Effectiveness of Monetary and Fiscal Policies

BP Curve

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

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

Figure 4. Fiscal Policy

Figure 5. Fed sells dollar

Flexible Exchange Rate System

Effect of an Increase in Money Supply

Figure 6.

Figure 7.

Result: An increase in money supply induces an increase in investment. Income also increases.

Effect of an Increase in Government Spending

Figure 8


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.