Monetary and Fiscal Policy under Fixed Exchange Rates: Reply and Some Further Results

Abstract

In an interesting paper published in this Journal, Douglas Needham (1973) has commented on and extended my analysis (Blomqvist, 1970) of the assignment problem under fixed exchange rates. In the original treatment of this problem by Mundell (1962), monetary policy was identified with changes in the rate of interest. The main purpose of my paper was to investigate whether the principle he derived, i.e., that fiscal policy should be assigned to the employment objective and monetary policy to the external-balance objective, would remain valid when monetary policy is instead identified with changes in the money supply, as is done in the usual Hicksian IS-LM analysis. Assuming the same type of policy-making behavior as that implied by Mundell, i.e., that one disequilibrium at a time is eliminated, I found that there were cases, associated with a low interest elasticity of the demand for money and a high interest-responsiveness of external capital flows, in which the Mundell assignment would lead to cyclical behavior in employment and interest rates, and even to progressive divergence from equilibrium. For the latter case, I showed that the reverse assignment, i.e., using fiscal policy to correct external imbalance and monetary policy to correct internal disequilibrium, would generate stable behavior. As Needham observes, the assumption that policy-makers behave in such a way as to eliminate one disequilibrium at a time, is unrealistic; actual policymaking is considerably more complex and may involve simultaneous adjustments of monetary and fiscal policy, time lags in recognizing disequilibria, different speeds of adjustment of policy tools, etc. It is therefore of interest