Figure 16.1 Reaction to Fiscal Policy This flowchart shows the reaction of the economy to an increase in government spending under both flexible and exchange rate systems.
16.4 Fiscal Policy Under Fixed Exchange Rates
When the exchange rate is fixed, the balance of payments surplus created by a stimulating dose of fiscal policy does not cause the exchange rate to rise. Instead, it causes an increase in the money supply as the Fed buys foreign currency (the balance of payments surplus) with dollars. This increase in the money supply augments the stimulating effect of the policy dose, making fiscal policy stronger in affecting the income level. This process too is shown in figure 16.1.
16.5 Monetary Policy Under Flexible Exchange Rates
An increase in the money supply lowers the interest rate, and the lower interest rate stimulates aggregate demand and moves the economy to a higher level of income. This rise in income increases imports, creating a balance of payments deficit, and the fall in the interest rate reduces capital inflows, thus augmenting this balance of payments deficit.
Under a flexible exchange rate system, the balance of payments deficit causes the exchange rate to depreciate. This lower exchange rate increases exports directly increasing demand for domestically produced goods and services. It also decreases imports increasing demand for domestically produced goods and services that compete against imports. The rise in aggregate demand for domestically produced goods and services augments the impact on the economy of the stimulating dose of monetary policy, thus giving greater strength to monetary policy in affecting the income level. This process is shown in figure 16.2.
