Fiscal Implications for Monetary and Exchange Rate Policies
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1 Monetary and Exchange Rate Policies in Cambodia, Laos and Vietnam: The Scope for Regional Cooperation Fiscal Implications for Monetary and Exchange Rate Policies Regional Workshop, Luang Prabang, Dec Stefan Kooths DIW Berlin Macro Analysis and Forecasting
2 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 2
3 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 3
4 General Scope of the Paper General theoretical framework - suitable to discuss fiscal policy effects (demand shocks in general) - allows for general conclusions potential to be specified in terms of individual country cases way of thinking Exposition of principle model mechanics help general audience to follow main conclusions Fiscal Implications 4
5 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 5
6 Key Assumptions Markets: - Goods and services (IS) - Money (LM) - Foreign exchange (FX) Productions follows demand Demand drivers - Income - Interest - (Real) Exchange rate Net capital inflows respond to interest rate differentials Fiscal Implications 6
7 Simultaneous Equilibrium i IS FX LM Fiscal Implications 7 Y
8 Fixed Exchange Rates: Disequilibirum and Adjustment Processes i IS FX LM' B LM A Fiscal Implications 8 Y
9 Flexible Exchange Rates: Disequilibirum and Adjustment Processes FX i IS IS' FX' A B LM Fiscal Implications 9 Y
10 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 10
11 Cross-Border Capital Flows Interest elasticity of net capital inflows (NCI) - depth of domestic financial markets - integration with world markets Impact - income effects of fiscal policy - monetary disturbances (foreign reserves, exchange rate) Geometrical interpretation - low interest elasticity steep (extreme case: vertical) FX (case 1: FX steeper than LM) - high interest elasticity flat (extreme case: horizontal) FX (case 2: FX flatter than LM) Fiscal Implications 11
12 Fiscal Policy Impact Under Fixed Exchange Rates Case 1: Low Interest Elasticity of NCI i IS IS' FX LM' C LM B A Fiscal Implications 12 Y
13 Fiscal Policy Impact Under Fixed Exchange Rates Case 2: High Interest Elasticity of NCI IS' i LM IS LM' B FX A C Fiscal Implications 13 Y
14 Fiscal Policy Impact Under Flexible Exchange Rates Case 1: Low Interest Elasticity of NCI IS'' IS' FX i IS FX' B C LM A Fiscal Implications 14 Y
15 Fiscal Policy Impact Under Flexible Exchange Rates Case 2: High Interest Elasticity of NCI IS' IS'' i LM IS B FX' FX C A Fiscal Implications 15 Y
16 Intermediate Conclusion Fiscal impact on domestic production depends on - exchange rate regime - interest elasticity of NCI Fiscal impact on monetary/currency sphere - depends on interest elasticity of NCI - is not minimized by extreme elasticities of NCI neither perfect mobility of capital flows (full liberalization of financial markets) nor total immobility of capital flows (protectionist separation of financial markets) Fiscal Implications 16
17 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 17
18 Modifications Inverse trade response to exchange rate fluctuations demand shocks become a source of foreign exchange market instability in case of low interest elasticity of NCI Income-dependent capital flows scenarios of high interest elasticity of NCI become more likely possibly destabilizing effect under fixed exchange rates Flexible money wages and prices - here: exchange-rate induced price level fluctuations only - markup-pricing and rigid real wages real exchange rate remains unchanged results for fixed exchange rates apply Fiscal Implications 18
19 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 19
20 Monetization of Public Deficits Pooling two macroeconomic instruments (deficit spending and money supply) reduces the number of other independently achievable political targets Continuous use of monetary policy for fiscal financing destabilizes the economy and can potentially lead to serious financial crises Fiscal Implications 20
21 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 21
22 Fiscal Rules and Coordination Theoretical evidence: Fiscal policies matter! Empirical evidence - Crash of Bretton Woods - EMS crisis 1992/93 Fiscal rules for monetary unions? - Eurozone: Stability and Growth Pact - No bail out no spill-overs external to market processes Fiscal Implications 22
23 Outline Introduction The Basic Mundell-Fleming Framework Fiscal Policy and (Inter-) National Financial Institutions Modifications of the Basic MF-Framework Monetization of Public Deficits Fiscal Rules for Monetary and Exchange Rate Cooperation: Lessons from Historical Evidence Conclusions Fiscal Implications 23
24 Conclusions Foreign exchange system matters for impact of fiscal policy Interest elasticity of NCI and therefore financial institution building plays an important role for fiscal effectiveness - impact on domestic production extreme values - monetary/currency side effects medium values J-curve trade effects potentially more disturbing the lower the interest elasticity of NCI fiscal policy potentially destabilizing under fixed exchange rates if income-dependent cross-border investments are important Fiscal Implications 24
25 Conclusions (cont.) Flexible prices and rigid real wages make fixed and flexible exchange rate regimes more similar Large-scale use of monetization leads to harmful monetary and exchange rate disruptions Monetary/currency side-effects of fiscal policy less important in monetary unions; higher fiscal responsibility of anchor country in fixed exchange rate system Fiscal Implications 25
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