Exam 18: Macroeconomic Policy and Floating Exchange Rates

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Mixtures of fiscal and monetary policy that are inconsistent with one another (one expansionary and one contractionary) are inconsistent with internal balance objectives. For example, a mixture of a contractionary monetary policy and expansionary fiscal policy produces an ambiguous outcome for the equilibrium level of output and the price level in the short run. When policy mixes are inconsistent, they can have ambiguous effects on the domestic economy in the short run. However, inconsistent policy mixes have explicit effects on a country's external balance. An expansionary fiscal policy coupled with a contractionary monetary policy causes the currency to appreciate and likewise the current account balance would deteriorate. In this case, both fiscal and monetary policies reinforce each other and the effect on a country's external balance can be quite significant. The same would be true of a contractionary fiscal policy coupled with an expansionary monetary policy. In this case, the exchange rate depreciates and the country's current account balance improves. The important point is that these types of policy mixes can have extreme effects on a country's external balance.

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In an open economy with international capital mobility, an expansionary monetary policy leads to a fall in interest rates that causes an outflow of foreign capital. The outflow of foreign capital tends to cause the exchange rate to depreciate. The capital outflows result in a capital account deficit and a current account surplus. The effects of expansionary monetary policy cause the aggregate demand curve to increase. It also causes an improvement of the current account balance that causes aggregate demand to increase again. As a result, an expansionary monetary policy in an open economy is more effective in changing real GDP than it is in a closed economy.

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Governments now tend to use monetary and fiscal policy to focus on a country's internal balance. Internal balance refers to the levels of unemployment and inflation that fit the preferences of the citizens of various economies. For most countries, the focus of fiscal and/or monetary policy is on managing the growth rate of real GDP and the price level. In many cases, this focus on internal balance comes at the expense of external balance considerations. In effect, the exchange rate and the current account balance become secondary variables as countries attempt to manage the domestic economy and the exchange rate and current account balance adjust to these policies. In many cases, this approach seems sensible as the exchange rate and the current account are important. However, the state of the domestic economy is usually considered to be far more important. This focus on internal balance is not without a cost. Policies designed to achieve a desired internal balance may have large consequences for a country's external balance. Governments may not like the results of fiscal and/or monetary policy changes on the country's external balance, but in many cases, they are willing to accept these consequences as the price of maintaining internal balance.