Question

8. Discuss the relative effectiveness of fiscal and monetary policy in restoring internal balance under a fixed exchange rate regime.

Answer 1

When thereis fixed exchange rate, monetary policy is completlely ineffective. Suppose there is recession so Central bank undertakes expansionary monetary policy. However, as the interest rate falls below rest of the world, there is pressure on currency to depreciate. So central bank has to intervene to sell foreign currency and buy domestic currency. So LM curve is back in original position i.e. money supply is back to original.

on the other hand, fiscal policy is completely effective when there is fixed exchange rate. Suppose government undertakes expansionary fiscal policy to counter recession. This would lead to higher output in economy. Hence demand for money increases, putting upward pressure on interest rate. This would put pressure on currency to appreciate. So to keep fixed exchange rate, central bank will have to buy foreign currency and sell domestic currency i.e. increase money supply. Hence, both IS and LM curve shift out and