Lecture 17
FISCAL POLICY

1. Floating Exchange Rates

• Suppose G increases

1.1 Goods market

• In the income-expenditure diagram, the AE-line shifts up
• Eqbm GNP rises

1.2 Money market

• Money demand increases (why?)
• Interest rate goes up
  This will cause a decline in C and I leading to a...
  ... slight decrease in AE

1.3 Forex market

• The increase in R leads to...
  ... greater capital inflows leading to...
  ... an appreciation of the domestic currency

• This is captured by a rightward shift of the "Return on Dollar Deposits" line...
  ... causing E to decrease

1.4 Further effects

• The stronger dollar (lower E) will cause net exports to fall...
  ... and thus the AE-line to shift down yet again

1.5 Results of the expansionary fiscal policy

• The increase in GDP is somewhat muted (why?)
• Higher interest rates
• A stronger currency
• Larger capital account surplus and current account deficit
• Bigger budget deficit
• Lower investment

2. Fixed Exchange Rates

• Increase in G leads to higher Y and R

• Increase in R leads to capital inflows

• Domestic currency will tend to appreciate ...
  
  But since the exchange rate is fixed ...
  ... the central bank must prevent the incipient appreciation by ...
  ... buying foreign-exchange reserves

• Domestic money supply rises

• Interest rate falls back (to original level)

• Results:
  • Large increase in GDP
  • No change in interest rates
  • Increase in current account deficit (why?)
  • Increase in central bank's holdings of foreign reserve assets

Conclusion: Fiscal policy is more potent under fixed exchange rates.