Monetary Fiscal Expansion

8/8/2019 Monetary Fiscal Expansion

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DE EC ON OM IST 134, NR. 4 , 1986M O N E T A R Y - F I S C A L P O L I C Y A S S I G N M E N T U N D E R

F L O A T I N G E X C H A N G E R A T E SBY

JAY H. LEVIN*

T h i s p a p e r e x a m i n e s t h e u s e o f m o n e t a r y a n d f i sc a l p o l i c y i n a s m a l l o p e ne c o n o m y i n w h i c h t h e e x c h a n g e r a t e i s f lo a t i n g , a n d i n w h i c h th e g o v e r n m e n ta t t e m p t s t o a c h i e v e se v e ra l m a c r o e c o n o m i c o b j e c t iv e s . B e c a u s e o f s t i c kyw a g e s a n d p r i c e s , f ul l e m p l o y m e n t d o e s n o t n e c e s s a r i l y p r e v a i l , a n d t h e le v e lo f e c o n o m i c a c t i v i ty , t h e r e f o r e , is t a k e n t o b e a b a s ic p o l ic y ta r g e t . I n a d d i t i o n ,t h e g o v e r n m e n t is c o n c e r n e d w i th t h e c o m p o s i t i o n o f o u t p u t , i n t e r m s o f t h ef r a c t io n o f g r o s s n a t i o n a l p r o d u c t d e v o t e d t o in v e s t m e n t s p e n d i n g , a s p a r t o fa n o v e r a l l g r o w t h p o l i c y ' ; a n d it a l so r e g a r d s t h e c o u n t r y ' s c u r r e n t a c c o u n tp o s i t i o n a s a n i m p o r t a n t o b j e c t i v e , W i t h r e s p e c t t o th e l a t te r p o s s ib i l i ty ,D o r n b u s c h , f o r e x a m p l e , h a s s u g g e s t e d th a t

External balance, o f course, is no problem if we think o f it as overall balance of paymentsequilibrium that is insured by the flexible rate. External balance remains an objective.though, if we think o f current account targets. A co untry m ay wish a particular currentaccount o r trade balance because it may not w ish to borrow o r lend abroad excessively.:

F o r a g i v e n l e v e l o f e c o n o m i c a c t i v i t y , it w i ll b e s h o w n i n S e c t i o n i b e l o w t h a t at r a d e - o f f ex i st s b e t w e e n t h e l ev e l o f d o m e s t i c i n v e s t m e n t s p e n d i n g a n d t h ec o u n t r y ' s c u r r e n t a c c o u n t p o s i t io n a s t h e m o n e t a r y - f i s c a l p o l i c y m ix c h a n g e s .i d e a l l y , t h e n , p o l i c y - m a k e r s c a n s e le c t t h e m o n e t a r y - f i s c a l m i x t h a t p r o d u c e st h e t a r g e t l e v e l o f e c o n o m i c a c t iv i ty a n d a n o p t i m u m c o m b i n a t i o n o f i n ve s t-m e n t s p e n d i n g a n d c u r r e n t a c c o u n t p o si t i o n . H o w e v e r , i n t h e a b s e n c e o fr e li a b le q u a n t i t a t iv e i n f o r m a t i o n a b o u t t h e e c o n o m y ' s m a c r o e c o n o m i c s t r u c -t u r e ( a n d b y i m p l i c a t i o n t h e a b o v e t r a d e - o f f in q u a n t i t a t i v e t e r m s ) , p o l i c y -m a k e r s m u s t r e s o r t t o a s s i g n in g i n s t r u m e n t s t o ta r g e ts . 3 T h e r e f o r e , S e c t i o n 2o f t h e p a p e r d i s cu s s e s t h e a s s i g n m e n t o f m o n e t a r y a n d f is ca l p o l i c y t o th e* Professor of Econom ics, W ayne State University. The author is grateful to the referee forhelpful comments but m ust absolve him from all remaining errors.1 Fo r example, see Go rdon [4, pp. I40-142].2 Do rnbusch [1, p. 19 8]. Fo r extensive discussion of the current accoun t as a possible target o fgovernment policy, and a compilation of official statements indicating such a target, see Salop andSpitfiller [11, esp. p p. 12 4-128]; and on p ossible determinants of the current accou nt, see D orn -busch [2] and Sac hs [10].3 Th e classic discussion of monetary-fiscal assignment underfixedexchan ge rates is, of course,Mu ndell [7]. A m ajo r critique is Johnson [5, pp. 314-318].


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468 J.H. LEV INt a r g e t s o f e c o n o m i c a c ti v it y a n d d o m e s t i c i n v e s t m e n t s p e n d i n g ; a n d S e c ti o n 3a n a l y z e s t h e m o n e t a r y - f i s c a l a s s i g n m e n t w h e n e c o n o m i c a c ti v it y a n d t h ec u r r e n t a c c o u n t a r e t h e t a r g e t s . 4 T h e r e s u l ts o f th e p a p e r a r e s u m m a r i z e d i nS e c t i o n 4 . T h e m a j o r c o n c l u s i o n i s t h a t m o n e t a r y a n d f i s ca l p o l i c y c a n b ef e a s i b l y a s s i g n e d t o e i t h e r s e t o f t a r g e t s , a l t h o u g h i n b o t h c a s e s th e s y s t e m m a yr e s p o n d w i t h o s c i l l a t i o n s .

1 TH E TRA D E-O FF BETWEEN IN V ESTMEN T SPEN D IN G A N DT H E C U R R E N T A C C O U NTT h e b a s i c p r e m i s e o f th is p a p e r i s t h a t a ta r g e t f o r t h e l e v e l o f e c o n o m i ca c t iv i t y , a c h i e v e d b y t h e u s e o f m o n e t a r y a n d f is c al p o l i c y , im p l i e s a s p e c if i cr a t e o f d o m e s t i c i n v e s t m e n t s p e n d i n g a n d a s p e c if i c p o s i t i o n f o r t h e c u r r e n ta c c o u n t u n d e r a f l o a ti n g e x c h a n g e r a te s y s te m . F u r t h e r m o r e , c h a n g in g t h em o n e t a r y - f i s c a l m i x a t t h e t a r g e t l e v el o f e c o n o m i c a c t iv i ty , s o a s t o , s a y , r a i s et h e i n v e s t m e n t c o m p o n e n t o f G N P , w ill s i m u l t a n e o u s l y i n c re a s e t h e c o u n t r y ' sc u r r e n t a c c o u n t p o s i t i o n . I d e a l l y t h e n , t h e o p t i m u m m o n e t a r y - f i s c a l m i x is t h eo n e t h a t a c h i ev e s t h e m o s t d e s i ra b l e c o m b i n a t i o n o f in v e s t m e n t s p e n d i n g a n db a l a n c e o f p a y m e n t s s t r u c t u r e a t t h e t a r g e t l e v el o f i n c o m e .

T h e s e c o n c l u s i o n s ca n b e d e ri v e d f r o m t h e s ta n d a r d K e y n e s i a n o p e n e c o n -o m y s t a ti c m a c r o m o d e l u n d e r f l oa t in g e x c h a n g e r a te s , g i v e n b e lo w :

1 M ( f ' , ~ ) = I ( ] ) + X (~r) + G( % + ~ -

Q = L ( ~ ' , i )

( 1 )

( 2 )

1 M ( 9 ,X ( T r ) - (3 )w h e r e Y = r e a l G N P ; rr = e x c h a n g e r a t e o n t h e h o m e c u r r e n c y ( u ni ts o ff o r e i g n c u r r e n c y p e r u n i t o f d o m e s t i c c u r r e n c y ) ; 1" = d o m e s t i c i n t e r e s t r a t e ;S = d o m e s t i c s av i ng ; I - - d o m e s t i c i n v e s t m e n t s p e n d i n g ; G = g o v e r n m e n ts p e n d i n g o n d o m e s t i c g o o d s an d s e rv i c es ; M = v o l u m e o f i m p o r t s ; X = v o l u m eo f e x p o r t s ; Q - - m o n e y s u p p l y ; L = d e m a n d f o r m o n e y ; a n d K = n e t s u s t ai n e dc a p i t a l i n f lo w s . P a r a m e t e r s ig n s a r e s h o w n a b o v e t h e a r g u m e n t s . E q u a t i o n (1)is t h e e q u i l i b r i u m c o n d i t i o n f o r t h e g o o d s m a r k e t . H e r e , f o r s im p l i c it y , t a x e sh a v e b e e n o m i t t e d , a n d g o v e r n m e n t s p e n d i n g i s t a k e n t o b e th e f is ca l c o n t r o lv a r i a b l e . ( A l t e r n a t i v e l y , o n e c a n i m a g i n e t h a t t a x e s ar e in c l u d e d i n t h e s a v i n g4 The rate of inflation is not an ex plicit target in this paper. How ever, one can imagine that thegovernm ent chooses a particular rate of mo netary growth consistent with its goal for the long-runinflation rate. The actual rate of monetary growth is then allowe d to deviate from this num ber asmo netary policy is assigned to one of the targets considered here.


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M O N E T A R Y - F I S C A L P O L I C Y A S S I G N M E N T 469

f unc t io n . ) A l s o f o r sim pl i c ity , im por t s a r e t a k e n to c ons i s t on ly o f c ons um p-t i o n g o o d s . E q u a t i o n ( 2) d e n o t e s m o n e y m a r k e t e q u i l ib r i u m , a n d d o m e s t i cg o o d s p r i c e s ( a n d w a g e s ) a r e t a k e n t o b e f i x e d a n d n o r m a l i z e d a t u n i t y .F ina l ly , e qua t ion (3 ) i s t he f o r e ign e xc ha n ge m a r ke t c l e ar ing c ond i t ion whe nc a p i t a l i s im pe r f e c t ly m ob i l e . No t i c e tha t s toc k - a d jus tm e n t c a p i t a l f lows a ndc a p i t a l m o v e m e n t s s t e m m i n g f r o m e x p e c t e d c h a n g e s in t h e e x c h a n g e r a t e a r eo m i t t e d h e r e s i n c e , i n t h e s t e a d y s t a t e , w h e n t h e s y s t e m r e a c h e s a s h o r t - r u ne q u i l i b r i u m , i n t e r e st r a t e s a r e s t a t io n a r y a n d e x c h a n g e r a t e e x p e c t a t i o n s a r ef u l fi l le d . A l so , f o r the t im e b e ing , i n t e r e s t pa y m e n t f lows in the c u r r e n ta c c o u n t a r e n e g l e c t e d .Eq ua t io ns ( 1 ) - (3 ) c on ta in the e nd og e no us va r i a b le s K r a nd ~r, a nd thee x o g e n o u s p o l ic y v a r i a b le s G a n d Q . S u p p o s e n o w t h a t th e g o v e r n m e n t w i s h e sto a t t a in a t a r ge t l e ve l o f GN P , Y*. The n the c ho ic e o f a ny pa r t ic u la r c om bina -t ion o f G a nd Q tha t p r od uc e s Y* wi ll a lso de te r m in e a pa r t i c u la r r a t e o fin t e r e s t . 5 Th i s in tu r n p r o du c e s a spe c i fi c l e ve l o f dom e s t i c inve s tm e n t spe nd -ing ; a nd by a l so e s t a b l ish ing a pa r t i c u la r l e ve l o f ne t sus t a ine d c a p i t a l i n flows ,th i s in t e r e s t r a t e im p l i e s a spe c i fi c c u r r e n t a c c oun t pos i t ion tha t e xa c t ly o f f se t sthe c a p i t a l i n f lows unde r the f loa t ing r a t e sys t e m .

N o w s u p p o s e t h e g o v e r n m e n t u n d e r t a k e s m o n e t a r y e x p a n s i o n a n d f i s c a lc o n t r a c t i o n s o as to l e a v e G N P a t Y * b u t l o w e r d o m e s t i c i n t e re s t r a t es . T h e ndo m e s t i c inve s tm e n t spe nd in g wi ll r i s e , a nd the r e du c e d c a p i t a l i n f lows wil l beo f f se t by a sm a l l e r c u r r e n t a c c ou n t de f i c it un de r the f loa ting r a t e sys t e m . Th i sw ill b e a c h i e v e d b y a d e p r e c i a t i o n o f t h e h o m e c u r r e n c y t o i ts n e w l o n g - ru ne qu i l ib r ium le ve l. The m a jo r c onc lus ion , t he n , i s t ha t t he l e ve l o f inve s tm e n ts p e n d i n g a n d t h e s t r u c t u r e o f t h e b a l a n c e o f p a y m e n t s a r e n o t in d e p e n d e n tt a r ge t s in th i s po l i c y set t ing a t a g ive n le ve l o f e c on om ic a c t iv i ty . C hoo s ing on eof the m im pl i e s a pa r t i c u la r s t a t e f o r the o the r .

2 P O L I C Y A S S I G N M E N T W H E N I N V E S T M E N T S P E N D I N G I S A T A R G E TW e a r e n o w i n a p o s i t i o n t o c o n s i d e r th e a s s i g n m e n t o f m o n e t a r y a n d f i sc a lp o l i c y w h e n i n v e s t m e n t s p e n d i n g , a l o n g w i t h G N P , a r e th e p o l i c y t a r g e tsu n d e r t h e f l o a t i n g r a t e s y s t e m . I n F i g s . l a a n d l b t h e Y Y s c h e d u l e s h o w sc om bina t ions o f G a nd Q f o r wh ic h the l e ve l o f e c on om ic a c tiv i ty is on t a r ge t .A s i s we l l know n f r o m the w or k o f F le m ing [ 3] a nd M und e l l [ 8 ], a s long a sc a p i t a l i s l e s s tha n pe r f e c t ly m ob i l e , f i s c a l e xpa ns ion r a i se s the l e ve l o f e c o -n o m i c a c ti v it y u n d e r t h e f l o at i n g e x c h a n g e r a te s y s t e m , a n d m o n e t a r y e x p a n -s i on h a s t h e s a m e e f f e c t f o r a n y d e g r e e o f c a p it a l m o b i li t y . 6 C o n s e q u e n t l y , t h e5 I f c a p i t a l is p e r f e c t l y m o b i l e , t h e e q u i l i b r i u m i n t e r e s t r a t e is s e t in t h e r e s t o f t h e w o r l d .A l t h o u g h d o m e s t i c i n v e s t m e n t s p e n d i n g i s n o l o n g e r a f f e c te d b y t h e m o n e t a r y - f is c a l p o l ic y m i x ,t h e c u r r e n t a c c o u n t i s s t il l s e n s i t i v e t o i t.6 T h e r e l e v a n t m u l t i p li e r s f r o m s y s t e m ( 1 )- (3 ) ar e d Y / d G - - L , . / A ; a n d d Y / d Q = ( K ; - I O A,w h e re A = - s L , . + L y ( K , - I , ) , s d e n o t i n g ( S S / S Y ) .


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4 70 J . H . L E V I N

Y Y s c h e d u l e i s d o w n w a r d s lo p i n g . S i m i la r ly , t h e I I s c h e d u l e s h o w s c o m b i n a -t io n s o f G a n d Q f o r w h i c h t h e l ev e l o f i n v e s t m e n t s p e n d i n g i s o n t a r g e t . H e r et h e F l e m i n g - M u n d e l l m o d e l i n d i c a t e s t h a t , w i t h i m p e r f e c t c a p i t a l m o b i l i t y ,f i s c a l e xpa ns ion r a i se s in t e r e s t r a t e s a nd the r e f o r e p r oduc e s a c u tba c k ini n v e s t m e n t s p e n d i n g ; w h e r e a s m o n e t a r y e x p a n s i o n l o w e r s i n t e r e s t r a t e s ,t h e r e b y s t i m u l a t i n g i n v e s t m e n t s p e n d i n g 5 H e n c e , t h e I I s c h e d u l e i s u p w a r ds lop ing .

C

i k _ ~ v

I

I / _.j "6 G

F i g u r e l a - M o n e t a r y P o l i c y A s s i g n e d toI n v e s t m e n t S p e n d i n g

F i g u r e l b - F i s c a l P o l i c y A s s i g n e d toI n v e s t m e n t S p e n d i n g

I n th i s k ind o f s i tua t ion , t he p o l i c y in s t r um e n t s do no t ha ve a c om pa r a t iv ea d v a n t a g e w i t h r e s p e c t t o t h e p o l i c y t a r g e ts , s o th a t t w o a s s ig n m e n t s a r ef e a s ib le , s I n F ig . l a , f is c a l po l i c y is a s s igne d to the G N P ta r ge t , a nd m on e ta r yp o l i c y t o t h e i n v e s t m e n t t a r g e t . T o s e e h o w t h e s y s t e m m i g h t r e s p o n d t o t h isa s s ignm e n t , im a g ine th a t t he e c on om y i s in it ia l ly a t po in t a , whe r e G N P i sbe low Y* a nd inve s tm e n t spe nd ing be low i t s t a r ge t l e ve l , I * . Th i s s i tua t ionc a l l s f o r b o t h m o n e t a r y a n d f i s c a l e x p a n s i o n , w h i c h e v e n t u a l l y m o v e t h ee c o n o m y t o t h e o u t p u t t a r g e t a t b . H o w e v e r , s i nc e i n v e s t m e n t s p e n d i n gr e m a i n s b e l o w I* , t h e m o n e t a r y e x p a n s i o n c o n t i n u e s , p u s h in g G N P a b o v e Y * .C o n s e q u e n t l y , t h e f i s c a l a u t h o r i t i e s b e g i n t o r e d u c e g o v e r n m e n t s p e n d i n g ,t h u s r e i n f o r ci n g t h e d e c l in e i n i n t e r e st r a t e s p r o d u c e d b y t h e m o n e t a r y e x p a n -7 T h e r e l e v a n t m u l t ip l i e r s f r o m th e m o d e l a r e dr /dG = Lv/A; a n d dr /dQ - - s /A .8 I t i s c o n c e i v a b l e t h a t fi sc a l e x p a n s i o n c o u l d le a d t o a n in c r e a s e in i n v e s t m e n t s p e n d i n g d e s p i t ei ts e f f e c t o n i n t e r e s t r a t e s . F o r t h e i n c r e a s e d G N P c o u l d c a u s e f i rm s t o r e v i s e t h e i r s a le s f o r e c a s t su p w a r d s , t h u s f a v o r i n g h i g h e r i n v e s t m e n t s p e n d i n g . I n t h e e v e n t t h a t f is c al e x p a n s i o n d i d h a v e t h i se f f e c t , th e I I s c h e d u l e w o u l d b e d o w n w a r d s l o p i n g a n d f l a t t e r t h a n t h e Y Y s c h e d u l e . M o n e t a r yp o l i c y w o u l d h a v e a c o m p a r a t i v e a d v a n t a g e o v e r i n v e s t m e n t s p e n d i n g a n d s h o u l d a l w a y s b ea s s i g n e d t o t h a t t a r g e t .


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MONETARY-FISCAL POLICY ASSIGNMENT 471sion. The upshot is that the investment target is eventually achieved at c; butthe on-going fiscal contraction continues to lower interest rates, eventuallycausing investment spending to rise above I*. The system proceeds in thisoscillatory fashion until both targets are eventually attained. 9

In Fig. lb monetary policy is assigned to the GNP target, and fiscal policy toinvestment spending. Suppose again that GNP is initially below Y* andinvestment spending below I * at point d. The GNP shortfall now calls formonetary expansion, but the investment shortfall elicits fiscal contraction.Consequently, as the result of lower interest rates, the investment target isnow the first one to be achieved. The fiscal contraction then ceases at point e,but the monetary expansion continues because of the GNP shortfall. Interestrates thus continue to decline, now pushing investment spending above I* andinducing fiscal expansion. With both monetary and fiscal policy now operatingin an expansionary direction, GNP eventually reaches Y* at point f. Here themonetary expansion comes to an end, but the continued fiscal expansion nowforces GNP above its target level. Once again, the system proceeds in anoscillatory manner until both targets are ultimately reached, m

In choosing investment spending as a target, the government must be awareof one potential limitation. To illustrate, imagine that investment is initiallybelow its target level by the amount I * - I o , but that GNP is at Y*. The solutionrequires a decline in interest rates in the amount ( I * - I o ) / I r , leading to areduction in sustained capital inflows in the amount K r ( I * - I o ) / I r . Thus thecurrent account deficit must decline by this amount, and from equation (1)government spending must be reduced by the amount ( K , - I , ) ( 1 " - I o ) / I ,. tokeep GNP on target. The potential problem is that these required changes inthe current account and government spending increase with the degree ofcapital mobility. So if capital is highly mobile, the solution may involve a vastchange in the current account position and an even larger change in govern-ment spending (or taxes) that would be regarded as unacceptable. Indeed, ifcapital is perfectly mobile, no amount of change in the current account andgovernment spending will matter since interest rates are tied to the outsideworld level, completely fixing investment spending. The moral is that highcapital mobility may limit the government 's ability to alter investment spend-ing by a significant amount, and perfect capital mobility eliminates it com-pletely. Of necessity, the current account then becomes the second target.

9 It is certainly possible that the system will converge without oscillations from points b or c, asshown in section 1 of the Appendix. For example, a high interest sensitivity of the demand formoney tends to enlarge the fiscal policy multiplier on output. Since fiscal policy is being assigned toGNP, this increased leverage favors direct convergence of the system.10. Again, the system need not converge with oscillations, as shown in the Appendix. Forexample, a high degree of capital mobility would increase the leverage of monetary policy overGNP. Since monetary policy is being assigned to the output target, the chances for directconvergence are increased.


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472 J.H. LEVIN3 POLICY ASSIGNMENT WHEN THE CURRENT ACCOUNT IS A TARGETNow consider the assig nment of mone tary and fiscal policy when the structureof the ba lanc e of paym ent s and GN P are the policy targets under the floatingrate system. Fig. 2a and 2b again contain a downwar d sloping YY schedule,given the assu mpti on of imperfect capital mobility, u The CC schedule showscom bi na ti ons of G an d Q for which the cur rent acc ount is at its target level.This schedule is upwar d sloping because fiscal and mo net ary expansi on haveopposite effects on the current account. By raising GNP and thus interestrates, f iscal expansion increases net sustained capital inflows and thereforeproduces an i ncrease in the current account deficit . 12 Mone tar y expansion , onthe othe r hand, lowers interest rates, leading to a decline in net sustainedcapital inflows and therefore a decrease in the current account deficit viacurrency depreciat ion. ~s

Figure 2a - Monetary Policy Assigned to theCurrent Account

Figure 2b - Fiscal Policy Assigned to theCurrent Account

11 If capital is perfectly mobile, fiscal policy becomes powerless to affect GNP, and the YYschedule becomes horizontal. However, the two assignments discussed in this section still remainfeasible. The only modification is that the fiscal policy-current account assignment necessarilyconverges without oscillations.12 In the case of perfect capital mobility, it is well known that the tendency for interest rates torise leads to a currency appreciation and an increase in the current account deficit that exactlyoffsets the fiscal expansion. With imperfect capital mobility, the offset is only partial. The relevantmultiplier is d(X- ( 1/ Tr )M ) /d G = - K r L r / A , decreasing algebraically to -1 as K,,-+~c.13 In the case of perfect capital mobility too. the tendency for interest rates to decline causes adepreciation of the currency and a smaller current account deficit. Indeed. the latter is themechanism by which aggregate demand expands: but with imperfect capital mobility, the currentaccount deficit decreases by a smaller amount. Here d(X- ( 1 /r r )M ) / d Q = K , s / A , increasing tos / L r as K,.--+:c.


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M O N E T A R Y - F I S C A L P O L I C Y A S S I G N M E N T 473

O n c e a g a i n t h e p o li c y i n s t r u m e n t s d o n o t p o s se s s a c o m p a r a t i v e a d v a n t a g ew i t h r e s p e c t t o t h e p o l i c y t a r g e t s , a n d b o t h a s s i g n m e n t s a r e f e a s ib l e . I n F ig . 2 a ,f is c al p o l ic y is a ss ig n e d t o t h e G N P t a r g e t a n d m o n e t a r y p o l i c y to t h e c u r r e n ta c c o u n t . S t a r t i n g a t p o i n t a , w h e r e G N P i s b e l o w t a r g e t a n d t h e c u r r e n ta c c o u n t d e f i c it is t o o l a rg e ( o r s u r p l u s t o o s m a l l) , t h e g o v e r n m e n t u n d e r t a k e sb o t h f is ca l a n d m o n e t a r y e x p a n s i o n , a n d t h e e c o n o m y e v e n t u a l ly re a c h e s t h eG N P t a r g e t a t b . 14 H o w e v e r , t h e c u r r e n t a c c o u n t d e f i c i t is s ti ll a b o v e t a r g e th e r e , a n d t h e e x p a n s i o n a r y m o n e t a r y p o l ic y t h e r e f o r e c o n t i n u e s , p u s h in gG N P a b o v e i t s t a r g e t l ev e l. C o n s e q u e n t l y , t h e f i sc a l a u t h o r i t i e s n o w b e g i n t oc o n t r a c t g o v e r n m e n t s p e n d i n g , a n d b o t h p o li ci es o p e r a t e t o e v e n t u a l l y m o v et h e c u r r e n t a c c o u n t d e f i c i t t o it s d e s i r e d l e v e l a t p o i n t c. H o w e v e r , w i t h G N Ps ti ll a b o v e t a r g e t , t h e f i s ca l c o n t r a c t i o n c o n t i n u e s , a n d t h e c u r r e n t a c c o u n td e f i c i t n o w m o v e s b e l o w i t s t a r g e t l e v e l . T h i s o s c i l l a t o r y b e h a v i o r o f t h es y s t e m c o n t i n u e s u n t i l b o t h t a r g e t s a r e e v e n t u a l l y a c h i e v e d . 15

I n F i g . 2 b m o n e t a r y p o l i c y is a s s i g n e d t o t h e G N P t a r g e t , a n d f is c a l p o l i c y t ot h e c u r r e n t a c c o u n t . S t a r t i n g a g a i n in a s i t u a t i o n o f a G N P s h o r t f a ll a n d t h ec u r r e n t a c c o u n t d e f i c i t a b o v e i ts t a r g e t l e v e l a t d , t h e c u r r e n t a c c o u n t p o s i t i o nn o w c a ll s f o r fi sc a l c o n t r a c t i o n , w h i le t h e c e n t r a l b a n k u n d e r t a k e s m o n e t a r ye x p a n s i o n . C o n s e q u e n t l y , w i th t h e p o l i ci es c o n f li c ti n g w i t h e a c h o t h e r w i t hr e s p e c t t o t h e l e v e l o f G N P , t h e c u r r e n t a c c o u n t t a r g e t i s t h e f i r s t t o b ea c h i e v e d a t e. H o w e v e r , t h e m o n e t a r y e x p a n s i o n c o n t i n u e s b e c a u s e o f t h eG N P s h o r t f a ll , a n d t h e c u r r e n t a c c o u n t d e f ic i t n o w m o v e s b e l o w t a r g e t.C o n s e q u e n t l y , t h e f i s c a l a u t h o r i t i e s b e g i n t o i n c r e a s e g o v e r n m e n t s p e n d i n g ,a n d w i th b o t h p o l ic i es o p e r a t i n g i n a n e x p a n s i o n a r y d i r e c t io n , t h e t a r g e t l ev e lo f G N P is e v e n t u a l l y r e a c h e d a t f. H e r e t h e m o n e t a r y e x p a n s i o n c e a se s , b u tt h e c o n t i n u e d f i sc a l e x p a n s i o n n o w c a u se s G N P t o m o v e a b o v e it s t a r g e t le v e l.T h i s c y c l ic a l m o v e m e n t c o n t i n u e s u n t i l b o t h t a r g e t s a r e a tt ai n ed .1 6

A l t h o u g h b o t h a s s i g n m e n t s h a v e b e e n s h o w n t o b e f e a s i b l e w h e n t h ec u r r e n t a c c o u n t is o n e o f th e t a r g e ts , a c o m p l i c a ti o n n o w a r is es w h e n i n t e r e stp a y m e n t f l o w s a r e i n c o r p o r a t e d i n t o t h e m o d e l . A s i s w e l l k n o w n , t h e r e -s p o n s e o f t h e s e f l o w s t o i n t e r e s t r a t e s i s i n t h e d i r e c t i o n o p p o s i t e t o t h er e s p o n s e o f t h e s u s t a in e d c a p i ta l f l o w s J 7 C o n s e q u e n t l y , m o n e t a r y a n d f is ca lp o l ic y w il l h a v e a n u n c e r t a i n e f f e c t o n t h e t r a d e b a l a n c e , w h i c h d e p e n d s o n t h e14 T h e g o v e r n m e n t m i g h t i n c o r r e c tl y b e l i e v e t h a t t h e c u r re n t a c c o u n t p o s i ti o n ca ll s f o r m o n e t a r yc o n t r a c t i o n , o n t h e g r o u n d s t h a t t h e l a t t e r 's d e f l a t i o n a r y e f fe c t o n t h e e c o n o m y w o u l d h e l p c o r r e c tt h e e x t e r n a l s i t u a t io n . H o w e v e r , t h is b e l i e f i g n o r e s t h e o v e r w h e l m i n g e f fe c t th a t t h e r e s u l t i n ge x c h a n g e r a t e a p p r e c i a t i o n e v e n t u a l l y w o u l d h a v e o n t h e c u r r e n t a c c o u n t . F o l l o w i n g s u c h a ni n c o r r e c t p o l i c y w o u l d c a u s e t h e s y s t e m t o d i v e r g e e x p l o s i v e l y f r o n t p o i n t a i n a s o u t h - e a s t e r l yd i r e c t i o n .15 A s b e f o r e , t h e p a t h o f t h e s y s t e m n e e d n o t b e o s c i l l a t o r y , a s s h o w n in s e c t i o n 2 o f t h eA p p e n d i x .16 O n c e a g a i n , t h e s y s t e m c a n b e n o n c y c l i c a l. H i g h c a p it a l m o b i l i t y f a v o r s t h i s p o s s i b i l i t y , a n di n d e e d i t i s e a s y t o s h o w t h a t p e r f e c t c a p i t a l m o b i l i t y g u a r a n t e e s i t .17 S e e , f o r e x a m p l e , W i l l e t t a n d F o r t e [ 12 ].


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474 J.H. LE VINr e s p o n s e o f s u s t a in e d c a p i t a l fl o w s a n d i n t e r e s t p a y m e n t f lo w s c o m b i n e d ; a n dt h e t r a d e b a l a n c e , t h e r e f o r e , c a n n o t b e u s e d r e l ia b l y a s a t a r g e t . N e v e r t h e l e s s ,t h e c u r r e n t a c c o u n t , i n c l u d i n g i n t e r e s t p a y m e n t f l o w s , r e m a i n s a f e a s i b l et a r g e t s i n c e i ts r e s p o n s e t o m o n e t a r y a n d f i sc a l p o l ic y d e p e n d s o n l y o n t h el a t t e r s ' e f f e c t o n s u s t a i n e d c a p i t a l f l o w s . T h e i m p l i c a t i o n t h e n i s t h a t t h eg o v e r n m e n t m u s t h a v e d a t a o n t he e n t i r e c u r r e n t a c c o u n t , a n d n o t j u s t t h et r a d e b a l a n c e , w h e n s e t ti n g it s p o l ic i e s a c c o r d i n g t o t h e a s s i g n m e n t r u l e sd i s c u s se d a b o v e . F o r t u n a t e l y , f r o m a w e l f a r e v i e w p o i n t , th e c u r r e n t a c c o u n t ist h e p r o p e r m e a s u r e o f t h e n e t r e s o u rc e s b e i ng l e n t t o o r b o r r o w e d f r o mf o r e i g n e r s , a n d t h e r e f o r e i t is a m o r e a p p r o p r i a t e t a r g e t t h a n t h e t r a d e b a l a n c ea n y w a y .

4 CONCLUSIONST h i s p a p e r h a s d e v e l o p e d a m o d e l i n w h i c h m o n e t a r y a n d f is c al p o l ic y ca n b eu s e d t o a c h i e v e a t a r g e t l e v e l o f e c o n o m i c a c t iv i ty a n d e i t h e r a n i n v e s t m e n ts p e n d i n g o r c u r r e n t a c c o u n t t a r g et . A c h o i ce m a y h a v e to b e m a d e b e t w e e nt h e l a t t e r t w o o b j e c t i v e s b e c a u s e , f o r a g i v en le v e l o f e c o n o m i c a c t iv i t y , at r a d e - o f f e xi st s b e t w e e n t h e m a s t h e m o n e t a r y - f i s c a l p o l i c y m i x c h a n g e s .S p e c i f ic a l l y , a n e a s i e r m o n e t a r y a n d t i g h t e r f i sc a l p o l i cy c o m b i n a t i o n i n c r e a s e si n v e s t m e n t s p e n d i n g a n d r e d u c e s t h e c u r r e n t a c c o u n t d ef ic i t. H o w e v e r , a s t h ed e g r e e o f c a p it a l m o b i l i t y in c r e a s e s , s o d o e s th e r a t e o f t r a d e - o f f b e t w e e nt h e s e t a r g e t s , a n d t h e c a s e f o r c h o o s i n g th e c u r r e n t a c c o u n t a s a t a r g e t b e c o m e ss t r o n g e r .

O n c e t h e c h o i c e b e t w e e n i n v e s t m e n t s p e n d i ng a n d t h e c u r r e n t a c c o u n t h asb e e n m a d e , a s si g n in g m o n e t a r y a n d f is c al p o l i c y l e a d s to a c o n v e r g e n c e o f t h es y s t e m , a l t h o u g h p o s s i b ly a n o s c i l la t o r y o n e , b e c a u s e t h e p o l i ci e s a re a l w a y s ina t u g o f w a r w i t h r e s p e c t t o o n e o f t h e t a r g et s . F u r t h e r m o r e , either m o n e t a r y orf is c a l p o l i c y c a n b e a s s i g n e d t o t h e G N P t a r g e t , a n d t h e o t h e r p o l ic y to t h es e c o n d t a r g e t .

F i n a l l y , t h e r e a d e r i s r e m i n d e d t h a t t h e s e c o n c l u s i o n s a r e d e r i v e d f r o m av e r y s im p l e o p e n e c o n o m y K e y n e s i a n m o d e l , i n w h i c h c a pi ta l f lo w s d e p e n do n l y o n t h e i n t e r e s t d i f f e r e n t ia l b e t w e e n d o m e s t i c a n d f o r e i g n a s se t s. H o w -e v e r , if o n e d r o p s th is O c c a m ' s R a z o r a p p r o a c h , a m o r e e l a b o r a t e r e p r e s e n -t a t i o n o f th e c a p i t a l a c c o u n t u n d e r c o n d i t i o n s o f i m p e r f e c t c a p i ta l m o b i l i t y isp o s s i b l e , i n c l u d i n g a s p e c i f i c a t i o n o f e x c h a n g e r a t e e x p e c t a t i o n s , 18 a l t h o u g h Iw o u l d c o n j e c t u r e t h a t t h e p o l ic y m o d e l s w o u l d r e m a i n s t a b le u n d e r e i t h e ri n e l a s t i c o r r a t i o n a l e x p e c t a t i o n s . A s e c o n d s i m p l i f i c a t i o n is t h e a b s e n c e o f la g si n t h e m o d e l , a n a p p r o a c h t h a t is s t a n d a r d i n t h e a s s i g n m e n t p r o b l e m l i te r a -t u r e . H o w e v e r , a s P h i ll ip s [9] d e m o n s t r a t e d l o n g a g o , t o o f o r c e f u l a n a p p li -c a t i o n o f i n te g r a l s t a b i li z a t io n p o l i cy - t h e t y p e c o n s i d e r e d i n a ss i g n m e n tm o d e l s - c a n p r o d u c e e x p lo s iv e m o v e m e n t s i n a m a c r o e c o n o m i c s y s te m w h e n18 For examp le, see my paper [6].


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MON ETARY-FISCAL PO LICY ASSIGNMENT 475o u t s i d e l ag s a r e p r e s e n t . C o n s e q u e n t l y , i f t h e a s s i g n m e n t ru l e s in th i s p a p e rw e r e f o l l o w e d , m o n e t a r y a n d f i s c a l c h a n g e s m i g h t h a v e t o b e m a d e q u i t eg r a d u a l l y in o r d e r f o r t h e s y s t e m t o c o n v e r g e .

A P P E N D I X1 G N P a n d I n v e s t m e n t S p e n d i n g a s T arg ets"W h e n m o n e t a r y p o l ic y is a s si g n e d t o t h e i n v e s t m e n t t a rg e t a n d f is ca l p o l ic y toG N P , t h e d y n a m i c s y st e m m a y b e r e p r e s e n t e d a s f o llo w s :

d Q - f i j r [ d r + ~ r ( G - G *)]d t d Q ( Q - Q * ) d Gd G [ d Y + d Y ( G _ G , ) ]d t - /3 2 d - Q ( Q - Q * ) d G -

(/3,0)

~4


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476 J.H. LEV IN

/ l d r - f i a d - O ) + fi~ fi4 " kd G d Q d O d G ),~2_~2 [ - - / ~ 3 , ~ d Y I ( d r d Y d r d Y = 0 . ( A 5)

T h e c o e f f ic i e n t o f 2 a n d t h e c o n s t a n t t e r m a r e a g a in p o s i ti v e , a n d t h e s y s t em i ss t a b l e . I t i s n o n c y c l i c a l if a n d o n ly i f[fl3I,.L,, - t34 ( K,. - I,)12 + 4fi3fl 4sL, l_ >O, ( A 6 )

w h i c h i s g u a r a n t e e d , f o r e x a m p l e , b y a l a r g e e n o u g h v a l u e o f t h e c a p i t a lm o b i l it y p a r a m e t e r , K r.2 G N P a n d t h e C u r r e n t A c c o u n t a s Ta rg ets"W h e n m o n e t a r y p o l i c y i s a s s ig n e d t o t h e c u r r e n t a c c o u n t a n d f i sc a l p o l i c y t oG N P , t h e d y n a m i c sy s te m b e c o m e s

_ ( d~r m d V td Q 0 1[ B ~ ( Q - Q * ) +d t d Q d Q ]( d~ r d Y ) ( G - G * ) ]B,~ d G - m d -G -

d G _ 0 7 [ d Y + d Y ( G - G * ) Id t - d O - ((2 - Q * ) d G

( 0 , < 0 )

(0 2 < 0 ) ( A 7 )

w h e r e f r o m s y s t e m ( 1 ) -( 3 ) , d r r/ d Q = ( - K , . ( s + m ) + m I , ) / - B ~ A ) ; a n dd ~r/d G = ( K r L Y + m L , . ) / - B , A ) . B ~ d e n o t e s X ~ - M ~ + M ( < 0 b y v i r t u e o f t h eM a r s h a l l - L e r n e r c o n d i t i o n ) a n d m r e p r e s e n t s D M / D Y . T h e c h a r a c t e r i s t i ce q u a t i o n o f t h i s s y s t e m r e d u c e s t o[ O K d r _ _ o d Y ] ( d Y d r d Y 2 ; )

, v + , z t ' ' d O 2 7 d ~ / + 0 ,0 ~K , = 0 . ( a s )d Q d G d GT h i s s y s t e m i s c l e a r ly d y n a m ic a l l y s t a b l e , a n d i t i s n o n c y c l i c a l i f a n d o n ly i f

( 0 1 K r s + 0 2 L , ) 2 - 4 0 1 0 ~ (K , - I , ) K , L y > O . ( A 9 )T h i s c o n d i t i o n c a n b e s a t i s f i e d if , f o r e x a m p le , ]L ,. i s su f f ic i e n t ly l a r g e .T h e r e v e r s e a s s i g n m e n t is g iv e n b y


11/12

M O N E T A R Y - F I S C A L P O L I C Y A S S IG N M E N T 477d Tr d Y )d G - 0 3 [ B ~ - - - m ( Q - Q * ) +

d t d Q d Q( B , d rr r n d Y ] ( G - G * ) ] ( 0 3 > 0 )d Q - d G - J

d O _ 04 [ d Y d Y ( G - G * ) ] ( 0 4 < 0 )d t d Q ( Q - Q * ) + d - G (Am)t h e c h a r a c t e r is t i c e q u a t i o n o f w h i c h r e d u c e s t o

( d r - 0 d Y ] ( d r d Y d r d Y )470 + OO . ( A 1 2 )T h i s c o n d i t i o n is f u l fi l le d , i f , f o r e x a m p l e , II,.l i s s u f f i c i e n t l y l a r g e .

R E F E R E N C E SDornbusch, R., Open Economy Macroeconornics, New York, 1980.Dornbusch, R ., 'Rea l Interest Rates, H om e Goods, and Optimal External Borrowing, ' Jou rnal o fPolitical Eco nom y, Februa ry, 1983, pp. 141-153.Fleming, J.M ., 'Domestic Financial Policies under F ixed and unde r Floating Exchange R ates, 'I .M.F. Staff Papers , No. 3, 1962, reprinted in: R.N. Cooper (ed.), International Finance,

Harmon&wor th , 1969 .Gordon , R .J . , Macroeconomics, Boston and Toronto, 1984.Joh nso n, H .G ., 'Theoretical P roblems of the International Mo netary System,' Pakistan Develop-ment Review (1967), reprinted in: R.N. Co ope r (ed.), b~ternational F inance, EIarmondsworth,

1969.Levin, J.H ., 'Th e Dynam ics of Stabilization Policy und er Flexible Exchange Rates: A Synthesis of

the Asset and Neo-Keynesian Approaches, ' Oxford E conomic Papers, Novem ber, 1980, pp.411-427.

Mu ndell, R .A ., 'Th e Appropriate Use of Mo netary and Fiscal Policy under Fixed ExchangeRates , ' I.M.F. Staff Papers, March, i962 , reprinted as Chapter 16 in: R.A. M undell, Interna-tional Econ omics , Lon don, 1968.

Mundell, R.A., 'Capital Mobility and Stabilization Policy under Fixed and Flexible ExchangeR ates , ' reprinted as Chapter 18 in: R.A . M undell. International Econom ics, London, 1968.

Phillips, A.W., 'Stabilization Policy in a Closed Economy,' Econom ic Journal, June, 1954.Sachs, J,D ., 'Th e Current Ac cou nt and Macroeconom ic Adjustment in the 1970's, ' BrookingsPape~ on Econom ic Activ ity , 1: 1981, pp. 201-282.Salop, J. and E. Spitfiller, 'W hy Does the Current A ccou nt M atter. '? 'I. M . F. Sta ff Pap ers, March,

1980, pp. 101-134.


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478 J.H. LEV[NWillett, T.D. and F. Forte, 'Interest Rate Policy and External Balance,' Quarterly Journal ofEconomics, May, 1969, pp. 242--262.

SummaryMONETARY-FISCAL POLICY ASSIGNMENT UNDER FLOATING EXCHANGE

RATESThis pape r examines the use of monetary and fiscal policy in a small country model under floatingexchange rates. The government attempts to achieve a target level of economic activity and eitheran investment spending (output composition) or current account target. However, a choice mayhave to be made between the latter two objectives because a trade-off exists between them as themonetary-fiscal policy mix changes. It is shown that either monetary or fiscal policy can beassigned to the GNP target, and the second policy to one of the other targets, although the pathmay be oscillatory.

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Monetary Fiscal Expansion