Comment: Monetary and Fiscal Policy for an Economy with Fixed Exchange Rates

Abstract

In Jones's paper, as in related studies in the past, international capital flows play a critical role. If they are sufficiently responsive to interest-rate and other changes, they may, under certain circumstances, more than offset shifts in the current account and thus dominate the balance of payments. In an argument of this type, the function which is used for capital flows is a matter of prime importance. In Jones's basic capital-account function, the international flow of investment is assumed to depend on income at home and on the home interest rate. High interest rates at home will attract debt capital, while high levels of economic activity in the home country will attract direct investment and other equity investment. This function certainly seems plausible on a priori grounds and is a common one in the literature. However, in spite of its impressive credentials, some misgivings may be held regarding its general validity. A significant part of the discussion of the mix of policy has been inspired by the international-payments difficulties of the North American countries over the past decade, the United States in attempting to protect its gold reserves and Canada in making a rather uncomfortable transition back to a fixed rate. It is perhaps fitting, therefore, to look at econometric work which has been done on capital flows between the two countries. In his econometric model of the Canadian economy, Rudolf Rhomberg found the major determinants of U.S. direct investment in Canada to be Canadian fixed investment and the deviation from trend of U.S. GNP. That is, Canadian prosperity attracted U.S. capital (although questions may be raised about the cause-effect relationship because of the relative importance to Canada of U.S. investment), while U.S. prosperity also stimulated the flow, presumably because it reflected business profits in the United States available for direct investment abroad (Rhomberg, 1964, p. 11). Thus, we have a situation where prosperity in one country (Canada) attracts direct investment, while prosperity in the other country