Question

Explain the effect of Fiscal Policy Under Floating Exchange Rates. Explain the crowding out and its effect. USE GRAPHS and within the IS-LM Framework. Explain changes in the main economic variables: interested rate (i), Demand (D), Output (Y), and exchange rate (E).

Answer 1

It shall be noted that an expansionary fiscal policy caused by a tax cut or increased government spending will shift the IS curve to the right.

Initially, the economy is in equilibrium at point e, where the IS curve is equal to the LM curve. The Balance of payment is zero and the domestic interest rate i, is equal to the interest rate if in the rest of the world.

In the graph given below, the expansionary fiscal policy shifts the IS curve right, from IS to IS'.

This shift would result in an intermediate equilibrium at the point, e'.

At e', the goods market and money market will be in equilibrium with higher aggregate demand (D) and higher output (Y), but there will be an official settlement surplus because of the lower capital account deficit induced by the higher interest rate i' > i at e'. The higher interest rate i' immediately invites a massive capital inflow.

Since the exchange rate (E) is free to adjust under the floating exchange rate regime, to eliminate the balance of payments surplus, the intersection of the IS and LM curves cannot remain above the BP curve.

The official settlement surplus causes the domestic currency to appreciate.

This appreciation will reduce domestic exports and increase imports.

As net exports fall, the IS curve shifts left. When the IS curve has returned to the initial equilibrium position that passes through point e, equilibrium is restored in all markets.

It shall be noted that the final equilibrium occurs at the initial level of i and Y.

Thus, as observed, with floating exchange rates, fiscal policy is ineffective in shifting the level of income. When an expansionary fiscal policy has no effect on income, complete crowding out has occurred. This crowding-out effect occurs because the currency appreciation induced by the expansionary fiscal policy reduces net exports to a level that just offsets the fiscal policy effects on income.

Thus, with the floating exchange rate regime with perfect capital mobility, an expansionary fiscal policy only result in the appreciation of the domestic currency, with no eventual effect on the interested rate (i), aggregate Demand (D), and level of Output (Y).