101 Concepts for the Level I Exam

Essential Concept 15: Effects of Monetary and Fiscal Policy on Exchange Rates

Effects of monetary and fiscal policy on exchange rates are explained through the following models:

The Mundell-Fleming model: The short run impact of monetary and fiscal policies is summarized in the tables below.

High Capital Mobility

	Expansionary Monetary Policy	Restrictive Monetary Policy
Expansionary Fiscal Policy	Indeterminate	Domestic currency appreciates
Restrictive Fiscal Policy	Domestic currency depreciates	Indeterminate

Low Capital Mobility

	Expansionary Monetary Policy	Restrictive Monetary Policy
Expansionary Fiscal Policy	Domestic currency depreciates	Indeterminate
Restrictive Fiscal Policy	Indeterminate	Domestic currency appreciates

Monetary models of exchange rate determination: Monetary models assume that output is fixed and policies affect exchange rates through changes in price level and inflation. Two variations of the monetary approach are the

Basic monetary approach: It assume that PPP holds at all times, therefore an increase in money supply results in an increase in inflation and a depreciation of the domestic currency.
Dornbusch model: As money supply increases in the short run, price levels will not increase, rather, the higher money supply will cause short-term interest rates to decline leading to a capital outflow which in turn will cause the domestic currency to depreciate below its long-term equilibrium value. In the long run, as domestic interest rates rise, the currency will appreciate and the exchange rate will move in line with its long-term equilibrium value.

The Portfolio Balance approach: The Mundell-Fleming model focuses on the short-run; does not consider the long-run impact of budgetary imbalances. The portfolio balance approach addresses this limitation.

This approach can be combined with the Mundell-Fleming model to determine that an expansionary fiscal policy can be positive for a currency in the short run but negative in the long run in the condition of high capital mobility.

As budget deficit increases in the short run, interest rates increase bringing about capital flows and an appreciation of the domestic currency. In the long run, however, the growing budget deficit may imply the central bank may need to print more money to lend to the government and the fiscal stance may turn restrictive, which would lead to a decline in the currency’s value.

The following figure shows the short-and long-run response of exchange rates to changes in fiscal policy.