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

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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. This causes an incipient excess demand for domestic currency and drives up its price, so the exchange rate falls and domestic currency appreciates.

Figure 1

   interest         

    rate     IS        IS’    LM

                 

    i = iw                          BP = 0

                                   Output

Now turn to monetary policy. An increase of money supply shifts LM to the right in Figure 2, this shift would drive the interest rate down. As soon as domestic interest rates begin to move below the world interest rate, international investors start to move out of domestic bonds and try to get rid of domestic currency. The incipient excess supply of domestic currency leads to a depreciation.

Figure 2

interest                 LM

    rate     IS       IS’       

                                  LM’

                         

      i = iw                         BP = 0

                                    Output

The Dornbusch overshooting model is another famous theory in explaining the exchange rates fluctuations. Dornbusch assumed that the domestic country is relatively small to foreign economy; goods prices are sticky whereas interest rates and exchange rates adjust quickly to clear the markets. All variables are in natural logarithms and asterisks indicate variables of foreign economy.

Under perfect capital mobility, which means capital flows respond strongly to incipient yield differentials, and assumed that domestic and foreign bonds are perfect substitutes, the yield on domestic bonds given by the domestic interest rate r minus the expected depreciation of the domestic currency ee is equal to the yield on foreign bonds r*:

                       r - ee = r*                       Equation (1)

This is the uncovered interest parity (UIP) condition.  

With rational expectations, private sector agents correctly calculate the long-run equilibrium exchange rate e and know that the exchange rate adjusts towards that long-run equilibrium by some proportionθof the difference between it and the current exchange rate:

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                       ee =θ(e – e), 0 <θ<1                 Equation (2)

Next, the equilibrium in the money market requires the real money supply m-p to equal real money demand which depends positively on real income, here assumed to be constant at the natural rate of output y, and negatively on the interest rate:

                m – p = ky –λr,   k,λ> 0               Equation (3)

Consider domestic aggregate demand, which is ...

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