Under most conditions, the models indicate, that given a fixed nominal exchange rate regime, fiscal policy is relatively more powerful than monetary policy in affecting domestic output. Expansionary fiscal policy increases demand for domestic goods but also tends to raise interest rates as additional public borrowing is required. Higher interest rates attract more foreign capital, increasing reserves. The increase in domestic resources to that sector. The current account balance deteriorates, partly absorbing the increased capital flows. Real currency appreciation occurs as domestic prices rise, even though the nominal rate if fixed.
Conversely, monetary policy has a greater effect on the external account. Raising domestic interest rates attracts foreign capital and builds reserves, the amount depending on the substitutability of foreign and domestic assets. Attempts to stimulate domestic demand by lowering interest rates are diluted, as capital flows overseas to seek higher rates there, reducing any effect on domestic demand. The more substitutable foreign and domestic assets are, the less the interest rate change required for a given effect. Increased substitutability of assets leads to other problems, however. Where governments try to constrain domestic demand by raising interest rates, capital flows in, to benefit the higher rates, and counteracts the restraint. If sterilization is attempted- if, for example, governments sell bonds (tending to further increase domestic interest rates) to absorb the increase in the money supply associated with the influx overwhelm the authorities ability to continue to issue bonds to purchase foreign exchange. In such circumstance, it is hand to prevent a real currency appreciation.
For an economy dependent on export growth, as most East Asian countries are, the dangers of expansionary fiscal policy, combined with monetary constraint to keep inflation under control, are evident. East Asian countries generally adopt more conservative fiscal stances than Latin American countries.
Under a floating-rate regime, the additional exchange rate flexibility dampens some of these effects, but at the cost of loss of control over the nominal exchange rate. Fiscal policy becomes relatively lass effective in influencing domestic output. The increase in demand from expansion leads to an appreciation of the nominal (and, consequently, the real) exchange rate, increased imports and lower exports, and less demanded for money and bonds.
Interest rates rise, but less than in the fixed-rate case, and the floating rate keeps the external accounts in balance. The increase in capital inflows offsets the higher current account deficit. Under most reasonable assumptions, output rises, but less than under a fixed exchange rate for a given increase in expenditures. By contrast, monetary policy can have a more compelling effect. An expansionary action, such as open market purchase of domestic bonds, increases output through the effects of money supply on demand. It also leads to a depreciation, which shifts resources to the tradable sector and decreases the current account deficit, offsetting the outflow of capital brought about by the more perfect substitutability of assets, although the interest rate change will be smaller.
These models can also be used in reverse to examine the effects of a change in external variables on the domestic economy. What are the implications when we look at the effect on domestic policy of increases in foreign capital inflows? For a regime with a fixed nominal exchange rate, an increase in foreign inflows tends to reduce the domestic interest rate and increase domestic demand. This, in turn, leads to an increase in domestic prices that will bring about a real appreciation through higher domestic inflation. Reserves tend to accumulate, although by less than the capital inflows, as the current account also deteriorates. Monetary policy action to absorb the capital inflows through, for example, open-market sales of bonds (sterilized intervention) could offset the impact on demand. But such an action would tend to increase interest rates, which could well attract more capital inflow. It is not likely to be effective in the long term if there are practical limits on how many bonds can be issued, and it could be costly (because of negative carry on the reserves accumulated). The more substitutability there is between domestic and foreign assets, the less variance is possible between domestic and foreign interest rates before increase in the domestic interest rate become self-defeating. Fiscal contraction would offset the increase in demand and perhaps allow a reduction in interest rates, which would diminish the attraction of domestic assets to foreign investors. A fiscal response would take longer to orchestrate than a monetary response, however, become public budgets are hard to cut in the short run.
Under a floating-rate regime, a foreign capital inflow leads directly to an appreciation of the nominal and real exchange rates. The impact on output depends on the relative strengths of the increase in demand resulting from the capital inflow and the reduction in demand for domestic output because of the appreciation, but an increase in output is likely. If the exchange rate is allowed to adjust, the real appreciation attributable to the capital inflow has less effect on the domestic economy. Prices may rise, and interest rates may fall. However, for export-oriented economies a sustained appreciation may pose serious long-term problems for the export sector. Many fear that appreciation would cause significant loss of exports and eventually overall growth, as markets are lost to lower-cost competitors. Depending on the relative strengths of different effects, the expansion of domestic demand could be counteracted by either tighter fiscal policy or monetary contraction, offsetting some of the appreciation. The former still raises the same questions about the speed of response; the latter may raise interest rates enough to attract more foreign inflows, exacerbating the initial problem. Furthermore, exchange rate appreciation induced by capital inflows will increase the yield to foreign investors as measured in their own currencies, which may extend the capital inflows, particularly short-term, yield-sensitive flows. The ability of floating exchange rates to insulate an economy from external influences depends on the authorities willingness to accept exchange rate movements determined, in part, by foreign investment demand. A floating-rate regime also depends on the flexibility of domestic prices and wages and on adequate factor mobility to be effective. The prevailing fixed or managed exchange rate regimes in East Asia and most other countries indicate a marked reluctance to accept the implications of fully floating exchange rates.
Even at this simple level, the models illustrate several important points. The degree of openness of the capital account and the substitutability of foreign and domestic assets have an important bearing not only on financial sector policies but also on real sector policies. Financial flows can have tremendous effects on the real economy for example, on interest and exchange rates and, through those variables, on output, employment, and trade . The more open an economy and he more integrated into world capital markets, the harder it is for the country to maintain interest rates that deviate significantly from world rates or an exchange rate that is far out of line with what markets believe to be proper. The markets views on these rates are driven by many short-and medium-term considerations and, particularly for interest rates by forces in the major financial markets. Market pressures on a given countrys capital markets reflect a great deal more than just the fundamentals of a particular country. Countries cannot afford to have key policy variables that are inconsistent with global trends. Thus the capital accounts openness exposes the economy to pressures that may complicate achievement of the countrys long-term real sector objectives, and stabilization issues must be more finely balanced against growth objectives. Integration into capital markets has its price.
To be more realistic in these models, one can admit leakages and other factor- such as unemployed resources, market imperfections, and expectations- that may mintage or enhance the basic impacts described above. Introducing greater sophistication increases the complexity and number of variables that must be considered in reaching any conclusion, but it does not make reaching a conclusion any easier. In fact, the results can be less determinant. The amount of unemployment in the economy affects the extent to which changes in aggregate demand move output or prices. In developing economies with limited factor mobility among sectors, the question of unemployed resources may have to be considered on a sectoral as well as an aggregate level, or by skill level. Depending on the particular model used, the inclusion of expectation function private investors will apply to any government action or nonaction. In some cases, where governments have announced a commitment to protect exchange rates or fix interest rates, guesswork is reduced for the market, but possibly at the cost of offering privat speculative investors a largely covered bet. In other cases it is much harder to predict whether a policy course outlined by a government will be seen as credible. In factor in a policys effectiveness. The history of government commitment and the markets estimation of the resources the government has available to defend a position figure into this equation. Although models provide useful general guidance and help frame the issues, their implementation must be tempered by an analysis of the features of practical