The Effects Of The Fiscal And Monetary Policy On The Exchange Rate

Term Paper (Advanced seminar), 2016

18 Pages, Grade: 2,3


ii. Table of Contents

i. Executive Summary

ii. Table of Contents

iii. List of Abbreviations

iv. List ofFigures

1. Introduction
1.2. Problem Definition
1.3. Objective

2. Fiscal Policy
2.1 Taxation Method
2.2 Spending Method

3. Monetary Policy
3.1 Discount Rates
3.2 Open Market Operations
3.3 Reserve Requirements

4. Policy Lag

5. Exchange Rate

6. Results
6.1 The effects of Macroeconomic policies on the exchange rate

7. Conclusion


iii. List of Abbreviations

illustration not visible in this excerpt

iv. List of Figures

Figure 1: MPC Formula

Figure 2: The Crowding-Out Effect

Figure 3: Policy Lag

Figure 4: Expansionary Fiscal Policy on Floating & Fixed Exchange Rate

Figure 5:Expansionary Monetary Policy on Floating & Fixed Exchange Rate

Figure 6: The Effects of Macroeconomic Policies on Exchange Rate

i. Executive Summary

The value of a nation’s currency and its exchange rate is a key indicator for the performance of an economy’s import and export. This assignment evaluates the different impacts of macroeconomics policies on the exchange rate, the following research also draws attention to the fact that economists have had mixed findings about the effects of macroeconomic policies on the exchange rate. The use of secondary research and the AA-DD model will further enhance the various factors that are responsible to appreciate or depreciate a currency. The results of this assignment showthat; fixed and floating exchange rates as well as the MPC score have significant impacts on the efficiency of macroeconomic policies altering the exchange rate. Macroeconomic policies trigger disposable income, prices and interest rates within an economy, which consequently affects the foreign exchange market leading to a change in the exchange rate. Especially in the field of a floating exchange rate economy, the impacts of fiscal but also monetary policies can be shown, fixed exchange rates disable economies to use monetary policies due to the fact that these will with high certainty have an impact on the exchange rate.

1. Introduction

Policymakers use fiscal and monetary policies as instruments to actively stabilise the economy in respects to the aggregate demand. Monetary, fiscal and exchange-rate policies with differential effects are seen as tools to achieve a countries internal employment-income equilibrium with an external balance in its international payment1. Robert Mundell, a Canadian economist, believed that policy effectiveness in a small open economy is very precise, stating that monetary policies only work in a floating exchange rate market, whereas fiscal policies would be impotent and only be effective on a fixed exchange rate2.

1.2. Problem Definition

For a country to effectively influence the exchange rate, macroeconomic policies (fiscal & monetary) have to be adjusted to stimulate a change in the nation’s currency value. Policies are therefore necessary to sustain a profitable exchange rate due to its potential powerful effects on the national economy including a change in the demand for imports and exports in the international trade market as well as a nation’s GDP. Each policy can have a completely distinctive impact on the economy from inflation to recession. Most economists including Goldfajn and Gupta3 believe that tight monetary policies can decrease the impact of a currency crisis. Also Furman and Stiglitz4 evaluated that especially monetary policies in concerns to interest rates and high inflation cases, is responsible for exchange rate collapses, especially in emerging market economies. On the other hand, Kamin5 has not identified any correlation between changes of interest rate policies and exchange rates during the Asia crisis; Ohno et al. conducted similar findings6.

By looking at how fiscal as well as monetary policies influence the economy and consequently the exchange rate will give a parameter for economists to react according to various influences in the economy.

1.3. Objective

In order to identify the effects of both policies on the exchange rate, it is necessary to analyse and differentiate how each macroeconomic policy influences the economy differently. Furthermore, the exchange rate will be evaluated to identify how a fluctuation of currency occurs and to what extend these are influenced by the policies of the federal bank and the national government. Finally, an example will be given to illustrate the consequences that an exchange rate will face after changing macroeconomic policies.

2. Fiscal Policy

The fiscal policy is a government decision regarding taxes and spending to alter the growth rate of the economy. This policy has begun with the evolution of the Keynesian Model by John Maynar. Keynes believed that inflation or a recession could only be restored with the use of macroeconomic policies. However, the Keynesian Model has been criticised due to its lack of response to stagflation, a condition when the economy suffers slow growth and inflation7.

During the great depression, John M. Keynes believed that inadequate overall demand could lead to prolonged periods of high unemployment8. The Keynesian Model dissociates completely with the classical economic model that every economy is self-sustainable. According to the Keynesian Model and the fiscal policy, an increase in the governments spending on goods and services will increase the demand for products and services leading to growth within the economy, on the other hand, if the economy overheats, a decrease in spending could possibly decrease the demand as well as the production. The stimulation of aggregate demand as mentioned, is known as the expansionary fiscal policy; a reduction in AD is called contractionary fiscal policy. Therefore, the primary effect of the fiscal policy is on aggregate demand for goods and services9. The fiscal policy aims to correct a particular disequilibrium to regulate a dynamic course of development10. This fiscal policy depends on 2 methods, which are taxation and government spending; nevertheless, some economists believe that transfer payments can also be used as a policy. All three policies are applied either as an expansionary (stimulating economic growth during recession), or contractionary fiscal policy (decelerating economic growth during inflation).

2.1 Taxation Method

This fiscal policy tool influences the average consumers disposable income by altering taxes, consequently changing the consumption and causing a change in GDP. Marginal taxes can therefore be lowered, increased or even eliminated entirely. As mentioned above, the effects of a change in taxation depends on the application of the policy being either expansionary or contractionary. The effects of the changes in policies also depend on the multiplier effect, thus, the willingness of customers to consume, which can be measured through the marginal propensity to consume (MPC)11. The MPC is the ratio of an increase in consumption to an increase in income. In other words it is the proportion of every additional income dollar that is consumed12 and can be calculated as shown in Figure 1.

illustration not visible in this excerpt

The MPC derives from the change in consumption expenditure (C) divided by the change in disposable income (YD)13. The MPC can vary from 0-1. A small MPC shows that consumers only use up a small amount for consumption and a bigger share for savings, which has a direct effect on the economy.

2.2 Spending Method

When the government alters it’s spending on goods and services directly, this process leads to a direct shift in the aggregate demand curve14. Similar to the taxation approach, an increase or decrease in government spending will influence the aggregate demand and GDP accordingly. However, it is believed that using government spending as a fiscal policy tool can cause two effects that influence the aggregate demand contrarily, these are known as the multiplier effect and the crowding-out effect.

illustration not visible in this excerpt

Figure 2: The Crowding-Out Effect15

The Multiplier Effect is caused when the government spends a high amount of money, for instance on new planes for the defence department. This spending instigates an increase in production and job openings for these specific departments. This first initiative of a higher demand from the government has positive feedback as higher demand leads to higher income, which in turn leads to higher demand again. This process can be seen in Figure 2B as aggregate demand shifts upwards (AD2).

A completely opposite response to government spending can also occur, this is known as the crowding-out effect as shown in figure 2A. As the government spends more money to increase income, which additionally leads to a multiplier effect, the demand for money increases accordingly. This shift in aggregate demand causes the equilibrium interest rate to rise16. The increase in interest rates, to keep demand and supply balanced, has a negative effect on the demand for goods and services.

3. Monetary Policy

Monetary policy is the second macroeconomic policy tool that a government can use to intervene the economy. Monetary, refers to the quantity of money available in the economy known as the money supply17, which is regulated by the national bank. Furthermore, this policy alters the credit availability for individuals to increase or decrease investment and economic growth. As mentioned in Chapter 2., the Keynesian Model can also be successfully applied for the monetary policy, either being expansionary or contractionary to alter aggregate demand and GDP. The difference however, between the two macroeconomic policies, is the tools used, but also the time to apply each policy. According to research, monetary policy is more effective than the fiscal policy18 ; this assumption will be looked at in more detail in the next subchapters. The three different tools that the monetary policy applies, focusing on the supply of money in relation with the central bank, are called discount rates, open market operations and reserve requirements.

3.1 Discount Rates

The discount rate, also known as the interest rate that the Federal Reserve charges for loans it makes to banks19. Banks need to borrow money from the Fed to satisfy their reserve requirements. Using the discount rate as an expansionary monetary tool would mean a reduction in discount rates to reduce the costs of borrowing money, which consequently encourages banks to borrow reserves from the Fed. Additionally, the central bank is able to interpret two discount rates; the primary discount rate, being one percentage point above the federal funds rate, and on the other hand, the secondary discount rate, which is one-half a percentage point higher than the primary discount rate.

Even though the discount rate is an effective tool, according to Thomas Havrilesky the discount rate is usually changed to keep it in line with market rates of interest to discourage massive borrowing and reduce the need for the Fed to ration loans20.


1 McKinnon R.I. and Oates, W.E. (1966)

2 Prachowny, M.F.J. (1977) p. 462

3 Goldfajn, I. and Gupta, P. (1999)

4 Furman, J., and Stiglitz, J. (1998)

5 Gould, D.M. and Kamin, S.B. (2000)

6 Ohno, K., Shirono, K., and Sisli, E. (1999)

7 Jahan, S., Mahmud, A.S., and Papageorgiou. (2014)

8 Jahan, S., Mahmud, A.S., and Papageorgiou. (2014)

9 Mankiw, N.K. (2015)

10 Hansen, B. (1958)

11 Haavelmo, T. (1947)

12 Murad, A. (1962)

13 McTaggart, D., Findlay, C., and Parkin, M. (2013)

14 Mankiw, N.K. (2015)

15 Mankiw, N.K. (2015) p.535

16 Mankiw, N.K. (2015)

17 Mankiw, N.K. (2015) p.652

18 Dwivedi, D.M. (2005)

19 McEachern, W.A. (2009) p.332

20 Havrilesky, T. (1993)

Excerpt out of 18 pages


The Effects Of The Fiscal And Monetary Policy On The Exchange Rate
University of applied sciences, Munich
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ISBN (Book)
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Economics, VWL, MBA, Monetary, Policy, Exchange Rate, International
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Alexander Bremann (Author), 2016, The Effects Of The Fiscal And Monetary Policy On The Exchange Rate, Munich, GRIN Verlag,


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