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Principles of Macroeconomics (Curtis and Irvine)
12: Exchange rates, monetary policy, and fiscal policy

12: Exchange rates, monetary policy, and fiscal policy

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In 1999 the Canadian economist Robert Mundell won the Nobel Prize in Economics for his work on the importance of exchange rate policy for the effectiveness of monetary and fiscal policies as tools to manage aggregate demand. Mundell showed for a small open economy like Canada, with a high degree of international capital mobility, that:

With flexible exchange rates monetary policy is a powerful demand management tool, but fiscal policy is weak, and
With fixed exchange rates monetary policy is ineffective as a demand management tool, but fiscal policy is strong.

The Bank of Canada's monetary policy framework, using interest rates, flexible exchange rates and an inflation rate target reflects these strong theoretical arguments. Furthermore, the difficulties European countries using the euro have experienced trying to cut budget deficits and stimulate income growth show the constraint a fixed exchange rate imposes on fiscal adjustments.

This chapter explains the foreign exchange market, flexible and fixed exchange rates and the reasons why different exchange rate policies affect the design and effectiveness of monetary and fiscal policy.