International Finance Theory and Policy
by Steven M. Suranovic

Finance 90-2

# Fiscal Policy with Fixed Exchange Rates

In this section we use the AA-DD model to assess the effects of fiscal policy in a fixed exchange rate system. Recall from Chapter 50, that fiscal policy refers to any change in expenditures or revenues within any branch of the government. This means any change in government spending, transfer payments or taxes, by federal, state or local governments, represents a fiscal policy change. Since changes in expenditures or revenues will often affect a government budget balance, we can also say that a change in the government surplus or deficit represents a change in fiscal policy.

When government spending or transfer payments increase, or tax revenues decrease, we refer to it as expansionary fiscal policy. These actions would also be associated with an increase in the government budget deficit, or a decrease in its budget surplus. If the government acts to reduce government spending or transfer payments, or increase tax revenues, it is referred to as contractionary fiscal policy. These actions would also be associated with a decrease in the government budget deficit, or an increase in its budget surplus.

Expansionary Fiscal Policy

Suppose the US fixes its exchange rate to the British pound at the rate Ē\$/£. This is indicated on the adjoining diagram as a horizontal line drawn at Ē\$/£. Suppose also that the economy is originally at a super equilibrium shown as point J with GNP at level Y1. Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). As shown in section 60-2, fiscal policy changes cause a shift in the DD-curve. More specifically, an increase in government spending (or increase transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., ↑G, ↑TR, and ↓T, all are DD-rightshifters). This is depicted in the diagram as a shift from the red DD to the blue D’D’ line (Step 1).

If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for G&S will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase leading to an increase in consumption demand. In either case, aggregate demand increases. Before any adjustment occurs, the increase in aggregate demand causes aggregate demand to exceed aggregate supply, which will lead to an expansion of GNP. Thus the economy will begin to move rightward from point J.

As GNP rises, so does real money demand, causing an increase in US interest rates. With higher interest rates, the rate of return on US assets rises above that in the UK and international investors increase demand for dollars (in exchange for pounds) on the private FOREX. In a floating exchange rate system this would lead to a US \$ appreciation (and £ depreciation), that is, a decrease in the exchange rate E\$/£.

However, because the country maintains a fixed exchange rate, excess demand for dollars on the private FOREX will automatically be relieved by FED intervention. The FED will supply the excess dollars demanded by buying pounds in exchange for dollars at the fixed exchange rate. As we showed in section 70-4, FED purchases of foreign currency results in an increase in the US money supply. This is because when the FED sells dollars in the private FOREX, these dollars are entering into circulation and thus become a part of the money supply. The increase in the money supply causes the AA curve to shift up. (Step 2) The final equilibrium will be reached when the new A’A’ curve intersects the D’D’ curve at the fixed exchange rate Ē\$/£, shown at point K.

Note that in the transition, FED intervention in the FOREX occurred because investors responded to rising US interest rates by increasing demand for dollars on the FOREX. The FED’s response causes an increase in the money supply, which in turn will lower interest rates back to their original level. This result is necessary to maintain the fixed exchange rate interest rate parity condition of i\$ = i£.

Note also that as GNP increases in the transition, causing interest rates to rise, this rise is immediately countered with automatic FED intervention in the FOREX. Thus the exchange rate will never fall below the fixed rate. There will be pressure for the exchange rate to fall, but the FED will always be there to relieve the pressure with its intervention. Thus, the adjustment path from the original equilibrium at J to the final equilibrium at K will follow the rightward arrow between the two points along the fixed exchange rate.

The final result is that expansionary fiscal policy in a fixed exchange rate system will cause an increase in GNP (from Y1 to Y2) and no change in the exchange rate in the short-run. Since the new equilibrium at K lies below the original CC curve representing a fixed current account balance, expansionary fiscal policy, consisting of an increase in G, will cause the current account balance to fall. This corresponds to a decrease in a trade surplus or an increase in a trade deficit.

Contractionary Fiscal Policy

Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments or an increase in taxes. It would also be represented by a decrease in the government budget deficit or an increase in the budget surplus. In the AA-DD model, a contractionary fiscal policy shifts the DD-curve leftward. The effects will be the opposite of those described above for expansionary fiscal policy. A complete description is left for the reader as an exercise.

The quick effects however, are as follows. Contractionary fiscal policy in a fixed exchange rate system will cause an decrease in GNP and no change in the exchange rate in the short-run. Also, contractionary fiscal policy, consisting of an decrease in G, will cause the current account balance to rise. This corresponds to an increase in a trade surplus or a decrease in a trade deficit.

International Finance Theory and Policy - Chapter 90-2: Last Updated on 4/7/05