How do monetary and fiscal policies affect exchange rate movements?

The Mundell-Fleming Model

Changes in monetary and fiscal policy both affect the level of interest rates and economic activity, which in turn have impact on trade flows and capital flows. For example, an expansionary monetary policy will increase demand (and imports), lower interest rates and thus encourage capital outflows. The more sensitive capital flows are to the change in interest rates, the greater the exchange rate's responsiveness to the change in monetary policy. An expansionary fiscal policy will also increase demand and imports. It will, however, increase interest rates and thus lead to capital inflows.

The Mundell-Fleming Model assumes the price level remains relatively stable. It then analyzes the role played by international capital mobility in determining the effectiveness of macro-economic policies.

If capital is highly mobile, a combination of a restrictive monetary policy and an expansionary fiscal policy will be bullish for a currency, and a combination of an expansionary monetary policy and a restrictive fiscal policy will be bearish for a currency. The effect on the currency is ambiguous for any other combinations.

When capital mobility is low, monetary and fiscal policy effects on exchange rates will operate primarily through trade flows rather than capital flows. A combination of expansionary monetary policy and fiscal policy will give rise to a depreciation of the currency, while a combination of restrictive monetary and fiscal policy will give rise to an appreciation of the currency.

Monetary Models

These models assume output is fixed and price level is not. One variation, the monetary approach, further assumes that PPP holds all the times - an increase of money supply will increase domestic price level, which will lead to depreciation of domestic currency. Another variation, the Dornbusch overshooting model, assumes that short-term prices are fixed. It argues that the foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices in the economy. Thus, there will be more volatility in the exchange rate due to overshooting and subsequent corrections that would otherwise be expected.

The Taylor Rule

The Taylor rule states that the policy rate should be set at a level that depends on:

• The deviation of the inflation rate from target.
• The size and direction of the output gap.

The Taylor rule can be used to explain the trend in exchange rates. Equation 17 in the textbook shows that the real value of the base currency is determined by its long-term equilibrium value, real interest rate differential, inflation gap, output gap and relative risk premium. Unlike what a PPP framework would suggest, the equation implies that the value of the base currency is positively related to the level of inflation.

Portfolio Balance Approach

This approach asserts that a steady increase in the stock of government debt outstanding, perhaps generated by a steady widening of the government budget deficit over time, will be willingly held by investors only if they are compensated in the form of higher expected return. The higher expected return could come from (1) higher interest rates and/or higher risk premium, (2) depreciation of the currency to a level sufficient to generate anticipation of gains from subsequent currency appreciation, or (3) some combination of the two.

This approach can be used with the Mundell-Fleming model to explain the responses of exchange rates to changes in fiscal policy under conditions of high capital mobility. For example, an expansionary fiscal policy:

• In the short run, it will lead to higher interest rates and higher real rates, which will lead to currency appreciation.
• In the long run, the government will not be able to finance its debt so it will be tempted to monetize its debt or shift its fiscal stance to be restrictive. In either case the currency will depreciate.