Policy Effects with Floating Exchange Rates: Overview

This section uses the AA-DD model to describe the effects of fiscal and monetary policy under a system of floating exchange rates. Fiscal and monetary policies are the primary tools governments use to guide the macro-economy. In introductory macroeconomics courses, students learn how fiscal and monetary policy levers can be used to influence the level of GNP, the inflation rate, the unemployment rate and interest rates. In this section that analysis is expanded to an open economy (i.e., one open to trade) and to the effects on exchange rates and current account balances.

Results

Using the AA-DD model, several important relationships between key economic variables are shown.

1. Expansionary monetary policy (↑M^S ) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short-run.
2. Contractionary monetary policy (↓M^S ) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short-run.
3. Expansionary fiscal policy ((↑G, ↑TR, or ↓T ) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
4. Contractionary fiscal policy ((↓G, ↓TR, or ↑T ) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.
5. In the long-run, once inflation effects are included, expansionary monetary policy (↑M^S ) in a full employment economy, causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls.
6. A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response.
7. A central bank can influence the exchange rate with direct FOREX interventions (buying or selling domestic currency in exchange for foreign currency). In order to sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.
8. A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and its effect on interest rates.
9. Purchases (sales) of foreign currency on the FOREX will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.

Connections

The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this section, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In the next chapter we’ll revisit these same government policies in the context of a fixed exchange rate system.

International Finance Theory and Policy - Chapter 70-0: Last Updated on 2/23/05