How Monetary And Fiscal Policies Are Affected By Such An Environment

1175 Words Mar 27th, 2016 null Page
An open economy is characterized by international trade and exchange rates determination and it assumes perfect capital mobility and sluggish prices (Krugman, Obstfeld, and Melitz 2012). In order to assess how and how much monetary and fiscal policies are affected by such an environment, this paper will first analyse their powerfulness in an open economy (both in floating and fixed exchange rates regimes) and afterwards it will address the implications of the ‘trilemma’ (Mundell 1963). Then, two empirical cases (America and China) will be used to show the difficulty in bypassing the ‘trilemma’ by opening to perfect capital mobility without giving up either fixed exchange rate or monetary sovereignty. Finally, building upon theory and the empirical examples, it will be argued that, if an economy is assumed to be open, monetary and fiscal policies are strongly constrained for they have to ease the negative effects deriving from the choice within the ‘trilemma’. To begin with, a country has a fixed exchange rate when its currency’s value is tied to another currency or to the price of gold (Krugman, Obstfeld, and Melitz 2012). Therefore, under a condition of perfect capital mobility, an expansionary monetary policy based on low interest rates in order to face a trade deficit is ineffective, due to the Central Bank sterilization. Indeed, lower interest rates and therefore exchange rates lead to capital outflows. Nevertheless, as the CB needs to keep the peg and cannot allow…

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