Chapter 15: Problem 5

Under a system of fixed exchange rates and high capital mobility, is monetary policy or fiscal policy better suited for promoting internal balance? Why?

Short Answer

Expert verified

Under a system of fixed exchange rates and high capital mobility, fiscal policy is generally considered more effective for promoting internal balance as it can still manipulate aggregate demand through public spending and taxes, while monetary policy's effectiveness is significantly restricted.

Step by step solution

Understanding the Fiscal and Monetary Policy

Fiscal and monetary policies are two major macroeconomic tools that governments and central banks use to manage the economy and promote economic stability. Fiscal policy involves governmental use of public spending and tax rates, while monetary policy involves manipulation of the money supply and interest rates by the central bank.

Effects of Fiscal and Monetary Policies

Under a fixed exchange rate system, a government can't use monetary policy to adjust the balance of the economy. The reason is simple, in a fixed exchange rate system, a country's central bank does not have the freedom to change money supply without causing changes in the exchange rate. Conversely, fiscal policy can still affect aggregate demand by changing government spending and taxes. Higher taxes and reduced spending can reduce aggregate demand, leading to lower prices and increased output, thereby promoting internal balance.

Considering Capital Mobility

In a global context with high capital mobility, capital can quickly move across borders in response to changes in interest rates or expected returns. This could weaken the impact of monetary policy and amplify the effects of fiscal policy, as capital influxes would be attracted by higher returns driven by increased spending or lower taxes.

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Under a system of fixed exchange rates and high capital mobility, is monetary policy or fiscal policy better suited for promoting internal balance? Why?

Short Answer

Step by step solution

Understanding the Fiscal and Monetary Policy

Effects of Fiscal and Monetary Policies

Considering Capital Mobility

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