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12.4: Monetary and fiscal policy with flexible exchange rates

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    In a closed economy with slow wage and price adjustments, monetary and fiscal policies are both important tools for aggregate demand management in the short run. Things are different in open economies with high international capital mobility. With flexible exchange rates monetary policy is powerful for changing AD. It works through both interest rate and exchange rate linkages in the transmission mechanism, not just the interest rate linkages of the closed economy. By contrast, the effects of fiscal policy on aggregate demand are reduced. In the absence of supporting monetary policy, fiscal expansions crowd out private sector expenditures through both interest rate and exchange rate linkages, leaving AD unchanged.

    Fixed exchange rates have the opposite implications for policy effectiveness as an AD management tool. The effects of fiscal policy are enhanced by induced changes in monetary conditions, but monetary policy alone is almost powerless to change AD. As a result, the first important step in the design of macroeconomic policy in the open economy is the choice of an exchange rate regime.

    Monetary policy

    With flexible exchange rates, monetary policy causes changes in both interest rates and exchange rates. Net international capital flows link exchange rates and changes in domestic interest rates when exchange rates are flexible. Given the exchange rate expected in the long run, higher interest rates in the short to medium run cause a capital inflow, an increased supply of foreign exchange on the foreign exchange market, which lowers the exchange rate, er.

    Conversely, lower domestic interest rates relative to international rates cause a rise in the exchange rate, er.

    As a result, current monetary policy and expected future monetary policies have strong effects on the nominal exchange rate and the international competitiveness of the domestic economy and AD. Changing current interest rates for a short time will have only small exchange rate effects. However, a credible change in monetary policy for a sustained period will cause a large and persistent change in current exchange rates, an important factor in the monetary transmission mechanism. This can have large short-run effects on the real economy.

    As a result, in an open economy with flexible exchange rates, monetary policy affects aggregate demand not just through the effects of interest rates on consumption and investment. Changing interest rates, by changing the exchange rate, also change the international competitiveness of exports and imports. Net exports change in the same direction as domestic expenditure, increasing the impact of interest changes on aggregate demand. Lower interest rates boost domestic expenditure, raise the exchange rate, and increase net exports. Higher interest rates reduce domestic expenditure, lower the exchange rate, and reduce net exports. With linkages through both domestic and international components of expenditure, monetary policy is more powerful under flexible exchange rates than in a closed economy.

    Canada and a number of other countries conduct monetary policy in terms of a target for the domestic inflation rate. A flexible exchange rate policy is essential for the monetary policy independence and power required to pursue that target. That is why the Bank of Canada defines Canada's flexible exchange rate as a key component of Canada's monetary policy framework. The other key component is the Bank's inflation control target.

    Fiscal policy

    With flexible exchange rates, but without monetary policy accommodation or support, the effect of interest rate changes on exchange rates and competitiveness undermines the power of fiscal policy to manage aggregate demand.

    Suppose the government undertakes a fiscal expansion, raising government expenditures or lowering taxes or some combination of the two: Aggregate demand increases. When monetary policy targets an inflation rate based on either an interest rate rule or a money supply rule, the expansion in AD caused by fiscal policy changes the economic fundamentals on which the central bank's policy had been set and induces the bank to raise interest rates. The higher interest rates cause a net capital inflow and an increased supply of foreign exchange on the foreign exchange market, and the nominal exchange rate falls. A fall in the nominal foreign exchange rate lowers the real exchange rate. International price competitiveness (as measured by the real exchange rate) is reduced and net exports fall, offsetting the expansionary effects of the change in fiscal policy. With flexible exchange rates monetary policy targeted to the inflation rate dominates fiscal policy as a tool for AD management.

    As discussed previously, Canadian experience provides an example. In the 2005-2007 period, the federal government provided fiscal stimulus through tax cuts and expenditure increases. The primary structural budget balance fell from an average 3.4 percent of potential GDP for 2002 to 2004 to 2.6 percent for 2005 to 2007. At the same time the Bank of Canada's estimates showed the economy operating with a small but persistent inflationary gap. The inflation rate was in the upper level of the Bank's target range. The Bank responded to strong current and expected demand (coming from both the government and private sector) by raising its overnight rate in steps, from 2.5 percent in late-2005 to 4.5 percent by mid-2007, to defend its inflation target. The inflationary gap and inflation were contained as higher interest rates and lower exchange rates limited the growth of aggregate demand, including that coming from fiscal stimulus.

    In a closed economy, fiscal expansions that push up interest rates cause partial crowding out of private expenditure by reducing consumption and investment. In an open economy with flexible exchange rates the crowding out mechanism is stronger. Fiscal expansion causes both a rise in interest rates and a fall in the exchange rate. Both domestic expenditure and net exports are reduced. The extended crowding out through the change in exchange rates and net exports when exchange rates are flexible reduces the power of fiscal policy to manage aggregate demand in the short run.

    However, if control or reduction of the debt ratio is the prime target of fiscal policy, the flexible exchange rate is helpful. If the government raises tax rates or cuts expenditures to raise its structural budget balance and reduce the debt ratio, lower settings for the central bank's interest rate and a rising exchange rate provide some offsetting "crowding in" through both domestic expenditure and net exports. The limited aggregate demand effects of fiscal policy under flexible exchange rates facilitate control of the government's budget balance and debt ratio.

    Policy co-ordination

    This analysis of the policy implications of flexible rate regimes leads to a clear recommendation for policy co-ordination. Flexible exchange rates provide the framework for effective monetary policy focused on a medium term inflation target. The exchange rate regime enhances the power of monetary policy to moderate business cycle fluctuations and the output gaps they create. Stabilizing the economy at or close to potential output avoids the cumulative inflationary or recessionary pressures that would push inflation rates away from the monetary policy target. Monetary policy is then the aggregate demand management tool.

    Fiscal policy is not an effective AD management tool when exchange rates are flexible. Its impacts on aggregate demand are limited by crowding out and dominated by monetary policy. However, this does enhance the power of fiscal policy to pursue deficit control and debt ratio control. The effects of fiscal restraint aimed at improved public finances are moderated by a monetary policy focused on an inflation target in a flexible exchange rate regime.

    The Canadian experience with economic policy and performance provides an excellent example of this sort of coordinated policy. Starting in 1995 the federal government introduced a policy of strong fiscal adjustment through restraint aimed at reducing the public debt-to-GDP ratio. The structural primary budget balance was increased through expenditure cuts and tax increases. At the same time, monetary policy was aimed at maintaining inflation within the 1-3 percent target band, which required monetary stimulus. The nominal and real overnight interest rates were reduced. Economic growth was constrained by the fiscal austerity but still sufficient to eliminate the recessionary gap by the end of the decade. The support of domestic monetary policy, a significant depreciation of the Canadian dollar, strong growth in the US economy and strong export growth were keys to this successful fiscal adjustment. The coordination of fiscal restraint and monetary stimulus moved the economy to potential output with stable inflation and a falling ratio of public debt to GDP.

    Policy responses to the recession of 2009 also involved strong policy co-ordination, both domestic and international. Monetary policy was the first line response, with central banks in most industrial countries lowering their interest rate to or close to the zero lower bound. Some countries, like the US, then went further to provide quantitative and credit easing through general and selective open market operations. Fiscal stimulus added to these highly accommodative monetary conditions. Central bank commitments, like those in both the US and Canada, to maintain policy rates at their minimum for periods as long as a year or more eliminated concerns about fiscal crowding out.

    Coordinating the focus of both monetary policy and fiscal policy was designed to stimulate aggregate demand and restore growth in real GDP. In a time of deep recession, high indebtedness, and high uncertainty even very low interest rates won't induce households and business to take on more debt to build more houses or factories. There is already an excess supply of productive capacity and housing. Monetary conditions can support an expansion in expenditure but cannot trigger it.

    Fiscal policy, by contrast, can add directly to expenditure and aggregate demand, especially expenditure on infrastructure, education, research, and similar public investments. Tax cuts are likely to have smaller expenditure effects if only because the recipients have marginal propensities to spend that are less than one. Nonetheless, there is an important debate about whether expenditure increases or tax cuts should be used for fiscal stimulus, and which will have the larger and more desirable effect.

    With this policy coordination there is no cause for concern about crowding out. Central banks were not concerned about the effects of increased aggregate demand on inflation rates and their inflation targets. Quite the opposite, like the Bank of Canada they hoped to raise inflation to their target. Fiscal expansion will not induce higher interest rates or lower exchange rates.

    This page titled 12.4: Monetary and fiscal policy with flexible exchange rates is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) .

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