Monetary and Fiscal Policy in Case of the Floating Exchange Rate and Various Degree of International Capital Mobility

Changes in the money market have a direct impact on the economy. The monetary policy in case of the floating exchange rate reacts to changes in the economy most effectively, unlike to its action in the conditions of the fixed exchange rate.

Effect of monetary policy in case of the floating rate and limited capital mobility is shown in Fig. 8.12. The increase in money supply from LMO to LM1 reduces an interest rate (rO—>rl) and increases the income (YO—>Y1). In the point A, corresponding to internal balance, there is a deficit in the balance of payments. In case of limited capital mobility its outflow and decrease of an interest rate will cause depreciation of national currency and improvement of balance of the current account, and as a result there will be a shift of curves (of) BP (BPO —>BP1) and IS (ISO —> IS1). Thus, a transition to a new point of balance B will be reached, where the economy is in a state of external and internal balance, but in case of higher level of income Y2, growth of which is caused by the depreciation of the currency.

Effect of monetary policy in case of the floating rate and lack of capital mobility is shown in Fig. 8.13. In case of implementation of the expansionary monetary policy by the government, the growth of income leads to increase in import and deterioration of the current account, and a decrease of an interest rate leads to a deficit in the account of capital flows and financial transactions. In case of non capital mobility, i.e. impossibility of its outflow abroad, the increased income stimulates import that provokes a depreciation of a national currency. As a result, export increases and import reduces, the balance of payments improves (BPO —>BP1), and the growth of income leads to increase in consumption (ISO—>IS1). The economy turns into a new balance - point B, where there is observed the increased income and depreciation of national currency in case of an invariable interest rate.

Effect of monetary policy in case of the floating rate and complete capital mobility is shown in Fig. 8.14. In case of complete capital mobility a growth of money supply will lead to interest rate reduction that will provoke a bigger capital outflow abroad, than in the first case. The capital outflow will lead to a depreciation of national currency that will help to improve the balance of payments, and it means a growth of income and consumption. As a result, the economy will pass to a new point of balance with higher level of income (YO —> Y2) in case with a constant interest rate.

Influence of monetary policy on economy in case of the floating exchange rate and limited capital mobility

Figure 8.12. Influence of monetary policy on economy in case of the floating exchange rate and limited capital mobility

Influence of monetary policy on economy in case of the floating exchange rate and lack of capital mobility

Figure 8.13. Influence of monetary policy on economy in case of the floating exchange rate and lack of capital mobility

Influence of monetary policy on economy in case of the floating exchange rate and complete capital mobility

Figure 8.14. Influence of monetary policy on economy in case of the floating exchange rate and complete capital mobility

Expansionary fiscal policy leads to stimulation of the total demand and changing in the commodity market, the curve IS0 shifts to the IS1 level, raises the income (Y0 —> Yl) and an interest rate (rO —> rl) that corresponds to the point A. Further corrective actions will depend on capital mobility.

Effect of fiscal policy in case of the floating exchange rate and limited capital mobility is shown in Fig. 8.15. There is a negative account balance in the point A. The excess of demand over supply of foreign currency promotes a depreciation of national currency, improving the balance of payments (BP0 —>BP1) and stimulating demand (IS1 —> IS2). Macroeconomic balance is reached in the point B in case of higher level of income Y2 and the raised interest rate r2.

Influence of fiscal policy on economy in case of the floating exchange rate and limited capital mobility

Figure 8.15. Influence of fiscal policy on economy in case of the floating exchange rate and limited capital mobility

Effect of fiscal policy in case of the floating exchange rate and lack of capital mobility (Fig.8.16). As the capital is completely immobile, import increases with the growth of income that causes depreciation of currency. Depreciation of national currency helps to improve the balance of payments (BP0 —>BP1) that generates an additional impulse to increase income and consumption (IS1 —► IS2). Thus, balance was established because of change of the exchange rate at higher level of income and interest rate.

Influence of fiscal policy on economy in case of the floating exchange rate and lack of capital mobility.

Figure 8.16. Influence of fiscal policy on economy in case of the floating exchange rate and lack of capital mobility.

Effect of fiscal policy in case of the floating exchange rate and complete capital mobility (Fig.8.17) [29, p.346].

Influence of fiscal policy on economy in case of the floating exchange rate and complete capital mobility

Figure 8.17. Influence of fiscal policy on economy in case of the floating exchange rate and complete capital mobility

In these conditions the curve BP0 will merge with the curve BP1. The growth of interest rate will lead to capital inflow from abroad and to the growth of national currency rate. Intermediate balance in the point A will not stay long so far as the growth of a rate will negatively affect trade balance. As a result, the curve IS1 will shift to the initial ISO level. Macroeconomic balance will be established at the initial level at the point E and in such case level of income and interest rate will not change.

Influence of Foreign Trade Policy on the Economy in Case of the Floating Exchange Rate

A protectionist foreign trade policy (together with monetary and fiscal policy) may have a stimulating impact on the economy. The government purposefully changes the size of net export, limiting import or encouraging export. And as a result it helps to increase a total demand. Such policy is justified in the conditions of fixed exchange rate and finally it leads to growth of total income.

In Fig. 8.18 it is shown that government impact changes the size of total demand (the curve IS0 shifts to the right in the position of IS1). Increase in exports change the condition of the balance of payments (the curve BPO shifts to the right in the position of BP1). The growth of total demand leads to increase of interest rate and capital inflows come to the country. As a result both accounts of balance of payments are improved. They raise pressure on the national currency rate that will continue to increase until (there will be an equilibration of) the balance of payments will be in equilibrium. In the process of growth of exchange rate of national currency export will be reduced, and import will increase. It will start decreasing after increase in net export that finally will shift the curves IS1 and BP 1 to the left to their initial position. Only in the point E the net balance of payments will be equal to zero, a growth of exchange rate will stop and macroeconomic balance will be restored.

Influence of a foreign trade policy on economy in case of the floating exchange rates in the conditions of limited capital mobility

Figure 8.18. Influence of a foreign trade policy on economy in case of the floating exchange rates in the conditions of limited capital mobility

In terms of complete mobility or in case of its absence, all processes in the economy will be performed similar to a case with limited capital mobility. The difference will be only in the degree of (rise in price of) national currency value appreciation and in rate of return of the economy to the initial balance.

So, in the conditions of the floating exchange rate a foreign trade policy has no effect on the income and consumption, and it is not the effective instrument of macroeconomic regulation.

 
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