Fixed vs. Floating Exchange Rates: Policy Effects

Floating Exchange Rate: When a country allows its exchange rate to be determined by currency markets, the exchange rate is said to be floating.

Effects of Fiscal Policy (Floating Rate)

Government Spending Increase (G↑) or Taxes Decrease (↓T) => IS* shifts right (↑) => exchange rate appreciation (e appreciation) => crowds out Net Exports (NX) => no effect on Aggregate Demand (AD) (When the economy is open, capital immediately flows inwards)

Effects of Monetary Policy (Floating Rate)

Money Supply Increase (M↑) => LM* shifts right (↑) => Output (Y) increases (↑), interest rate (r) decreases (↓) => exchange rate depreciation (e depreciation) => Demand (D) increases (↑) for foreign exchange => Net Exports (NX) increase (↑) (Capital flows out of the economy as soon as there is even a tendency for r to fall below r*)

Fiscal policy is ineffective in raising AD in a small, open economy with a floating exchange rate. Monetary policy is effective.

Fixed Exchange Rate: Arises when a Central Bank (CB) stands ready to buy and/or sell foreign currency on demand at a rate set by itself. (The shadow exchange rate = the exchange rate that would prevail in the open market if the exchange was not fixed)

Effects of Fiscal Policy (Fixed Rate)

Highly effective in raising AD: Government Spending Increase (G↑) or Taxes Decrease (↓T) => IS* shifts right (↑) => short-run exchange rate increases (sh e↑) => CB buys foreign exchange; sells domestic currency (Money supply increases (Ms↑) => LM* shifts right (↑) => short-run exchange rate falls back (sh e falls back↓))

Effects of Monetary Policy (Fixed Rate)

The CB of a small open economy loses the ability to control Ms or to influence AD: if CB increases (↑) Ms => LM* increases (↑) => short-run exchange rate decreases (sh e↓) below e along IS => There is a sale of foreign currency by the CB => Ms decreases (↓) and LM* decreases (↓) (shifts back) => Money supply falls back to its original level.

Large Country: Can affect both domestic and world prices and/or interest rates by its own economic activity.

Fiscal Expansion (Floating Rate)

As interest rate (r) and world interest rate (r*) increase (↑) => capital inflow decreases (↓) => appreciation decreases (↓) => Net Exports (NX) increases (↑) and Output (Y) increases (↑); also => Demand (D) increases (↑) for funds in both finance markets (global and local)

Effect:

Government Spending Increase (G↑) or Taxes Decrease (↓T) => IS* shifts right (↑) => intersect of LM*0 and IS*’ => as Government Spending Increase (G↑) interest rate (r), world interest rate (r*) increase (↑) => Money demand decreases (Md↓) and IS* shifts back => to maintain market equilibrium => Output (Y) has to increase (↑) so as LM* increases (↑) => some crowding out but less.

Monetary Expansion (Fixed Rate)

Pursues a monetary expansion; this will decrease both interest rate (r) and world interest rate (r) => Investment (I) increases (↑) => IS* increases (↑)

Effect:

CB Money supply increases (Ms↑) => LM* increases (↑) => at given interest rate (r) exchange rate decreases (es↓) => sale of USD by the CB; Money supply increases (Ms↑) => world interest rate (r*), interest rate (r) decrease (↓) => domestic Investment (I) stimulated => IS* increases (↑) (LM* shifts back) *The CB of a large economy has some control over its Ms and can influence AD.

Arguments for Fixed Rates:

1. Prevents uncertainty about the future exchange rate and this stimulates foreign Investment (I) and trade.
2. Prevents a country’s CB from pursuing excessive growth in the Money supply (Ms) (government expenses are often covered by issuing money).
3. Creates price transparency as prices can be directly compared by buyers.

Arguments for Floating Rates:

1. Act as automatic stabilizers (autonomous spending decreases (aut sp.↓) => exchange rate decreases (e↓) => Net Exports (NX) compensates).
2. Fixed rate systems are vulnerable to speculative attacks and panics.