Question

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

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.

Key concepts

Monetary Policy

Monetary policy refers to the actions undertaken by a nation's central bank to control the money supply and achieve objectives like controlling inflation, managing employment levels, and maintaining stable economic growth. In a fixed exchange rate system with high capital mobility, the central bank's ability to utilize monetary policy is significantly limited. A fixed exchange rate means the country pegs its currency to another currency or basket of currencies and maintains this rate by buying and selling its own currency.

When capital mobility is high, capital can quickly move across borders in search of better returns. If a central bank tries to change the interest rates or money supply, it risks causing fluctuations in the exchange rate. This is because high capital mobility may lead investors to move their money in or out of the country, disrupting the fixed exchange rate.

As a result, using monetary policy as a tool for promoting internal balance in this context is not effective. Changes in the money supply to influence domestic conditions will require adjustments in foreign reserves to maintain the exchange rate, often neutralizing the intended impacts of monetary policy adjustments.

Fiscal Policy

Fiscal policy involves adjusting government spending and taxation to influence an economy. Unlike monetary policy, fiscal policy is not limited by a fixed exchange rate system. Governments can increase spending or cut taxes to stimulate demand, or they can decrease spending or raise taxes to cool down an overheating economy. Fiscal policy can have a direct impact on a country's aggregate demand.

In a fixed exchange rate system, fiscal policy becomes particularly effective because it directly influences output and employment levels without interfering with the exchange rate. Given that monetary policy might be ineffective due to the constraints of maintaining a fixed exchange rate, fiscal policy steps in as a reliable tool.

Furthermore, in conditions of high capital mobility, fiscal policy can still be robust. While it may attract foreign investment due to increased economic activities, the focus remains domestically as government actions pump the capital needed for balancing internal economic conditions. This makes fiscal policy a more suitable choice for promoting internal balance in a nation with a fixed exchange rate and high capital mobility.

Capital Mobility

Capital mobility refers to the ease with which financial capital or investments can move across borders in response to differences in rates of return. This concept is crucial when considering the interaction between monetary and fiscal policies under a fixed exchange rate regime. High capital mobility implies that investors can swiftly respond to interest rate differentials, moving funds across national borders to take advantage of better returns.

In such a context, monetary policy loses its effectiveness since any attempts to manipulate domestic interest rates can lead to significant capital inflows or outflows, disrupting the maintained exchange rate. However, the same high mobility can amplify the effects of fiscal policy.

For instance, if a government increases spending or cuts taxes, it can stimulate the economy locally, making the country more attractive to foreign investors. Higher returns in the form of increased economic activity can lead to more capital being drawn into the country, supporting fiscal measures rather than contradicting them. Thus, under fixed exchange rates with high capital mobility, fiscal policy becomes a more practical and effective means of achieving internal economic balance.