Exchange Rates and Macroeconomic Policy with Income-Sensitive Capital Flows

James Perkins

No 769, Department of Economics - Working Papers Series from The University of Melbourne

Abstract: This paper considers some implications for macroeconomic policy in an open economy if-as appears highly probable-international flows of capital are now significantly sensitive to changes in income, and to expected changes in income, in different countries. This assumption is in contrast to that in accepted analysis where international capital flows are sensitive only to relative interest rates in different countries. One conclusion is that the effects on the exchange rate (or on the reserves in a fixed-exchange rate system) of monetary policy in an open economy will be less than if it is assumed that capital flows react only to changes in interest rates. The effects of fiscal policy changes upon the exchange rate (or the reserves if the exchange rate is fixed) will also be more likely to be largely or fully offset by capital flows than if relative interest rates alone affected the flow of capital. It will, however, remain true that so long as capital flows react also to some extent to relative interest rates, monetary policy retains a comparative advantage over fiscal policy in affecting the exchange rate, or the level of reserves in a fixed exchange rate system. It is also concluded that if capital flows react to changing levels of income, a shift from fixed to flexible exchange rates will have less effect in increasing the domestic effects of changes in monetary policy; and will be less likely to increase the domestic effect of changes in fiscal policy.

Keywords: MACROECONOMICS; CAPITAL; INCOME; INTEREST RATE; FISCAL POLICY (search for similar items in EconPapers)
JEL-codes: E24 E62 (search for similar items in EconPapers)
Pages: 18 pages
Date: 2000
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