Fiscal and Monetary Policy for Internal and External Stabilization Under Fixed and Floating Rates in the Presence of Capital Movements

Rattan J. Bhatia


The effect of fiscal and monetary stabilization policies has
been exten¬sively discussed, notably by Mundell [4,5] and Fleming [1].
Mundell discussed the problem under the special assumption of a perfect
interest-elastic mobility of international capital flows, but Fleming
assumed a less than perfect capital mobility. Mundell contends that
"fiscal policy completely loses its force as a domestic stabilizer when
the exchange rate is allowed to fluctuate," while monetary policy will
have appreciable effects on employment and output. Under fixed exchange
rates, on the other hand, monetary policy is shown by Mundell to be
ineffective while any positive effects of fiscal policy would be
conditional upon the country being able to sustain large trade deficits
by either borrowing abroad or running down its accumulated international
reserves. Fleming also demonstrates that the expansionary effects of
monetary policy will be greater under floating exchange rates than under
fixed rates and that it is uncertain whether the effects of fiscal
policy will be less or more expansionary under floating rates than under
fixed rates. In all but extreme cases, monetary policy is shown to exert
a more expansionary influence under floating rates.

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