Fiscal and Monetary Policy under Floating and Fixed Exchange Rate

Policy Choice Set

Mundell - Fleming Model

The Workhorse of International Macro

The Mundell-Fleming model illustrate how international capital mobility alters the e§ects of
macroeconomic policy

IS-LM Model for the Open economy with Perfect Capital Mobility
Digression: Interest Rate and Risk Premia

- i = i* not to be interpret literally –

- i + θ = i* - where θ = Risk Premium
- Country Risk, Exchange Rate Risk and Investor Risk Appetite

Mundell - Fleming Model

Fixed Exchange Rate

- IS shifts right
- pressure for i to increase and currency to appreciate
- Ms increases to maintain the Öx exchange rate
- LM Shifts right
BIG INCREASE IN INCOME
- LM shifts right
- pressure for i to fall and curency to depreciate
- Ms must fall to maintain the fix exchange rate
- LM Shifts back
NO EFFECT

- IS shifts right
- pressure for i to increase causing capital ináow
- currency appreciation
- NX falls
- IS shifts back
NO EFFECT

- LM shifts right
- pressure for i to decrease causing capital outflow
- currency depreciates
- NX increase
- IS shifts right
BIG INCREASE IN INCOME
Floating vs. Fixed Exchange Rates

- Argument for áoating rates: allows monetary policy to be used to pursue other goals
(stable growth, low ináation)
- Arguments for fixed rates: avoids uncertainty and volatility, making international
transactions easier
disciplines monetary policy to prevent excessive money growth & hyperinflation

Which system is best?

- Fixed:
o Preferable if shocks come from the money market
o Preferable if large importer of exporter of primary products
o Preferable if borrower from abroad ("Fear of Floating").
- Flexible:
o Preferable if shocks come from the goods market (IS) or from abroad (r*)
o If prices move slowly, less costly to move exchange rate in response to shock
that requires adjustment in the real exchange rate.

Global Financial Cycles?

After the Global Financial Crisis this picture is partly changed.

Policymakers around the globe anxiously await decisions in major economies.

Small open economies are particularly sensitive to policy changes in the economic centers.
"Quantitative Easing"
Taper tantrumî
Anticipated ìtakeo§î in the U.S.

The Efect of this "Global Shocks" are felt independently of the exchange rate regime adopted
From Trilemma to Dilemma

HÈlËne Rey @ Jackson Hole, 2013: ìDilemma not Trilemma: The Global Financial Cycle and
Monetary Policy Independenceî

- Whenever capital is freely mobile, the global Önancial cycle constrains national
monetary policies regardless of the exchange rate regime.
- It is a dilemma between capital mobility and monetary policy independence, not
trilemma

The US monetary policy ináuences other countriesínational MPs through capital áows, credit
growth, and bank leverages.

The “trilemma” reduces to an “irreconcilable duo” of monetary independence and K mobility –

- The types of exchange rate regime of the non-Core Economies no longer matter
- Restricting capital mobility and controlling credit growth are the onlys way for non-
central countries to retain monetary autonomy

Large Debate (1387 Citations!) - far from concluded

- flexible exchange rate robust to crisis. (Ghosh, et al, 2014)

- The focus is on the role of Global Banks (less important in South Africa, more in Latina
America)