8 Mart 2009 Pazar

Essay on Policy Effectiveness and Ineffectiveness Propositions

The developed economy (modern industrial economy) is subject to a relatively high degree of financial integration with other countries. We live in a world where information about foreign interest rates, exchange rates and etc., is widely available at a low cost by reaching for a phone or a computer terminal. With this, we initiate to discuss flexible exchange rate regimes under context of perfect capital mobility.

Under perfect capital mobility, the speed of adjustment is infinite, meaning that we can adjust portfolio instantaneously just in engage in telephone calls or a a computer terminal. Perfect capital mobility describes an environment of highly integrated (not disintegrated !) capital markets. In this markets the domestic economy, at any time, lends and borrows all it want at the going world interest rates. Similarly, foreign residents lends and borrows in domestic capital markets at the domestic interest rates. Arbitrage between domestic and world capital markets then guaranties an alignment of domestic and world interest rates. The condition of perfect capital mobility imposes the constraint that balance of payments occur at the world interest rates.

However, under imperfect capital mobility, the capital account responds to changes in interest rates, but to a lesser extend then in the case of perfect capital mobility. This means that domestic investors cannot borrow or lend all of the amount they wish to at the world interest rate. Thus, given the world interest rate an increase (or decrease) in domestic interest rate attracts a certain inflows (or outflows) of funds over time. However, it will not create a massive flood of funds, as with perfect capital mobility. Hence, the capital account is positively, but not infinitely, elastic with respect to the domestic interest rates.

In discussion of both fixed an flexible exchange rates, this is the fundamental analytic of policy ineffectiveness propositions under the perfect capital mobility and imperfect capital mobility regimes.

Under perfect capital mobility, monetary policy is highly effective in influencing output. For example, an increase in money supply places downward pressure on domestic interest rates, inducing incipient capital outflows and so depreciating domestic currency. This depreciation switches demand towards domestic goods and hence is expansionary. At the same time, because the domestic currency depreciation amounts to a foreign currency appreciation, higher domestic money growth that adversely affects output abroad. In this sense, monetary policy said to be a beggar-thy-neighbor policy under flexible exchange rates, meaning an increase of domestic output at the expense of the output of the country's trading partner under flexible exchange rates. Thus, under flexible exchange rates with perfect capital mobility monetary policy is effective in influencing output.

Monetary policy under flexible exchange rates is highly effective in influencing output over the short-run, in particular if the environment is one perfect capital mobility. Within this context, for example, expansionary monetary policy can be instrumental in leading recovery in an economy suffering from severe recession. Contractionary monetary policy, on the other hand, would have the opposite effect: it would effectively worsen the recession.

Whereas, under flexible exchange rates with perfect capital mobility, fiscal policymeasures (e.g government spending and taxes) are not effective in influencing output. For example, an increase in government expenditure would raise aggregate demand for domestic goods and place upward pressure on domestic interest rates. This induces financial capital flow into economy, leading to an appreciation of the exchange rates and so switching demand away from domestic goods. This reduction in aggregate demand offsets the direct expansionary effects of increased government spending in the economy.

Under flexible exchange rates, the impact of real disturbances on output is very limited. A real disturbance refers to any policy measure or exogenous disturbance that does not alter money demand or money supply, as opposed in the money market. Commercial policy, for example, is a real disturbance and, according to the Mundell-Fleming framework, it has no lasting effects on output.

Thus, floting exchang rate insulate an economy from foreign spending disturbances (when these involve uncoordinated actions) with no impact on world interest rates. If the foreign disturbance is simultaneously engaged by major foreign countries, it will then be transmitted domesticaly through its effects on world interest rates. However, without an effect on world interest rates, fiscal policy in one country tends to have no impact on the income of either country, imposing it or any other foreign country.