Compare the effects of expansionary monetary policy in (a) fixed and (b)   flexible exchange rate regimes. Use appropriate graphs and reasoning. Make the comparisons explicit.

 

a) Expansionary Monetary Policy under Fixed Exchange Rate is completely ineffective and fails to increase the output of the country.

b) Expansionary Monetary Policy under Flexible Exchange Rate is effective in increasing the income of the country.

Monetary Policy is a macroeconomic policy that is adopted by the Monetary Authority of the country to achieve high economic growth, stable interest rates, low inflation and unemployment rates. These objectives are achieved by altering the money supply in the economy through changes in interest rate, open market operation or required reserve ratio etc. There are two types of Monetary Policy that are Expansionary Monetary Policy and Contractionary Monetary Policy. The Central Bank adopts Expansionary Monetary Policy when there are low price level and it wants to stimulate economic activity in the country. Under this policy, Central Bank decreases interest rate which make borrowing cheaper and this leads to increase in consumption and investment spending, aggregate demand and income in the country. This policy is adopted to move the economy out of recession or to reduce the risk of recession.

a) Expansionary Monetary Policy under Fixed Exchange rate Regime:

Fixed Exchange Rate is a system in which government or the Central Bank of the country set the value of their currency in terms of other currency. The aim of this regime is to fix the value of their currency in a certain band and avoid large fluctuations in the value of their currency.

The effect of Expansionary Monetary Policy under fixed exchange rate regime is explained with the help of AA-DD model as it shows simultaneous equilibrium in asset market, goods market and foreign exchange market. AA curve represents assets market equilibrium as it is derived by money market and foreign exchange market. DD Curve represents equilibrium in good market. This is shown with the help of AA DD diagram below:

Initially the economy is in super equilibrium at point G where equilibrium exchange rate of US dollar is fixed to British Pound at E and equilibrium income is OY. The expansionary monetary policy shifts the AA curve upwards to AA' which leads to an upward pressure on the exchange rate and upward movement on AA curve to H. Exchange Rate rises because increase in money supply decreases interest rate which means foreign investment becomes more attractive and investors increases the demand for British pound and decreases the demand for U.S. Dollar which appreciates pounds and depreciated dollar. But Central Bank is following Fixed Exchange rate regime, so Central Bank will intervene and supply British Pounds in exchange for U.S. Dollar which will decrease the supply of U.S. Dollars in the economy and AA curve will shift back to its initial position and the initial equilibrium is restored in the economy.

Thus, after all the adjustments there is no effect of Expansionary Monetary Policy on the income of the country and it is completely ineffective.

b) Expansionary Monetary Policy under Flexible Exchange rate Regime:

Flexible Exchange Rate is a system in which market forces of demand and supply determines the value of currency in terms of other currency and there are no government interventions in determining the value of their currency. The value of the currency is determined in the foreign exchange market based on its demand and supply.

The effect of Expansionary Monetary Policy under flexible exchange rate regime is explained below with the help of AA-DD diagram:

Initially the economy is in super equilibrium at point G where equilibrium exchange rate of US dollar is fixed to British Pound at E and equilibrium income is OY. The expansionary monetary policy shifts the AA curve upwards to AA' which leads to an upward pressure on the exchange rate and upward movement on AA curve to H. The exchange rate increases E' which means pounds appreciates and dollar depreciates, this increases the demand for U.S. exports and decreases the demand for U.S. imports. This caused a downward movement on DD curve and economy moves to new equilibrium at point I where equilibrium exchange rate is OE'' and equilibrium income increases to OY''.

Thus, after all the adjustments Expansionary Monetary Policy increases exchange rate and equilibrium income of the country.

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