Policy Effects with Fixed Exchange Rates: Overview

Overview

This section uses the AA-DD model to describe the effects of fiscal, monetary and exchange rate policy under a system of fixed exchange rates. Fiscal and monetary policies are the primary tools governments use to guide the macro-economy. With fixed exchange rates a third policy option becomes available, namely exchange rate policy. Thus we also examine the effects of changes in the fixed exchange rate. These exchange rate changes are called devaluations, (sometimes competitive devaluations), and revaluations.

In introductory macroeconomics courses, students learn how government 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. A monetary policy (change in MS ) has no effect upon GNP or the exchange rate in a fixed exchange system. As such, the trade balance, unemployment and interest rates all remain the same as well. Monetary policy becomes ineffective as a policy tool in a fixed exchange rate system.
   
2. Expansionary fiscal policy (↑G, ↑TR, or ↓T ) causes an increase in GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment are both reduced.
   
3. Contractionary fiscal policy (↓G, ↓TR, or ↑T ) reduces GNP while maintaining the fixed exchange rate and constant interest rates. The trade balance and unemployment both rise.
   
4. A competitive devaluation lowers the currency value and causes an increase in GNP. Unemployment falls, interest rates remain the same and the trade balance rises.
   
5. A currency revaluation raises the currency value and causes a decrease in GNP. Unemployment rises, interest rates remain the same and the trade balance falls.
   
6. Monetary expansion by the reserve currency country forces the domestic country to run a balance of payments surplus to maintain its fixed exchange rate. The resulting money supply increase causes domestic interest rates to fall to maintain equality with the falling foreign interest rates. Domestic GNP remains fixed as does unemployment and the trade balance.
   
7. A currency crisis arises when a country runs persistent balance of payments deficits while attempting to maintain its fixed exchange rate and is about to deplete its foreign exchange reserves. A crisis can force a country to devalue its currency or move to a floating exchange rate. To postpone the crisis countries can sometimes borrow money from organizations like the IMF
   
8. Anticipation of a balance of payments crisis can induce investors to sell domestic assets in favor of foreign assets. This is called capital flight. Capital flight will worsen a balance of payments problem and can induce a crisis to occur.

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 main levers the government controls are monetary policy (changes in the money supply), fiscal policy (changes in the government budget) and exchange rate policy (setting the fixed exchange rate value). In this section, the AA-DD model is applied to understand government policy effects in the context of a fixed exchange rate system. In chapter 70 we considered these same government policies in the context of a floating exchange rate system. In chapter 110 we'll compare fixed and floating exchange rate systems and discuss the pros and cons of each system.

International Finance Theory and Policy - Chapter 90-0: Last Updated on 4/13/05