Domestic Financial Policies under Fixed and under Floating Exchange Rates

This 1962 IMF Staff Papers article by J. Marcus Fleming compares how effective monetary policy and budgetary (fiscal) policy are at stimulating domestic income and output under fixed versus floating exchange rates, using a simple Keynesian model of a small open economy in which taxation and private income after tax vary with national income, private expenditure varies directly with after-tax income and inversely with the interest rate, the interest rate varies directly with the income-velocity of money, the trade balance varies inversely with domestic expenditure and directly with the exchange rate, and net capital imports vary directly with the interest rate (pp. 369-370, with a full mathematical formulation in the Appendix, pp. 377-379). Fleming shows that a given increase in the money supply always produces a larger expansion of income under a floating exchange rate than under a fixed rate, because the balance-of-payments deficit a monetary expansion creates forces the currency to depreciate under floating rates, and the resulting improvement in the trade balance adds a further stimulus to income that is simply unavailable when the rate is pegged (pp. 372-374). By contrast, whether a given increase in public expenditure (or reduction in tax rates) produces a larger or smaller income expansion under floating rates than under fixed rates is genuinely ambiguous, because a fiscal expansion’s effect on the overall balance of payments is itself ambiguous: it worsens the current account through higher imports but improves the capital account through the higher interest rate it induces, so whether the currency depreciates or appreciates – and hence whether floating rates amplify or dampen the fiscal multiplier relative to fixed rates – depends on the model’s parameters, especially the interest-sensitivity of capital flows (pp. 370-372). Comparing a monetary expansion and a budgetary expansion calibrated to produce equal income gains under a fixed exchange rate, Fleming demonstrates that, except in the limiting case of zero interest-sensitivity of capital movements (where the two policies are equivalent under either regime), the monetary expansion’s income effect relative to the budgetary expansion’s is never smaller, and is generally larger, once both are switched to a floating exchange rate (pp. 374-376). The paper further notes an asymmetry in sustainability: under fixed rates, monetary expansion can be sustained only as long as reserves hold out, whereas budgetary expansion can in principle be sustained indefinitely if capital movements are sufficiently interest-sensitive; under floating rates, both types of policy can be sustained indefinitely so far as the balance of payments is concerned (pp. 375-376). Fleming closes by qualifying the whole analysis with the observation that equilibrating exchange speculation will narrow these differences in effectiveness while disequilibrating speculation will widen them (p. 376).

Staff Papers - International Monetary Fund | Macro Paper Warehouse

Domestic Financial Policies under Fixed and under Floating Exchange Rates