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The Monetary and Fiscal Policies and Determination of Exchange Rates

The Monetary and Fiscal Policies and Determination of Exchange Rates

Government policies have an impact on exchange rate fluctuations. These channels include:

1. The Mundell-Fleming Model

This model stipulates that changes in monetary and fiscal policies within a country interfere with interest rates and economic activity, which is reflected in capital flows and trading. Consequently, this is reflected in exchange rates. It is based on aggregate demand and assumes that the economy could increase without price level increase.

1.1 Expansionary Monetary Policies

According to this model, expansionary monetary policy affects economic growth by lowering the interest rates making the investment and consumption spending shoot. When this is coupled with flexible exchange rates, reduced domestic interest rates will make the capital flow to high-yielding markets, causing the local currency to depreciate.

1.2 Expansionary Fiscal Policies

On the other hand, expansionary fiscal policy (such as increased spending or lowering taxes) causes increased interest rates since the country will be operating with a higher budget deficit, which must be financed. When this is coupled with flexible exchange rates and mobile capital, increasing interest rates will attract capital from the low-yielding markets, leading to domestic currency appreciation. If the money is immobile and irresponsive to interest rate changes, an increase in aggregate demand caused by the government policies will increase imports and negatively impact the trade balance leading to currency depreciation.

1.3 The Mix of Monetary and Fiscal Policies

In the case of floating exchange rates and high capital mobility, the domestic currency will appreciate the presence of restrictive domestic monetary policy and/or expansionary fiscal policy. On the other hand, the money will depreciate in the presence of domestic expansionary monetary policy and/or restrictive fiscal policy. This is summarized in the following table. $$ \begin{array}{c|c} \textbf{Policy Combination} & \textbf{Effects} \\ \hline {\text{Expansionary Fiscal Vs.} } & \text{Indeterminate} \\ \text{Expansionary Monetary Policies} & {} \\ \hline \text{Expansionary Fiscal vs} & \text{Domestic currency appreciates} \\ \text{Restrictive Monetary Policies} & \\ \hline \text{Restrictive Fiscal vs} & \text{Domestic currency depreciates} \\ \text{Expansionary Monetary Policies} & \\ \hline \text{Restrictive Fiscal vs} & \text{Indeterminate} \\ \text{Restrictive Monetary Policies} & \\ \end{array} $$

In low mobile mobility, the effects of monetary and fiscal policies are only transmitted through the trade flows rather than the capital flows. When expansionary monetary and fiscal policies are mixed, it will exert downward pressure on the currency (bearish) since the expansionary fiscal policy will increase imports and, therefore, trade deficit leading to currency depreciation. When expansionary monetary policy is added, more will be spent on imports, leading to a deteriorating trade balance hence, further currency depreciation.

A mix of restrictive monetary and fiscal policies will exert upward pressure on the currency since it leads to decreased imports and improvement in the trade balance. The effects based on low capital mobility are summarized below:

$$ \begin{array}{c|c} \textbf{Policy Combination} & \textbf{Effects} \\ \hline {\text{Expansionary Fiscal Vs.} } & \text{Domestic currency depreciates} \\ \text{Expansionary Monetary Policies} & {} \\ \hline \text{Expansionary Fiscal vs} & \text{Indeterminate} \\ \text{Restrictive Monetary Policies} & \\ \hline \text{Restrictive Fiscal vs} & \text{Indeterminate} \\ \text{Expansionary Monetary Policies} & \\ \hline \text{Restrictive Fiscal vs} & \text{Domestic currency appreciates} \\ \text{Restrictive Monetary Policies} & \\ \end{array} $$

Monetary Models of Exchange Rate Determination

The Mundell-Fleming explanation is based on interest rate changes and the output. Consequently, it left out changes in the price level and inflation. According to monetary models of exchange rate determination, the output is fixed, and that price levels and the inflation rate majorly transmit the effects of monetary policies. There are two models as such:

2.1 Pure Monetary Approach 

According to this model, when the domestic money supply increase by a certain percentage, it will lead to a rise in the price level by the same percentage. If purchasing power parity is assumed to hold (fluctuations in the exchange rates are reflected in inflation rate differentials), an increase (decrease) in domestic foreign prices should induce a proportional reduction (growth) in the domestic currency value.

The assumption of purchasing power parity in both short and long runs turns out to be a disadvantage to this model since PPP does not, in most cases, hold in short or medium terms.

2.2 Modified Monetary Model

This model by Rüdiger Dornbusch (1976) assumes that price flexibility in the short-run is limited but fully flexible in the long run to make sure that an increase in domestic money supply will lead to the proportional increase in the domestic price levels and thus long-run depreciation of the domestic currency (consistent with pure monetary model).

If the domestic price level is not flexible in the short run, this model will imply that the exchange rate will overrun the long-run PPP in the short term; therefore, an increase in the nominal money supply will lead to a fall in the domestic interest rate. In the presence of high capital mobility, a reduction in domestic interest rate will increase capital outflow, which causes short-run depreciation of domestic currency below long-run equilibrium value. However, the currency will appreciate following the conventional monetary approach if the nominal interest rate increases in the long run.

The Portfolio Balance Approach

The Mundell-Fleming model does not accommodate the long-term effects of budgetary imbalance caused by continued fiscal policies. This shortcoming is surpassed by the portfolio approach by assuming that an investment consists of a diversified portfolio of both domestic and foreign assets, for instance, bonds. The proportion of each asset depends on the anticipated return and risks.

Take, for instance, when the government’s deficit grows steadily, there will be an increased supply of domestic bonds. The investors willingly hold the bonds if they are promised higher returns in the form of:

  • Higher interest rates or risk premium
  • Immediate depreciation of the currency to the level where the investors will gain from the anticipated appreciation or
  • combination of the two. The second point implies that currency adjustment is required. That is, in the long run, the government that operates at large budget deficits should expect its currency to depreciate.

Question

A decreasing interest rate and increasing money supply in a country with low levels of public and private debt will most likely cause:

  1. An indeterminate effect on the currency
  2. Currency appreciation
  3. Currency depreciation

Solution

The correct answer is C.

Decreasing interest rates will most likely cause capital flows to high yielding markets leading to currency depreciation.

Reading 6: Currency Exchange Rates: Understanding Equilibrium Value

LOS 6 (k) Explain the potential effects of monetary and fiscal policy on exchange rates.

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