International Finance Theory and Policy
by Steven M. Suranovic

Finance 70-2

Fiscal Policy with Floating Exchange Rates

In this section we use the AA-DD model to assess the effects of fiscal policy in a floating 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 either 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 economy is originally at a super equilibrium shown as point J in the adjoining diagram. The original GNP level is Y1 and the exchange rate is E\$/£1. 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.

There are several different levels of detail that can be provided to describe the effects of this policy. Below we present three descriptions with increasing degrees of completeness. First the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result: The increase in DD causes a shift in the super-equilibrium point from J to K. In adjusting to the new equilibrium at K, GNP rises from Y1 to Y2 and the exchange rate decreases from E\$/£1 to E\$/£2. The decrease in the exchange represents a decrease in the British pound value and an increase in the US dollar value. In other words, it is a depreciation of the pound and an appreciation of the dollar. Since the final equilibrium point K is below the initial iso-CAB line CC, the current account balance decreases. (caveat: this will be true for all fiscal expansions but the iso-CAB line can only be used with an increase in G; see section 60-7 for an explanation) If the CAB were in surplus at J then the surplus decreases, if the CAB were in deficit, then the deficit rises. Thus, US expansionary fiscal policy causes an increase in US GNP, an appreciation of the US dollar and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description:

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 and this causes the rightward shift in the DD curve. Immediately after aggregate demand increases, but before any adjustment has occurred at point J, the economy lies to the left of the new D’D’-curve. Thus, GNP will begin to rise to get back to G&S market equilibrium on the D’D’-curve. However, as GNP rises the economy will move above the AA-curve forcing a downward readjustment of the exchange rate to get back to asset market equilibrium on the AA-curve. In the end, the economy will adjust in a stepwise fashion from point J to point K, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA-curve. This process will continue until the economy reaches the super-equilibrium at point K.

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 implies aggregate demand exceeds aggregate supply, which will lead to a decline in inventories. To prevent this decline, retailers (or government suppliers) will signal firms to produce more. As supply increases so does the GNP and the economy moves to the right of point J.

Step 2) 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 shift funds back to the US resulting in a \$ appreciation (£ depreciation), that is, a decrease in the exchange rate E\$/£. This moves the economy downward, back to the AA-curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point J in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the AA-curve, as shown.

Step 3) Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in US interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point K in the diagram.

Step 4) The equilibrium at K, lies to the southeast of J along the original AA curve. As shown in section 60-7, the current account balance must be lower at K since both an increase in GNP and a dollar appreciation cause decreases in current account demand. Thus, the equilibrium at K lies below the original is-CAB line. However, this is only assured if the fiscal expansion occurred due to an increase in G.

If transfer payments increased or taxes were reduced, these would both increase disposable income and lead to a further decline in the current account balance. Thus, also with these types of fiscal expansions, the current account balance is reduced, however, one cannot use the iso-CAB line to show it.

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. US contractionary fiscal policy will cause a reduction in GNP and an increase in the exchange rate, E\$/£, implying a depreciation of the US dollar.

International Finance Theory and Policy - Chapter 70-2: Last Updated on 3/28/05