Question

1. What are the effects of fiscal policy under both fixed and floating exchange rates?

2. What are the effects of monetary policy under both fixed and flexible exchange rates?

3. What are the strength/weaknesses of fiscal vs. monetary policy under fixed and floating exchange rates?

Answer 1

1. Fiscal policy

Fixed exchange rate: If the economy is initially in equilibrium and expansionary fiscal policy is introduced under a fixed exchange rate system, say by an increase in government spending, then the IS curve shifts rightward as government spending increases (similar is the case if there is a reduction in taxes causing disposable income to increase). This puts an upward pressure on the exchange rate. However, given the fixed exchange rate system, there is an increased sale of foreign currency to the central bank. This causes the money supply to increase and LM to shift to the right, giving a higher level of income.

Floating exchange rate: on the other hand, under a floating exchange rate system, the same policy would cause the currency to appreciate with no change in income, given that the world interest rate remains constant.

2. Monetary policy

Fixed exchange rate: if the central bank pursues an expansionary monetary policy which increases money supply (LM shifts rightward), this would put a downward pressure on the exchange rate. However, to maintain the fixed exchange rate, there is an increase in the sale of domestic currency to the central bank, causing the money supply (LM) to return to the initial position.

Floating exchange rate: given floating exchange rates, the same monetary policy would shift the LM curve to the right, causing a lower exchange rate and increased income.

3. Under a fixed exchange rate system, the fiscal policy is effective and monetary policy isn't, while under a floating exchange rate system, monetary policy is effective while fiscal policy isn't.