Question

What is the role of the exchange rate in the transmission of the funds rate to aggregate demand in the open economy model, and is monetary policy or fiscal policy more effective in and open economy?

Answer 1

Part 1) When the central bank manipulates the funds rate then it has impact on the exchange rate that affects the aggregate demand in an open economy. For instance, if the central bank reduces the funds rate, then commercial banks will also reduce the primary credit rate in the economy. This will have impact on exports as well as investment.

Export: When interest rates are reduced there will be a capital outflow from the economy as investors will invest in other countries with higher interest rates. This will cause exchange rate to depreciate, as demand for domestic currency declines while that of foreign currency increases. Depreciation of the domestic currency will make exports cheaper and imports expensive. As a result, the aggregate demand will rise in the economy.

Investment: Reduction in interest rates will make borrowing for investment cheaper resulting in increased investment that will raise aggregate demand in the economy.

Part 2) In an open economy with perfect capital mobility and flexible exchange rate monetary policy is effective as compared to the fiscal policy.

For instance, assuming that the economy is initially in equilibrium. Now, let us assume that the central bank raises the level of money supply in the economy to raise the aggregate demand. For a given level of income, an increase in the money supply will result in people using the extra money for speculative purpose. This will put pressure on the interest rate. Rise in speculative balances will raise the demand for bonds because of which their prices will rise while the interest rate will decline.

Decline in the interest rate will stimulate investment demand as firms will find it cheaper to borrow for the purchase of plants and machinery. This will raise the aggregate demand and income level. However, things will not stop here, as decline in the interest rate will cause capital outflow, which will put pressure on the domestic currency to depreciate. Depreciation of the domestic currency will make exports cheaper and imports expensive. As a result, the aggregate demand will rise further.

Now let us take the case of fiscal policy. Assume that the government increases its expenditure to raise the aggregate demand in the economy. For a given level of money supply, increase in income from government expenditure will raise the transaction demand for the money. People will start to withdraw money from the speculative balances to finance their transaction needs. This will cause the bond prices to decline and interest rate to increase. Increase in the interest rate will result in decline in the investment demand as firms will find it expensive to borrow for investment in plants and machinery. So, the initial increase in demand by government expenditure is to some extent negated by the decline in the investment demand.

However, things will not stop here. An increase in the interest rate will result in capital inflow as investors looking for higher returns start to invest in the country. This will result in appreciation of domestic currency. As a result, exports will become expensive and imports cheaper.

So, the initial increase in aggregate demand by government expenditure is completely negated by decline in investment and net exports.