capital free to move. Fiscal policy is strong. Fiscal policy is strong. Lower interest rate => capital outflow. Declining reserves => falling M. 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. 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. If exchange rates are flexible, both fiscal and monetary policy do what they are supposed to do. Monetary policy is more reliable. Monetary policy is more reliable. Fiscal policy at least works weakly in the right direction. 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. 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. 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. 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. 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 quasi- segments. Exchange rates become more volatile with greater capital mobility. Overshooting becomes ubiquitous. Highly volatile exchange rates split the global market into quasi- segments. ER fixers regard this as too high a cost to have to pay. 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. 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. But, monetary & exchange rate policies are close to being one & the same. A change in monetary policy (interest rates) => changes in the exchange rate. A change in monetary policy (interest rates) => changes in the exchange rate. Pressure on exchange rates implies a limited scope for interest rates. 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. The three are tightly tied and are independent of any influence from the current account.