Exchange rate sensitivity of demand for money and effectiveness of fiscal and monetary policies

Abstract

One of the arguments between proponents and opponents of floating exchange rates centres around the relative effectiveness of fiscal and monetary policy. While proponents of floating rates argue that monetary policy is more effective under floating rates, its opponents contend that fiscal policy is more effective under fixed rates. However, economic theory suggests that there is room for both policies under both types of exchange rate system, depending upon degree of sterlization. Concentrating on the floating rates, Mundell (1963) has argued that the relative effectiveness of monetary and fiscal policies would also depend upon sensitivity of money demand to exchange rate. More precisely he has conjectured that The demand for money is likely to depend upon the exchange rate in addition to the interest rate and the level of income; this would slightly reduce the effectiveness of a given change in the quantity of money, and slightly increase the effectiveness of fiscal policy on income and employment under flexible exchange rates, while, of course, it has no significance in the case of fixed exchange rates. 1 1See Mundell (1963, p. 484). The primary purpose fo this paper is to provide some theoretical and empirical justification for mundell's original conjecture quoted above. On the theoretical ground, using a Keynesian open economy macro model, we show that the size of money and spending multipliers are reduced when demand for money depends, among other things, on the exchange rate. On the empirical ground we try to estimate a money demand function inclusive of exchange rate for Canada, Japan, and the United States which have enjoyed more flexibility in their exchange rates. Section I presents the model adn analytical arguments related to Mundell's proposal. Section II contains the empirical results. Our conclusion and a summary are provided in section III. Finally, the data and sources are cited in the appendix.