Why does a flexible exchange rate make monetary policy more effective but fiscal policy less effective?

Expert Solution

In a flexible exchange rate, the central bank can influence the output in the economy by targeting the exchange rate by means of monetary policy.

For that purpose, let us compare effects of expansionary fiscal and expansionary monetary policy. If the central bank wants to increase the output in the economy, then it can target the interest rate. The central bank can decrease the interest rate by means of expansionary monetary policy. This will lead to an increase in aggregate spending and hence output level increases. Further a decrease in interest rates will lead to capital outflow as the returns in domestic market will reduce. It will reduce the demand for local currency and will lead to its depreciation. This will lead to an increase in demand for exports and hence it will further increase the output by even more amount. However, an expansionary fiscal policy will only increase the output level but it will also reduce in a greater demand for imports as imports are positively related to output. The extra boost in output by monetary policy through an increase in demand for net exports than the same by means of fiscal policy.

Rahul Sunny answered 8 months ago

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