Fiscal Policy, Money and the Exchange Rate

Abstract

This chapter highlights the role of the money supply and the exchange rate in an open economy aggregate demand-oriented model of fiscal and monetary policy, including analysis of fiscal versus monetary stimulus and the effectiveness of countercyclical fiscal and monetary policy with inflation targeting.

Nothing has done more in my opinion to lead modern economics astray than the practice which Lord Keynes brought into fashion in the 1930’s of reasoning on the hypothesis of a “ closed economy ”… It is paradoxical that British economists should have led this intellectual fashion, at which Adam Smith , Ricardo, John Stuart Mill, Bagehot, and Alfred Marshall would certainly have knit their brows.

Sir Hubert Henderson , 1949

Appendices

Appendix: Deriving the Model

The slopes of the AE and MM schedules of the model are derived as follows.

The AE Schedule

Partially differentiating the expenditure equation

$$ \Upsilon = \frac{{ (\Lambda + (\upsilon + \sigma )q + (\xi + \varsigma ) (eP^{*} /P) - \phi (r^{*} + f/e - 1 + \theta )}}{ (1 + \mu - \alpha )}, $$

with respect to the nominal exchange rate, yields

$$ \partial\Upsilon /\partial e = \frac{{ (\xi + \varsigma ) (P^{*} /P) + \phi f/e^{2} }}{1 + \mu - \alpha } > 0. $$

This implies aggregate expenditure is positively related to the exchange rate as defined. Since $\partial y/\partial e > 0$, if we redefine e as the reciprocal of E, it follows that $\partial y/\partial E < 0$. Therefore, a downward sloping schedule labelled the AE schedule can be drawn in exchange rate-national income (or $\overline{E} -\Upsilon$) space, as shown in Fig. 5.1.

Moreover,

$$ \partial \varUpsilon /\partial q > 0,\;\partial \varUpsilon /\partial P < 0,\;\partial \varUpsilon /\partial r^{*} < 0,\;\partial \varUpsilon /\partial f < 0,\;\partial \varUpsilon /\partial \theta < 0. $$

Hence, higher asset prices shift the AE schedule right, whereas a higher price level, foreign interest rate, risk premium and expected depreciation shift it left.

The MM Schedule

Partially differentiating the monetary equilibrium equation

$$ \Upsilon = \frac{{M/P + \eta (r^{*} + f/e - 1 + \theta )}}{\kappa }, $$

with respect to the exchange rate ,

$$ \partial\Upsilon /\partial e = - \frac{\eta f}{{\kappa e^{2} }} < 0. $$

This implies a downward sloping money market schedule in exchange rate–national income space. Again, however, to facilitate understanding, the nominal effective exchange rate for the purposes of the diagrams to follow is redefined as $E = 1/e$, such that a rise (fall) in the value of E denotes appreciation (depreciation). This allows us to draw the upward sloping schedule MM schedule in $E - \Upsilon$ space, as shown in Fig. 5.1.

Moreover,

$$ \partial\Upsilon /\partial M > 0,\;\partial\Upsilon /\partial P < 0,\;\partial\Upsilon /\partial r^{*} > 0,\;\partial\Upsilon /\partial f > 0,\;\partial\Upsilon /\partial \theta > 0, $$

which means changes in base money, the price level, foreign interest rate, expected exchange rate and risk premium, as well as the parameters governing money demand, are shift factors for the MM schedule.

Notes

• 1. The following draws on, and extends Makin (2018).