Effectiveness of Monetary and Fiscal Policies

BP Curve

Fixed Exchange Rate System

An increase in money supply

• Monetary authorities increase money supply by buying domestic securities.
• Interest rate temporarily falls as LM curve shifts to the right (to LM').
• Since the foreign interest rate is higher, domestic investors convert dollars into the foreign currency.
• Supply of dollars in the foreign exchange market increases.
• Consequently, dollar becomes weak in the foreign currency market.
• To maintain the value of dollar, the monetary authorities sell foreign exchanges (e.g., yen) and soak up the excess dollar (denoted by ex $).
• This action by the monetary authories decreases money supply, thereby shifting the LM curve to the left, restoring the original LM curve.

Figure 2. Monetary Policy

Figure 3. Fed buys dollar back

Result
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

• The government increases its expenditure, shifting the IS curve to the right.
  
• This increases the interest rate.
  
• Foreign investors, seeting the higher interest rate in the US, convert foreign currencies into dollar, thereby increasing the demand for dollar.
• This would increases the value of dollar, if the government does not interfere.
• Committed to defend the given value of dollar, the monetary authorities sell dollars and buy foreign exchanges, thereby increasing the money supply.
• This shifts the LM curve to the right.
• This shift continues until the foreign and domestic interest rates are equalized.

Figure 4. Fiscal Policy

Figure 5. Fed sells dollar

Flexible Exchange Rate System

Effect of an Increase in Money Supply

• The monetary authorities increase money supply by buying domestic securities and decreases the interest rate.
• Domestic investors convert dollar into foreign currencies, thereby increasing the supply of dollar.
• dollar depreciates in the foreign exchange markets.
• This improves trade balance, shifting the IS curve to the right.
• This rightward shift of the IS curve continues until domestic and foreign interest rates are equalized.

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

• An increase in government spending shifts the IS curve to the right. As a result, domestic interest rate rises.
• Foreign investors convert foreign currencies into dollar, thereby increasing the demand for dollar.
• dollar appreciates. This has an adverse effect on balance of trade, i.e., (x - m) decreases.
• This shifts the IS curve to the left.
• This leftward shift continues until the domestic and foreign interest rates are equalized.

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.