Monetary and Fiscal Policy with Flexible Exchange Rates

Abstract

The implications of "perfect" capital mobility for the effectiveness of monetary and fiscal policy and the transmission of disturbances under floating or fixed exchange rates were drawn in the classic paper by Mundell (1963).With fixed rates, fiscal policy moves output but monetary policy does not, and vice versa under flexible rates.These results are among the most enduring and best-known in international economics.The flexible-rate version of the Mundell model was dynamized by Dornbusch (1976).A crucial feature of both the Mundell and Dornbusch analyses is the exclusion of the exchange rate from the money-market equilibrium condition.However, if the domestic price level is sensitive to changes in the exchange rate, then a movement in the rate changes real balances.Thus fiscal policy influences real balances through the exchange rate, opening the way for effects on home output in the Mundell model or the price level in the Dornbusch version.In addition to excluding the exchange rate from money-market equilibrium, Mundell and Dornbusch do not consider constraints of long-run portfolio balance.In a stationary economy, these would require balance on the current account in the long-run equilibrium, while the Mundell-Dornbusch model permits current account imbalance indefinitely.In this paper we revisit the Mundell-Dornbusch model to study its behavior with the price level dependent on the exchange rate, and with long-run portfolio balance constraints.We find that the flexible-rate fiscal policy result is a special case, dependent on the assumption of insensitivity of the price level to movement in the exchange rate.

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