Monetary and Fiscal Policy for an Economy with Fixed Exchange Rates

Abstract

The exchange rate can be a powerful instrument for control over the balance of payments. Variations in the rate of exchange generally alter the relationship between prices of home-produced goods and commodities produced abroad and thus directly affect the major elements in the current account. A commitment to fixed exchange rates therefore involves the sacrifice of a major policy instrument and raises the question of how to reconcile domestic goals, such as achieving full employment or stimulating economic growth, with the preservation of equilibrium in the balance of payments. In a classical world in which prices and wages are flexible in both directions other routes are available for altering the relationship between domestic and foreign costs and thus for maintaining payments equilibrium. It is in a world of rigid prices that the policy problems posed for an economy tied to a fixed rate of exchange become most acute, and it is a simple model of such a world that I wish to analyze in this paper. A rich literature in recent years has suggested that both internal balance (full employment) and external balance may be achieved by an appropriate mix of monetary and fiscal policy.1 By pointing out that balance-ofpayments equilibrium can be reached by changes in the capital account as well as (or instead of) the current account, this literature has suggested that an expansion of employment that upsets the balance of trade can be countered by a contractionary monetary policy that raises interest rates and attracts capital flows. However, when complications have been introduced