Exchange Rate Economics: Theories and Evidence

The sticky-price monetary model 111
s
LL
XX
XX
FF
FF
A
O
LM
IS
IS
y
i*
B
i
Figure 5.3 Fiscal policy and the MF model.
in g by raising income would increase the demand for money and the rate of
interest. The latter would attract a potentially infinite inflow of capital,shifting
LM rightwards and increasing income by the full multiplier. Since the interest
rate is jammed at the world level,and the exchange rate is fixed,we have an
expansion of income analogous to the expansionary effects of fiscal policy in the
classic textbook liquidity trap case. However,with floating exchange rates the
increased rate of interest leads to an exchange rate appreciation which worsens
the trade balance by crowding out exports and sucking in imports,pushing the IS ′
curve back to IS. In the top quadrant the FF curve shifts to FF ′ with no change
in output. 1 An alternative way to see this result is to consider the effect of the
fiscal shock on the velocity of money. Since fiscal policy cannot alter the domestic
interest rate,it cannot alter the velocity of circulation (y − m) and hence there is
only one level of output (the initial level) which can be supported by the given
money supply.
The effects of a change in government spending on income and the
exchange rate,with a flexible exchange rate and perfect capital mobility,are
given by the following multipliers: dy/dg = 0 and ds/dg =−1/γ 1 . With fixed
exchange rates,the corresponding multipliers are dy/dg =[1/(1 − γ 2 )] > 0 and
dm/dg =[β 0 /(1 − γ 2 )] > 0.
5.1.3 The insulation properties in the MF model
In this section we consider how well both fixed and flexible exchange rates insulate
a country against foreign interest rate and income shocks.