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

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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?

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

 

Answer & Explanation (1)

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Expansionary monetary policy results in an increase in money supply by the central bank whereas expansionary fiscal policy policy results in an increased government spending.

Explanation

In an economy functioning under fixed exchange rate and high capital mobility,fiscal policy is more effective than monetary policies. In fixed exchange rate,the exchange rate cannot be shifted whereas capital entry and exchange should reinforce the central bank's effort to restore the changes exchange rate.
 
For an economy currently suffering from recession,an expansionary monetary policy will result in increase in money supply which will result in a rise in consumption and aggregate demand.However, fall in interest rate will discourage foreign investors from investing in the country's capital and decrease in demand for domestic currency will again result in depreciation.The central bank will intervene again to purchase domestic currency with foreign reserves. However, this will result in a decrease in money supply available in the economy resulting in falling aggregate demand. Hence the monetary policy is ineffective due to counteractive secondary and primary effects.
Fiscal policy, under a fixed exchange rate system, in an economy suffering from recession is strengthened as primary and secondary effects reinforce each other.An expansionary fiscal policy, to combat recession will result in rise in government spending which will result in increase in consumption and aggregate demand.However, government will finance excess spending by borrowing from the market. This will result in a rise in interest rate. Hence demand for domestic currency by foreign investors will increase.This will put an upward pressure on domestic currency. The central bank intervenes to curb the appreciation by purchasing foreign currency with domestic currency which will increase the money supply and available loanable funds resulting in rising domestic spending and aggregate demand.

Verified Answer

Given fixed exchange rates and high capital mobility, fiscal policies will strengthen internal balance for an economy.
Monetary policy will further weaken the internal balance, given the scenario.

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