Effectiveness of Monetary and Fiscal Policies
The shape of BP curve generally depends on capital mobility between countries.
Capital immobility: BP is vertical
Perfect capital mobility: BP is horizontal
Intermediate case: BP is positively sloped
Figure 1. Capital mobility and BP curve
Fixed Exchange Rate System
The analysis applies when one country uses adjustable peg or dirty float. For simplicity,
assume also that capital is perfectly mobile.
An increase in money supply
- Monetary authorities increase money supply by buying domestic securities.
- Interest rate temporarily falls as LM curve shifts to the right (to LM').
- Since the foreign interest rate is higher, domestic investors convert dollars into the
- Supply of dollars in the foreign exchange market increases.
- Consequently, dollar becomes weak in the foreign currency market.
- To maintain the value of dollar, the monetary authorities sell foreign exchanges (e.g.,
yen) and soak up the excess dollar (denoted by ex $).
- This action by the monetary authories decreases money supply, thereby shifting the
LM curve to the left, restoring the original LM curve.
Figure 2. Monetary Policy
Figure 3. Fed buys dollar back
The monetary authorities bought domestic securities using up international reserves
(foreign currencies). There is no change in income. Monetary policy is ineffective
in increasing income, once they are committed to defend a pegged exchange rate.
An Increase in Government Spending
- The government increases its expenditure, shifting the IS curve to the right.
- This increases the interest rate.
- Foreign investors, seeting the higher interest rate in the US, convert foreign
currencies into dollar, thereby increasing the demand for dollar.
- This would increases the value of dollar, if the government does not interfere.
- Committed to defend the given value of dollar, the monetary authorities sell dollars
foreign exchanges, thereby increasing the money supply.
- This shifts the LM curve to the right.
- This shift continues until the foreign and domestic interest rates are equalized.
Figure 4. Fiscal Policy
Figure 5. Fed sells dollar
Flexible Exchange Rate System
Effect of an Increase in Money Supply
- The monetary authorities increase money supply by buying domestic securities and
decreases the interest rate.
- Domestic investors convert dollar into foreign currencies, thereby increasing the
supply of dollar.
- dollar depreciates in the foreign exchange markets.
- This improves trade balance, shifting the IS curve to the right.
- This rightward shift of the IS curve continues until domestic and foreign interest rates
Result: An increase in money supply induces an increase in investment. Income also
Effect of an Increase in Government Spending
- An increase in government spending shifts the IS curve to the right. As a result,
domestic interest rate rises.
- Foreign investors convert foreign currencies into dollar, thereby increasing the demand
- dollar appreciates. This has an adverse effect on balance of trade, i.e., (x - m)
- This shifts the IS curve to the left.
- This leftward shift continues until the domestic and foreign interest rates are equalized.
Figure 9. Fed does not intervene
Result: An increase in government spending has no effect on GNP. It only causes
an appreciation of dollar.
Remark: It should be noted that the analysis is based on the
assumption that capital is perfectly mobile. If capital is not perfectly mobile, both monetary
and fiscal policies will have some impact on interest rate and income.
If it is riskier to invest in a foreign country (e.g., Russia), capital may not be perfectly
mobile between countries. Capital might be considered almost perfectly mobile between
industrial countries, but not between developed and developing countries.