In this paper we are going to analyze the impact of monetary and fiscal policy in the UK economy by initially using the IS-LM BP framework and later on Philips curve under flexible and fixed exchange rate regimes by supposing perfect capital mobility.
The LM curve outlines the point at which there is an equilibrium condition of quantity of money demanded and quantity of money supplied (Dornbusch and Fisher 1994). As aggregate output rises, there is an increase for money demand and rise in the interest rates where the money demanded equals money supplied by resulting in the equilibrium.
The IS curves shows out the point at which the total quantity of goods produced equals the total quantity of goods demanded (Dornbusch and Fisher 1994a). At any level of the interest rate, the IS curve shows us what aggregate output has to be for the goods market to be in equilibrium. By rising the interest rates, planned investment spending and net exports fall, which as a result lowers aggregate demand.
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In the first part of the literature review we will present how monetary and fiscal policy can be implemented under flexible exchange rate regimes, while in the second part there will be analysis of how monetary and fiscal policy can be implemented under flexible exchange rate regimes. The last part of this literature review we will explain the Philips curve under the above mentioned policies.
Fiscal Policy under Flexible Exchange Rates
In this section we will demonstrate the impact of fiscal policy in the UK economy by using IS-LM BP model. An expansionary fiscal policy will involve an increase in government spending or a decrease in taxes. At any interest rate, if there is an increase in government spending there will be an increase in aggregate demand. This leads to an increase in the demand for goods which is shown by the IS curve which moved to the right as shown in Figure 1. At point E1 at the new equilibrium, where the goods market is in equilibrium but money market is not, resulted in an increase in income, which naturally consequences in increase in demand for money leading to an increase in the interest rates at i2. While there is an increase in the foreign interest rate there is a capital inflow because of the fact that foreign investors seek to take over the advantage of higher returns by buying domestic assets. As the interest rate is increased above the foreign interest rate, capital inflows as foreign investors seek to take advantage of the higher return by buying domestic assets, Blinder B. (2006).
The capital inflow because of the rise in interest rates pushes the interest rates back to initial equilibrium and because of the fact that investors buy pounds it increases the demand for pound in the foreign exchange market, which leads to the appreciation of the pound. By appreciating the pound, UK assets become more expensive in relation to foreign assets and as a result the net exports decreases. Any decrease in the net exports (NX), shifts the IS to the left until the capital inflow stops. Because the IS shifts to the left, the domestic interest rate will equal the foreign interest rates and will go back to the initial equilibrium Eo. This means that the fiscal policy under flexible exchange rate regime and perfect capital mobility has a little effect in increasing national output Oliver.B (2009).
Monetary Policy under Flexible Exchange Rates
By using IS-LM BP framework, we can also explain the effects of the monetary policy under flexible exchange rates regime as we explained in the fiscal policy. An increase in the money supply for any given interest rate it shifts the LM to the right and giving pressure on the domestic interest rate, Ahtiala P (1998). The shift of the LM curve to the right by increasing money supply is shown in the Figure 2.
Because of the increase in money supply, there will be a fall in the interest rate which will lead to a capital outflow. An increase in the money supply also causes pound to depreciate in the domestic market. Because of the depreciation of the pound and fall in the interest rates in the UK market, the domestic assets become inexpensive in relation to foreign assets which results in an increase in the net exports (NX). An increase in the net exports also increases aggregate demand which shifts the IS curve to the right at the point E2 as it is shown in Figure 2. By shifting the IS curve to the right at point E2, there is an increase in the output as well from the initial equilibrium to the Y1. This shift to the right of the IS curve increases the output and the domestic interest rate then equals to the foreign interest rate. In this case, because of the increase in the natural output and the adjustment of the interest rates, it is very obvious that fiscal policy is more effective rather than monetary policy under the flexible exchange rate regime, Dornbusch and Fisher (1994b).
Fiscal Policy under Fixed Exchange Rates
Under fixed exchange rate regime, an increase in government spending or a tax cut will shift the IS curve to the right from the initial equilibrium Eo to the point E1 as it is illustrated in the Figure 3. When the IS shifts to the right, more specifically at the point E1, interest rates increases and by doing so, there will be more capital inflow in the country from foreign investors. This is very much simple, since the higher the interest rates, the more the attractive domestic assets will be for international investors and as a result the higher will be the inflows of foreign capital in the domestic market Zapatero and Cadenillas (2000). The inflow of capital in the country and the increase demand for pounds leads to an appreciation of the pound. The shift of the IS from the initial position to IS’ creates a new equilibrium E2 where the output of the economy is higher. Thus, the use of fiscal policy under fixed exchange rate is more effective in creating higher domestic output in an economy.
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Under the fixed exchange rate regime, if a Central Bank decides to increase money supply, the LM curve shifts to the right from the initial equilibrium E0 to the new equilibrium E1 as it is illustrated in the Figure 4. At the new equilibrium, the interest rate decreases, so there will be more outflow of the domestic capital to foreign markets.
By the fact the there is an outflow of the domestic capital in the foreign markets, the demand for pounds will decrease which leads to a depreciation of the pound. According to Mishkin (2007), when the domestic currency is depreciated, the central bank must sell its international reserves and buy the domestic currency. It is obvious that by buying the domestic currency from the central bank, its supply decreases and there is a less money in circulation, which means that a money decrease shifts the LM curve to the left by bringing it to its initial equilibrium Eo. From the facts above and from the figure we can conclude that the monetary policy under fixed exchange rate regime is not effective in raising domestic output.
This negative relationship between unemployment and inflation in the short run is explained by the Philips curve. In contrary, in the long run Philips curve is vertical line which is at the natural rate of unemployment. To explain the Philips curve, we must use the aggregate demand and aggregate supply in order to see the swap between inflation and unemployment, Nason and Smith (2008). If an expansionary fiscal or monetary policy is implemented, the aggregate demand will increase and it will move the economy to the higher output (in the short run), which will decline the unemployment.
However, in the long run, because of the fact that aggregate demand increased and prices have increased, produces buy capital and pay workers at a higher price, which means that the IS will shift to the right, unemployment will start to rise again and the economy will end up at the initial output.
In conclusion, it depends from the type of the economy in order to prove the effectiveness of the fiscal and monetary policy. Usually, in a open economy, if a country chooses to keep fixed exchange rate the fiscal policy is very effective tool for increasing the domestic output, however, monetary policy is not effective. On the other hand, if a country decides to keep flexible exchange rate regime the effectiveness of monetary or fiscal policy would be opposite to the fixed exchange rate regime.
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