Short- and Long-Run Effects of Monetary and Fiscal Policies under Flexible Exchange Rates and Perfect Capital Mobility

Following the pioneering papers by John M. Fleming and Robert Mundell, a substantial literature has accumulated incorporating the Keynesian analysis of the effects of monetary and fiscal policies in the open economy under flexible exchange rates and perfect capital mobility. The general policy result which followed from this line of research has been the verification of the presumption that monetary policy is an effective stabilization tool under flexible exchange rates, while the ability of fiscal policy to affect the level of economic activity varies inversely with the degree of international capital mobility. The key to the results lies in the differential effect of both policies on the direction of the induced capital flows and thus on exchange rate movements. The latter in turn affect the trade balance and aggregate demand. To my knowledge, however, all authors have either been concerned with the derivation of short-run or "impact" multipliers describing the effects of monetary and fiscal policy on the level of economic activity or have otherwise ignored the "longer-run" effects of policy-induced changes in the level of international indebtedness and the service of that debt. Abstracting from growth and persistent shocks, it is reasonable to assume that, given enough time following the policy change, individuals will adjust their international portfolios of assets to the new desired proportions such that capital flows eventually cease. When long-run portfolio equilibrium is thus reached, the service account deficit of the balance of payments must necessarily be equal to the net export surplus (the trade balance), the exchange rate being the natural instrument through which this long-run external balance condition is achieved. It is therefore natural to conceive of the long-run level of the service account as the primary determinant of the long-run trade balance. In view of the above and the fact that in a Keynesian-type economy the trade balance plays a crucial role in the determination of the level of economic activity through its effects on aggregate demand, it follows that a longerrun analysis of the effects of monetary and fiscal policy cannot logically ignore the consequences of those policies for the service account. In this paper I intend to explore the longrun implications of induced changes in the level of the service account for the effects of monetary and fiscal policy; in the process of doing so, I will develop a simple model whose basic structure resembles that of Fleming and Mundell although it is modified to explicitly incorporate the stocks of domestic and foreign securities held. In order to provide the reader with a clearer perspective on the problem at hand, let us first discuss the impact effects of monetary and fiscal policy in the context of the standard short-run model. Given the Keynesian structure of the economy either policy will increase domestic income (and employment) only to the extent that it succeeds in expanding aggregate demand of which the trade balance is one component. At a given exchange rate, expansionary fiscal policy would increase aggregate demand but at the expense of a higher domestic interest rate (the "crowding out" effect); *Columbia University. I am indebted to G. Borts, L. Girton, and D. Henderson for their comments and suggestions. A preliminary version of this paper was written while I was visiting scholar at the Division of International Finance of the Board of Governors of the Federal Reserve System. The views expressed here should not be interpreted as necessarily those of the Board.