Question

Suppose there are two countries that are identical in every way with the following
exception. Country A is pursuing a fixed exchange rate regime and country B is pursuing a
flexible exchange rate regime. Suppose government spending in both countries rises by the
same amount. Given this information, do you think the change in output will be the same in
both countries? Explain your answer carefully

Answer 1

Country A with fixed exchange rate.

When government expenditure increases, output increases, money demand increases which in turn raises the interest rate. Since interest rate is higher than the world interest rate, there is more inflow of capital. Demand for domestic currect rises. Appreciation takes place. Arbitrager comes into role. He purchases foreign currency from market and sells it in the central bank. By this more domestic currency enters the market. Money supply increases. Output increases. Thus, fiscal policy in fixed exchange rate is effective.

Country B with flexible exchange rate.

When government expenditure increases, income increases, money demand increases which raises the interest rate. Since interest rate is higher than the world interest rate, there is an excess inflow of capital. There will be higher demand for domestic currency. This appreciates the domestic currency. Exchange rate increases. This inturn reduces net exports further reducing the output. Thus, output comes back to its original level. Thus, fiscal policy ineffective in flexible exchange rate.