Pakistan Institute of Development Economics

PDR

THE PAKISTAN DEVELOPMENT REVIEW 

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

The effect of fiscal and monetary stabilization policies has been extensively 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.

Rattan J. Bhatia

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