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Does economic theory suggest that monetary and fiscal policy play different roles in causing big exchange rate movements?

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Introduction

EC201 Assessment Two Question: Does economic theory suggest that monetary and fiscal policy play different roles in causing big exchange rate movements? Discuss the extent to which examples of big exchange rate movements in recent history can be attributed to monetary and fiscal policy changes. In 1950s proponents of flexible exchange rates had assumed that flexible exchange rates would move relatively slowly and smoothly. But within a few years of the disintegration of the Bretton Woods arrangements, that assumption had been shown to be misplaced: there were large and sometimes rapid changes in exchange rates. Are there any suggestive theories behind the observed large fluctuations? The aim of this essay is to demonstrate the different roles that monetary and fiscal policy has played in causing big exchange rates movements and the empirical evidence in recent currency experience. The basic Mundell-Fleming model in 1960s is essentially intact as a way of understanding policy effects to exchange rates. The key assumption in this model is perfect capital mobility which indicates a horizontal BP curve. Firstly, let us discuss the fiscal policy under flexible exchange rate. If the government increases expenditures the IS curve shifts to the right in Figure 1. The domestic interest rate increases and as a result financial investors will want to hold domestic bonds. ...read more.

Middle

Thus, for aggregate demand to remain equal to output, a rise in e must be accompanied by a smaller rise in p. The GG curve in Figure 3 represents this and the AA and GG curves interest on the 45 line at the long-run equilibrium levels e and p. Figure 3 P AA GG (p = 0) e e In Figure 4, above the e = 0 schedule the price is above its long-run equilibrium, so the interest rate is above the foreign level and the exchange rate is depreciating. These movements are indicated by the horizontal arrows. To the left of the p = 0 schedule the exchange rate is below the level where aggregate demand equals output, therefore there is excess supply and the price is falling. These movements are indicated by the vertical arrows. The AA schedule then can be seen as the locus of the points at which the left-right and up-down movements combine to bring about a movement towards the full equilibrium. This is the "saddle path", which is the unique stable path along that full equilibrium can be approached in rational expectations models, and it is assumed that the economy 'jumps' on to such a path. Figure 4 AA GG (p = 0) ...read more.

Conclusion

Individuals face a signal extraction problem when observing a monetary shock and they must infer whether the policy change is permanent. Given imperfect information, the only way to do so is to apply a filtering rule which suggests an increased probability that a monetary policy is persistent the longer it lasts. Under this framework, the exchange rate adjusts slowly to a monetary shock as agents only slowly realize that the shock is persistent. Figure 7 Exchange rate overshooting models However, some economists argued that so little of the post-1995 appreciation was explained by the change in monetary policy by using UIP-based methodology and they believed the behaviour of sterling during that time was puzzle. There are also many alternative explanations such as that the real exchange rate was low by historical standards in early 1996; and the German unemployment increased sufficiently relative to UK unemployment which resulted a further appreciation. To sum up, both the Mundell-Fleming model and the Dornbusch model indicate that a contractive monetary policy or an expansionary fiscal policy will lead an appreciation and vice versa. However, the exchange rates only overshoot under monetary policy. The rise of dollars in 1985 was due to the mixture of monetary and fiscal policy, and the appreciation of sterling since 1996 was also due to the tight monetary policy. Therefore, these theories do explain exchange rates fluctuations with relatively strong evidence. ...read more.

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