#### 21.4.2 Fiscal policy with fixed exchange rates

As we have seen above, fixed exchange rates severely limit the possibilities of monetary policy. Monetary policy can ultimately only react to shocks and changes. For fiscal policy shocks, this leads to a considerable multiplier effect on economic growth. The graph below illustrates this.

Expansive fiscal policy

If government expenditure is increased from ${G}_{0}$ to ${G}_{1}$ , slider to the right, the IS curve shifts to the right. The new ISLM equilibrium $G{G}_{Z}$ with higher interest rates and higher GDP (${y}_{0}$ increases to ${y}_{Z}$ and ${r}_{0}$ to ${r}_{Z}$) is established on the domestic goods market. However, the increased income leads to rising imports and thus to a negative current account balance (fictitious point B in the 3rd quadrant). This shifts the FF curve upwards, resulting in an imbalance on the foreign exchange market: with the fixed exchange rate $\overline{S}$, interest rates would have to rise to as high as point A in the 4th quadrant to balance the current account deficit. However, due to the expansive fiscal policy, they have even risen to ${r}_{Z}$ (point C). Although the current and capital account are developing in the same direction, there remains an interest rate gap between point A and point C, which represents a positive balance of payments ($K\left({r}_{Z}\right)>-B\left({y}_{Z},{S}_{0}\right)$). This imbalance is also evident from the fact that in this situation the BP(${S}_{0}$) line does not pass through the domestic goods market equilibrium. The interest rate gap implies an appreciation pressure, which the central bank must counteract by increasing the money supply to ${M}_{1}$. As a result, the LM curve shifts to the right and interest rates fall again slightly, while the GDP continues to rise.

Conclusion: The expansive fiscal policy causes an appreciation of the currency, which, by increasing imports, dampens the growth impulse and lessens the interest rate impulse. A part of government demand is thus satisfied by foreign countries and cannot have a growth-promoting effect.

The profits from printing the new money flow to the government as so-called seigniorage profits. The government thus experiences a double positive effect: the economy grows and the government receives additional billions in taxes and seigniorage profits. This is called accommodative monetary policy. Herein, monetary policy supports and reinforces fiscal policy measures, even though this is not actually the formal goal of the monetary policy, but the fixed exchange rate.

Recession and accommodative monetary policy

Of course, in the event of a recession the opposite applies: in order to prevent a depreciation as a result of austerity measures, the central bank must implement a restrictive monetary policy, i.e. reduce the money supply. A double negative effect results: in addition to the recession, potential seigniorage gains are lost, since the reduction of the money supply reduces the profits of the central bank, and the reduction of the money supply further exacerbates the recession.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de