Expenditure changing and expenditure switching: Effects of Expenditure Changing Policy
Although it is expected that expenditure changing policy with fiscal policy changes can affect output in the short run regardless of whether the exchange rate is flexible or fixed, its effect, or the ‘‘multiplier of fiscal policy,’’ is smaller in an open economy than in a closed economy. When fiscal expansion is implemented, money demand and thereby the interest rate increase. This rise discourages, or ‘‘crowds out,’’ private investment. This outcome arises as long as some degree of price stickiness is assumed. Hence some of the effect of fiscal expansion will be offset by the crowding out of investment, which makes the overall effect on income and also net exports (i.e., EXIM¼SI) smaller than what could have been if the interest rate were assumed to be constant. Also, the multiplier is smaller the more open to international trade the economy is, because a greater portion of income ‘‘leaks out’’ of the system in the form of demand for foreign goods.
Expenditure changing policy with monetary expansion, on the other hand, involves a reduction in the interest rate in the short run, which expands income and worsens net exports. Both types of expenditure- increasing policies function in the same way: income rises while current account worsens in the short run. However, while monetary expansion favors private investment, fiscal expansion favors government spending.
Under the fixed exchange rate system, while monetary policy becomes ineffective, the effect of fiscal policy can be larger than under the flexible exchange rate system. When expansionary fiscal policy is implemented, the interest rate would rise because of the crowd-out effect. At the same time, however, the central bank would have to implement accommodative, that is, expansionary, monetary policy to cancel the rise in the interest rate. The action of canceling the effect on the money supply or interest rate is called sterilization.Otherwise, the interest rate would be affected, and that would affect the capital flows across the border (given the unchanged foreign interest rate) and therefore the exchange rate. Because fiscal expansion must be accompanied with sterilization, the effect of fiscal expansion on output is larger than that under the flexible exchange rate systemwhere the exchange rate is allowed tofluctuate to reflect the change in the interest rate.