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DE ECONOMIST 134, NR.

4, 1986

MONETARY-FISCAL POLICY ASSIGNMENT UNDER
FLOATING EXCHANGE RATES

BY

JAY H. LEVIN*

This p a p e r examines the use of m o n e t a r y and fiscal policy in a small o p e n
e c o n o m y in which the exchange rate is floating, and in which the g o v e r n m e n t
a t t e m p t s to achieve several m a c r o e c o n o m i c objectives. Because of sticky
wages and prices, full e m p l o y m e n t does not necessarily prevail, and the level
of e c o n o m i c activity, therefore, is taken to be a basic policy target. In addition,
the g o v e r n m e n t is c o n c e r n e d with the composition of output, in terms of the
fraction of gross national p r o d u c t d e v o t e d to investment spending, as part of
an overall growth policy'; and it also regards the country's current account
position as an i m p o r t a n t objective, With respect to the latter possibility,
D o r n b u s c h , for example, has suggested that

External balance, of course, is no problem if we think of it as overall balance of payments
equilibrium that is insured by the flexible rate. External balance remains an objective.
though, if we think of current account targets. A country may wish a particular current
account or trade balance because it may not wish to borrow or lend abroad excessively.:

For a given level of e c o n o m i c activity, it will be shown in Section i below that a
trade-off exists between the level of domestic investment spending and the
c o u n t r y ' s current account position as the monetary-fiscal policy mix changes.
ideally, then, policy-makers can select the monetary-fiscal mix that produces
the target level of e c o n o m i c activity and an o p t i m u m c o m b i n a t i o n of invest-
m e n t spending and current account position. H o w e v e r , in the absence of
reliable quantitative information about the e c o n o m y ' s m a c r o e c o n o m i c struc-
ture (and by implication the above trade-off in quantitative terms), policy-
m a k e r s must resort to assigning instruments to targets. 3 Therefore, Section 2
of the p a p e r discusses the assignment of m o n e t a r y and fiscal policy to the

* Professor of Economics, Wayne State University. The author is grateful to the referee for
helpful comments but must absolve him from all remaining errors.
1 For example, see Gordon [4, pp. I40-142].
2 Dornbusch [1, p. 198]. For extensive discussion of the current account as a possible target of
government policy, and a compilation of official statements indicating such a target, see Salop and
Spitfiller [11, esp. pp. 124-128]; and on possible determinants of the current account, see Dorn-
busch [2] and Sachs [10].
3 The classic discussion of monetary-fiscal assignment underfixed exchange rates is, of course,
Mundell [7]. A major critique is Johnson [5, pp. 314-318].

468 J. raise the investment c o m p o n e n t of G N P . 1 M(9. H e r e . L = demand for money. rr = exchange rate on the home currency (units of foreign currency per unit of domestic currency). i) (2) X(Tr) . ~ ) = I ( ] ) + X(~r) + G (1) Q = L ( ~ ' . LEVIN targets of economic activity and domestic investment spending. achieved by the use of monetary and fiscal policy. for simplicity. Q -. G = government spending on domestic goods and services. will simultaneously increase the country's current account position. The m a j o r conclusion is that monetary and fiscal policy can be feasibly assigned to either set of targets.. one can imagine that the government chooses a particular rate of monetary growth consistent with its goal for the long-run inflation rate.m o n e y supply. taxes have been omitted. . 4 The results of the p a p e r are summarized in Section 4. (Alternatively. Furthermore.domestic investment spending. changing the monetary-fiscal mix at the target level of economic activity. 1 THE TRADE-OFF BETWEEN INVESTMENT SPENDING AND THE CURRENT ACCOUNT The basic premise of this paper is that a target for the level of economic activity. (3) where Y = real G N P . and Section 3 analyzes the monetary-fiscal assignment when economic activity and the current account are the targets. and government spending is taken to be the fiscal control variable. and K = net sustained capital inflows. I .M ( f ' . the optimum monetary-fiscal mix is the one that achieves the most desirable combination of investment spending and balance of payments structure at the target level of income. The actual rate of monetary growth is then allowed to deviate from this number as monetary policy is assigned to one of the targets considered here. Equation (1) is the equilibrium condition for the goods market. given below: s ( % + ~1. implies a specific rate of domestic investment spending and a specific position for the current account under a floating exchange rate system. so as to. one can imagine that taxes are included in the saving 4 The rate of inflation is not an explicit target in this paper. However.H. Ideally then. P a r a m e t e r signs are shown above the arguments. X = volume of exports. although in both cases the system may respond with oscillations. M = volume of imports. These conclusions can be derived from the standard Keynesian open econ- omy static macro model under floating exchange rates. say. S = domestic saving. 1"= domestic interest rate.

the 5 If capital is perfectly mobile./A.. equation (3) is the foreign exchange market clearing condition when capital is imperfectly mobile. As is well known from the work of Fleming [3] and Mundell [8]. Choosing one of them implies a particular state for the other. Then domestic investment spending will rise.s L . Finally. and the reduced capital inflows will be offset by a smaller current account deficit under the floating rate system. 6 Consequently. and dY/dQ = ( K . s denoting (SS/SY). ) . 2 POLICY A S S I G N M E N T WHEN INVESTMENT SPENDING IS A T A R G E T We are now in a position to consider the assignment of monetary and fiscal policy when investment spending. Notice that stock-adjustment capital flows and capital movements stemming from expected changes in the exchange rate are omitted here since. In Figs. .I . Then the choice of any particular combina- tion of G and Q that produces Y* will also determine a particular rate of interest. Although domestic investment spending is no longer affected by the monetary-fiscal policy mix. M O N E T A R Y . as long as capital is less than perfectly mobile. la and lb the YY schedule shows combinations of G and Q for which the level of economic activity is on target. This will be achieved by a depreciation of the home currency to its new long-run equilibrium level. 6 The relevant multipliers from system (1)-(3) are d Y / d G . Also. + L y ( K . interest rates are stationary and exchange rate expectations are fulfilled. for the time being. then. along with GNP. interest payment flows in the current account are neglected. Y*. imports are taken to consist only of consump- tion goods.-L. and monetary expan- sion has the same effect for any degree of capital mobility. fiscal expansion raises the level of eco- nomic activity under the floating exchange rate system. the current account is still sensitive to it. Equations (1)-(3) contain the endogenous variables K r and ~r. where A = .F I S C A L POLICY ASSIGNMENT 469 function. in the steady state. . is that the level of investment spending and the structure of the balance of payments are not independent targets in this policy setting at a given level of economic activity. and by also establishing a particular level of net sustained capital inflows. Suppose now that the government wishes to attain a target level of GNP. 5 This in turn produces a specific level of domestic investment spend- ing. and domestic goods prices (and wages) are taken to be fixed and normalized at unity. when the system reaches a short-run equilibrium. Now suppose the government undertakes monetary expansion and fiscal contraction so as to leave GNP at Y* but lower domestic interest rates. this interest rate implies a specific current account position that exactly offsets the capital inflows under the floating rate system. the equilibrium interest rate is set in the rest of the world.) Also for simplicity. are the policy targets under the floating rate system.IOA. Equation (2) denotes money market equilibrium. . and the exogenous policy variables G and Q. The major conclusion. .

For the increased GNP could cause firms to revise their sales forecasts upwards..j "¥ 6 G Figure la . the monetary expansion continues. Here the Fleming-Mundell model indicates that. In the event that fiscal expansion did have this effect. fiscal expansion raises interest rates and therefore produces a cutback in investment spending.470 J. since investment spending remains below I*. 8 It is conceivable that fiscal expansion could lead to an increase in investment spending despite its effect on interest rates. Similarly. . and monetary policy to the investment target. LEVIN YY schedule is downward sloping. the policy instruments do not have a comparative advantage with respect to the policy targets. This situation calls for both monetary and fiscal expansion. Consequently. whereas monetary expansion lowers interest rates.s / A . the II schedule shows combina- tions of G and Q for which the level of investment spending is on target. pushing GNP above Y*. s In Fig. and d r / d Q . where GNP is below Y* and investment spending below its target level. However. so that two assignments are feasible. Monetary policy would have a comparative advantage over investment spending and should always be assigned to that target. fiscal policy is assigned to the GNP target. I*.Monetary Policy Assigned to Figure lb . imagine that the economy is initially at point a. the II schedule is upward sloping. which eventually move the economy to the output target at b.H. thus favoring higher investment spending. thereby stimulating investment spending5 Hence. the II schedule would be downward sloping and flatter than the YY schedule. I C i k_~ v I/ _. the fiscal authorities begin to reduce government spending. la. thus reinforcing the decline in interest rates produced by the monetary expan- 7 The relevant multipliers from the model are d r / d G = L v / A . with imperfect capital mobility.Fiscal Policy Assigned to Investment Spending Investment Spending In this kind of situation. To see how the system might respond to this assignment.

the government must be aware of one potential limitation. Thus the current account deficit must decline by this amount. the investment target is now the first one to be achieved. and fiscal policy to investment spending. Consequently. and from equation (1) government spending must be reduced by the amount ( K . The moral is that high capital mobility may limit the government's ability to alter investment spend- ing by a significant amount. Again. With both monetary and fiscal policy now operating in an expansionary direction. but the continued fiscal expansion now forces GNP above its target level. now pushing investment spending above I* and inducing fiscal expansion. m In choosing investment spending as a target. Since monetary policy is being assigned to the output target.Io)/I . Here the monetary expansion comes to an end. The fiscal contraction then ceases at point e. if capital is perfectly mobile. MONETARY-FISCAL POLICY ASSIGNMENT 471 sion.. completely fixing investment spending. 9 It is certainly possible that the system will converge without oscillations from points b or c. Of necessity. . the solution may involve a vast change in the current account position and an even larger change in govern- ment spending (or taxes) that would be regarded as unacceptable. leading to a reduction in sustained capital inflows in the amount Kr(I* . eventually causing investment spending to rise above I*. no amount of change in the current account and government spending will matter since interest rates are tied to the outside world level. as the result of lower interest rates. So if capital is highly mobile. 10. GNP eventually reaches Y* at point f. For example. the chances for direct convergence are increased.I o ) / I r.) (1" . the system proceeds in an oscillatory manner until both targets are ultimately reached. The system proceeds in this oscillatory fashion until both targets are eventually attained. but the on-going fiscal contraction continues to lower interest rates. The potential problem is that these required changes in the current account and government spending increase with the degree of capital mobility.I. the current account then becomes the second target. as shown in section 1 of the Appendix. but the investment shortfall elicits fiscal contraction. and perfect capital mobility eliminates it com- pletely. the system need not converge with oscillations. but that GNP is at Y*. To illustrate. imagine that investment is initially below its target level by the amount I* . as shown in the Appendix. Suppose again that GNP is initially below Y* and investment spending below I* at point d. a high degree of capital mobility would increase the leverage of monetary policy over GNP. 9 In Fig. this increased leverage favors direct convergence of the system.Io. . The solution requires a decline in interest rates in the amount ( I * . The GNP shortfall now calls for monetary expansion. Interest rates thus continue to decline.I o ) / I r. Indeed. For example. a high interest sensitivity of the demand for money tends to enlarge the fiscal policy multiplier on output. to keep GNP on target. but the monetary expansion continues because of the GNP shortfall. Once again. lb monetary policy is assigned to the GNP target. The upshot is that the investment target is eventually achieved at c. Since fiscal policy is being assigned to GNP.

the two assignments discussed in this section still remain feasible.. decreasing algebraically to -1 as K. ~s Figure 2a . given the a s s u m p t i o n of imperfect capital mobility.472 J. With imperfect capital mobility. The only modification is that the fiscal policy-current account assignment necessarily converges without oscillations. and the YY schedule becomes horizontal. LEVIN 3 POLICY ASSIGNMENT WHEN THE CURRENT ACCOUNT IS A TARGET N o w c o n s i d e r the a s s i g n m e n t of m o n e t a r y a n d fiscal policy w h e n the structure of the b a l a n c e of p a y m e n t s and G N P are the policy targets u n d e r the floating rate system. lowers interest rates.(1/rr)M)/dQ = K. Here d ( X . By raising G N P a n d thus interest rates. the offset is only partial. The relevant multiplier is d ( X . 13 In the case of perfect capital mobility too. 12M o n e t a r y e x p a n s i o n .-+~c.. increasing to s / L r as K. 12 In the case of perfect capital mobility. fiscal e x p a n s i o n increases net sustained capital inflows a n d t h e r e f o r e p r o d u c e s an increase in the c u r r e n t a c c o u n t deficit. This schedule is u p w a r d sloping b e c a u s e fiscal a n d m o n e t a r y e x p a n s i o n have o p p o s i t e effects o n the c u r r e n t account. Fig. it is well known that the tendency for interest rates to rise leads to a currency appreciation and an increase in the current account deficit that exactly offsets the fiscal expansion. fiscal policy becomes powerless to affect GNP.Monetary Policy Assigned to the Figure 2b . u T h e C C schedule shows c o m b i n a t i o n s of G a n d Q for which the c u r r e n t a c c o u n t is at its target level.s/A. However. .H. the current account deficit decreases by a smaller amount. 2a a n d 2b again c o n t a i n a d o w n w a r d sloping Y Y schedule. the latter is the mechanism by which aggregate demand expands: but with imperfect capital mobility.--+:c. leading to a decline in net sustained capital inflows a n d t h e r e f o r e a decrease in the c u r r e n t a c c o u n t deficit via c u r r e n c y d e p r e c i a t i o n . the tendency for interest rates to decline causes a depreciation of the currency and a smaller current account deficit.Fiscal Policy Assigned to the Current Account Current Account 11 If capital is perfectly mobile. o n the o t h e r h a n d .(1/Tr)M)/dG = . Indeed.K r L r / A .

Following such an incorrect policy would cause the system to diverge explosively front point a in a south-easterly direction. Consequently. for example. 15 In Fig. 16 Once again. the target level of GNP is eventually reached at f.16 Although both assignments have been shown to be feasible when the current account is one of the targets. with the policies conflicting with each other with respect to the level of GNP. and the expansionary monetary policy therefore continues. and with both policies operating in an expansionary direction. this belief ignores the overwhelming effect that the resulting exchange rate appreciation eventually would have on the current account. the fiscal authorities begin to increase government spending. 2b monetary policy is assigned to the GNP target. and indeed it is easy to show that perfect capital mobility guarantees it. This cyclical movement continues until both targets are attained. monetary and fiscal policy will have an uncertain effect on the trade balance. as shown in section 2 of the Appendix. on the grounds that the latter's deflationary effect on the economy would help correct the external situation. and fiscal policy to the current account. 2a. and both assignments are feasible. and the current account deficit now moves below its target level. while the central bank undertakes monetary expansion. Starting again in a situation of a GNP shortfall and the current account deficit above its target level at d. fiscal policy is assigned to the GNP target and monetary policy to the current account. the current account deficit is still above target here. and both policies operate to eventually move the current account deficit to its desired level at point c. the re- sponse of these flows to interest rates is in the direction opposite to the response of the sustained capital flowsJ 7 Consequently. pushing GNP above its target level. the monetary expansion continues because of the GNP shortfall. the current account target is the first to be achieved at e. the current account position now calls for fiscal contraction. the fiscal authorities now begin to contract government spending. In Fig. Consequently. 15 As before. However. where GNP is below target and the current account deficit is too large (or surplus too small). the fiscal contraction continues. M O N E T A R Y . and the economy eventually reaches the GNP target at b. . As is well known. Willett and Forte [12].F I S C A L POLICY ASSIGNMENT 473 Once again the policy instruments do not possess a comparative advantage with respect to the policy targets. which depends on the 14 The government might incorrectly believe that the current account position calls for monetary contraction. the government undertakes both fiscal and monetary expansion. However. Here the monetary expansion ceases. 17 See. 14 However. However. the path of the system need not be oscillatory. but the continued fiscal expansion now causes GNP to move above its target level. High capital mobility favors this possibility. a complication now arises when interest payment flows are incorporated into the model. and the current account deficit now moves below target. the system can be noncyclical. Consequently. Starting at point a. This oscillatory behavior of the system continues until both targets are eventually achieved. with GNP still above target.

LEVIN response of sustained capital flows and interest payment flows combined. and the case for choosing the current account as a target becomes stronger. a trade-off exists between them as the monetary-fiscal policy mix changes. the current account. How- ever. therefore. including interest payment flows. see my paper [6]. Finally. either monetary or fiscal policy can be assigned to the GNP target. as Phillips [9] demonstrated long ago. and therefore it is a more appropriate target than the trade balance anyway. A choice may have to be made between the latter two objectives because. . Fortunately. the current account is the proper measure of the net resources being lent to or borrowed from foreigners. in which capital flows depend only on the interest differential between domestic and foreign assets. too forceful an appli- cation of integral stabilization policy . assigning monetary and fiscal policy leads to a convergence of the system. 4 CONCLUSIONS This paper has developed a model in which monetary and fiscal policy can be used to achieve a target level of economic activity and either an investment spending or current account target. an easier monetary and tighter fiscal policy combination increases investment spending and reduces the current account deficit. and the other policy to the second target. However. an approach that is standard in the assignment problem litera- ture. the reader is reminded that these conclusions are derived from a very simple open economy Keynesian model. from a welfare viewpoint. However. remains a feasible target since its response to monetary and fiscal policy depends only on the latters' effect on sustained capital flows. Once the choice between investment spending and the current account has been made. for a given level of economic activity.the type considered in assignment models . a more elaborate represen- tation of the capital account under conditions of imperfect capital mobility is possible. Specifically. although possibly an oscillatory one. as the degree of capital mobility increases. and the trade balance. so does the rate of trade-off between these targets. 18although I would conjecture that the policy models would remain stable under either inelastic or rational expectations. Furthermore. Nevertheless. The implication then is that the government must have data on the entire current account. including a specification of exchange rate expectations. when setting its policies according to the assignment rules discussed above. cannot be used reliably as a target.H. and not just the trade balance.474 J. because the policies are always in a tug of war with respect to one of the targets. if one drops this Occam's Razor approach. A second simplification is the absence of lags in the model.can produce explosive movements in a macroeconomic system when 18 For example.

the system is noncyclical if and only if the discriminant of (A2) is positive. respectively.<0) dt d Q (Q .! is sufficiently large. Furthermore. the dynamic system may be represented as follows: dQ-fijr[dr + ~ r ( G . + L~.(K. for example.) 2 + 4t3' fix 1.)/A). The reverse assignment is given by dr dr ( G .sL.G'~)] (9~>0) dGdt . . [L. where A = . and this condition reduces to (fi. Consequently. monetary and fiscal changes might have to be made quite gradually in order for the system to converge. dr/dQ = .1.) ] @_~<0) dt -/32 d-Q (Q .Q*) dG (al) dG [dY + dY (G_G... and dY/dG = .s / A . (A2) 22+2 (-/J* I"do dr _ / ~ 2d ~Y ) + filfi21.L J A .. and the system is therefore dynamically stable. and Q* and G":"denote the unknown optimal levels of Q and G.G*)] (/3.)>0. if the assignment rules in this paper were followed. MONETARY-FISCALPOLICY ASSIGNMENT 475 outside lags are present./.l.I..(d_Q dG dG dQ From system (1)-(3) in the text..Q*) + d G (A4) dQ dY + dY ~4<0) the characteristic equation of which is . (A3) which can be satisfied if.s ...). .fi3I" -dQ (Q . .Q*) d G - where 13~and 132 are speed of adjustment coefficients. dY/dQ = (K. APPENDIX 1 G N P and Investment Spending as Targets" When monetary policy is assigned to the investment target and fiscal policy to GNP.Ly ( K. Thus.fixL. dr/dG = Ly/A. the coefficient of 2 and the constant term are positive. The characteristic equation of this system is dr dY dr d Y ) = 0 .

476 J.O ) +fi~fi4 "kdG dQ dO dG) The coefficient of 2 and the constant term are again positive. It is noncyclical if and only if [fl3I.. drr/dQ = (-K.~ d G .z t ' 'dO 27d~/+ 0. dQ dG dG = 0.Q*) dG where from system (1)-(3).(s + m) + mI. the dynamic system becomes dQ _ 01[( B~ d~r m d V t (Q .G*)] (0. L y > O . (A9) This condition can be satisfied if. ]L. B~ denotes X~ .4010~(K.~2_~2 [--/~3 . by a large enough value of the capital mobility parameter.f i a d .) 2 . for example.M~ + M (<0 by virtue of the Marshall-Lerner condition) and m represents DM/DY.t34( K.)12 + 4fi3fl 4sL.((2 . and it is noncyclical if and only if (01Krs + 02L. for example.>O..0~K.<0) B..A). The reverse assignment is given by .)/-B~A). and the system is stable.I.I. (as) This system is clearly dynamically stable.Q*) + dt dQ dQ ] ( d~r dY) (G . (A6) which is guaranteed.m d-G- dG_07[dY + dY ( G . . . ~ dY I ( dr dY dr dY =0. .L.)K.. The characteristic equation of this system reduces to [OK dr__o d Y ] ( d Y dr dY 2 .. (A5) / l d r .d O . K r. 2 GNP and the Current Account as Targets" When monetary policy is assigned to the current account and fiscal policy to GNP. and d~r/dG = (KrL Y + mL.G * ) I (A7) (02<0) dt . ) .I is sufficiently large..H. LEVIN .)/-B.v +. l_.

' Oxford Economic Papers. 'Real Interest Rates.' Pakistan Develop- ment Review (1967). i962.N. 411-427. International Economics. Mundell. Home Goods.M. Spitfiller. A.M. 3. 1980. Cooper (ed. J. 1962. 1969.G*)] (04<0) (Am) dt d Q (Q . Johnson. Interna- tional Economics. and E. 1968.. Harmon&worth.1. 1980.A. 1969. 101-134. b~ternationalFinance.Q*) + d . New York. reprinted in: R.. London. London. R..40304K. 1968.0 3 [ B ~ . 'Theoretical Problems of the International Monetary System. R. 'Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. and it is noncyclical if and only if [03K.. March..L v + 04(K.F. F. if.0 dY] (dr dY dr dY) =0. February.A. June. 1980. R. 201-282. Cooper (ed. 'Domestic Financial Policies under Fixed and under Floating Exchange Rates.dTr --m dY ) (Q-Q*)+ dt dQ dQ (B.H. Staff Papers. and Optimal External Borrowing. Fleming. (All) 470 + O<Xr dO dC dC dQ This system is also dynamically stable. Dornbusch.. No.' Brookings Pape~ on Economic Activity. Macroeconomics. drr rn dY ] ( G .J.. Staff Papers. reprinted as Chapter 16 in: R. .l is sufficiently large. Mundell.G.' reprinted as Chapter 18 in: R. Gordon. 141-153.G the characteristic e q u a t i o n of which reduces to ( dr . Levin.£>O. H. II.' Economic Journal. 'The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange Rates.' Journal of Political Economy. EIarmondsworth. MONETARY-FISCAL POLICY ASSIGNMENT 477 d G . Staff Papers. 1: 1981. March..W. 1983. REFERENCES Dornbusch. (A12) This condition is fulfilled.' I. pp. November. R..)]2 . pp. .A. 'Why Does the Current Account Matter. Sachs.).'?'I. 'Stabilization Policy in a Closed Economy. J.M..D.F. 1984. Open Economy Macroeconornics. reprinted in: R. Salop.). G*)] (03>0) dQ -dG-J d O _ 04 [ d Y d Y (G . Phillips. Mundell. for example.. 'The Current Account and Macroeconomic Adjustment in the 1970's. 'The Dynamics of Stabilization Policy under Flexible Exchange Rates: A Synthesis of the Asset and Neo-Keynesian Approaches. pp. M. pp. Mundell.N. Boston and Toronto. R..' I.A. 1954. J.L.. International Finance. J.

The government attempts to achieve a target level of economic activity and either an investment spending (output composition) or current account target. and F.D. However. LEV[N Willett. 242--262. and the second policy to one of the other targets.H. a choice may have to be made between the latter two objectives because a trade-off exists between them as the monetary-fiscal policy mix changes. although the path may be oscillatory. Summary MONETARY-FISCAL POLICY ASSIGNMENT UNDER FLOATING EXCHANGE RATES This paper examines the use of monetary and fiscal policy in a small country model under floating exchange rates. pp. 1969. .' QuarterlyJournal of Economics. It is shown that either monetary or fiscal policy can be assigned to the GNP target.478 J. T. May. 'Interest Rate Policy and External Balance. Forte.