DE ECONOMIST 134, NR.

4, 1986

MONETARY-FISCAL POLICY ASSIGNMENT UNDER

FLOATING EXCHANGE RATES

BY

JAY H. LEVIN*

This p a p e r examines the use of m o n e t a r y and fiscal policy in a small o p e n

e c o n o m y in which the exchange rate is floating, and in which the g o v e r n m e n t
a t t e m p t s to achieve several m a c r o e c o n o m i c objectives. Because of sticky
wages and prices, full e m p l o y m e n t does not necessarily prevail, and the level
of e c o n o m i c activity, therefore, is taken to be a basic policy target. In addition,
the g o v e r n m e n t is c o n c e r n e d with the composition of output, in terms of the
fraction of gross national p r o d u c t d e v o t e d to investment spending, as part of
an overall growth policy'; and it also regards the country's current account
position as an i m p o r t a n t objective, With respect to the latter possibility,
D o r n b u s c h , for example, has suggested that

External balance, of course, is no problem if we think of it as overall balance of payments

equilibrium that is insured by the flexible rate. External balance remains an objective.
though, if we think of current account targets. A country may wish a particular current
account or trade balance because it may not wish to borrow or lend abroad excessively.:

For a given level of e c o n o m i c activity, it will be shown in Section i below that a

trade-off exists between the level of domestic investment spending and the
c o u n t r y ' s current account position as the monetary-fiscal policy mix changes.
ideally, then, policy-makers can select the monetary-fiscal mix that produces
the target level of e c o n o m i c activity and an o p t i m u m c o m b i n a t i o n of invest-
m e n t spending and current account position. H o w e v e r , in the absence of
reliable quantitative information about the e c o n o m y ' s m a c r o e c o n o m i c struc-
ture (and by implication the above trade-off in quantitative terms), policy-
m a k e r s must resort to assigning instruments to targets. 3 Therefore, Section 2
of the p a p e r discusses the assignment of m o n e t a r y and fiscal policy to the

* Professor of Economics, Wayne State University. The author is grateful to the referee for
helpful comments but must absolve him from all remaining errors.
1 For example, see Gordon [4, pp. I40-142].
2 Dornbusch [1, p. 198]. For extensive discussion of the current account as a possible target of
government policy, and a compilation of official statements indicating such a target, see Salop and
Spitfiller [11, esp. pp. 124-128]; and on possible determinants of the current account, see Dorn-
busch [2] and Sachs [10].
3 The classic discussion of monetary-fiscal assignment underfixed exchange rates is, of course,
Mundell [7]. A major critique is Johnson [5, pp. 314-318].
468 J.H. LEVIN

targets of economic activity and domestic investment spending; and Section 3

analyzes the monetary-fiscal assignment when economic activity and the
current account are the targets. 4 The results of the p a p e r are summarized in
Section 4. The m a j o r conclusion is that monetary and fiscal policy can be
feasibly assigned to either set of targets, although in both cases the system may
respond with oscillations.

1 THE TRADE-OFF BETWEEN INVESTMENT SPENDING AND

THE CURRENT ACCOUNT
The basic premise of this paper is that a target for the level of economic
activity, achieved by the use of monetary and fiscal policy, implies a specific
rate of domestic investment spending and a specific position for the current
account under a floating exchange rate system. Furthermore, changing the
monetary-fiscal mix at the target level of economic activity, so as to, say, raise
the investment c o m p o n e n t of G N P , will simultaneously increase the country's
current account position. Ideally then, the optimum monetary-fiscal mix is the
one that achieves the most desirable combination of investment spending and
balance of payments structure at the target level of income.
These conclusions can be derived from the standard Keynesian open econ-
omy static macro model under floating exchange rates, given below:

s ( % + ~1- M ( f ' , ~ ) = I ( ] ) + X(~r) + G (1)

Q = L ( ~ ' , i) (2)

X(Tr) - 1 M(9, (3)

where Y = real G N P ; rr = exchange rate on the home currency (units of

foreign currency per unit of domestic currency); 1"= domestic interest rate;
S = domestic saving; I - - domestic investment spending; G = government
spending on domestic goods and services; M = volume of imports; X = volume
of exports; Q -- m o n e y supply; L = demand for money; and K = net sustained
capital inflows. P a r a m e t e r signs are shown above the arguments. Equation (1)
is the equilibrium condition for the goods market. H e r e , for simplicity, taxes
have been omitted, and government spending is taken to be the fiscal control
variable. (Alternatively, one can imagine that taxes are included in the saving

4 The rate of inflation is not an explicit target in this paper. However, one can imagine that the
government chooses a particular rate of monetary growth consistent with its goal for the long-run
inflation rate. The actual rate of monetary growth is then allowed to deviate from this number as
monetary policy is assigned to one of the targets considered here.
 M O N E T A R Y - F I S C A L POLICY ASSIGNMENT 469

function.) Also for simplicity, imports are taken to consist only of consump-
tion goods. Equation (2) denotes money market equilibrium, and domestic
goods prices (and wages) are taken to be fixed and normalized at unity.
Finally, equation (3) is the foreign exchange market clearing condition when
capital is imperfectly mobile. Notice that stock-adjustment capital flows and
capital movements stemming from expected changes in the exchange rate are
omitted here since, in the steady state, when the system reaches a short-run
equilibrium, interest rates are stationary and exchange rate expectations are
fulfilled. Also, for the time being, interest payment flows in the current
account are neglected.
Equations (1)-(3) contain the endogenous variables K r and ~r, and the
exogenous policy variables G and Q. Suppose now that the government wishes
to attain a target level of GNP, Y*. Then the choice of any particular combina-
tion of G and Q that produces Y* will also determine a particular rate of
interest. 5 This in turn produces a specific level of domestic investment spend-
ing; and by also establishing a particular level of net sustained capital inflows,
this interest rate implies a specific current account position that exactly offsets
the capital inflows under the floating rate system.
Now suppose the government undertakes monetary expansion and fiscal
contraction so as to leave GNP at Y* but lower domestic interest rates. Then
domestic investment spending will rise, and the reduced capital inflows will be
offset by a smaller current account deficit under the floating rate system. This
will be achieved by a depreciation of the home currency to its new long-run
equilibrium level. The major conclusion, then, is that the level of investment
spending and the structure of the balance of payments are not independent
targets in this policy setting at a given level of economic activity. Choosing one
of them implies a particular state for the other.

2 POLICY A S S I G N M E N T WHEN INVESTMENT SPENDING IS A T A R G E T

We are now in a position to consider the assignment of monetary and fiscal

policy when investment spending, along with GNP, are the policy targets
under the floating rate system. In Figs. la and lb the YY schedule shows
combinations of G and Q for which the level of economic activity is on target.
As is well known from the work of Fleming [3] and Mundell [8], as long as
capital is less than perfectly mobile, fiscal expansion raises the level of eco-
nomic activity under the floating exchange rate system, and monetary expan-
sion has the same effect for any degree of capital mobility. 6 Consequently, the

5 If capital is perfectly mobile, the equilibrium interest rate is set in the rest of the world.
Although domestic investment spending is no longer affected by the monetary-fiscal policy mix,
the current account is still sensitive to it.
6 The relevant multipliers from system (1)-(3) are d Y / d G - -L,./A; and dY/dQ = ( K ; - IOA,
where A = - s L , . + L y ( K , - I , ) , s denoting (SS/SY).
470 J.H. LEVIN

YY schedule is downward sloping. Similarly, the II schedule shows combina-

tions of G and Q for which the level of investment spending is on target. Here
the Fleming-Mundell model indicates that, with imperfect capital mobility,
fiscal expansion raises interest rates and therefore produces a cutback in
investment spending; whereas monetary expansion lowers interest rates,
thereby stimulating investment spending5 Hence, the II schedule is upward
sloping.

i k_~ v I/ _.j "¥

6 G

Figure la - Monetary Policy Assigned to Figure lb - Fiscal Policy Assigned to

Investment Spending Investment Spending

In this kind of situation, the policy instruments do not have a comparative

advantage with respect to the policy targets, so that two assignments are
feasible, s In Fig. la, fiscal policy is assigned to the GNP target, and monetary
policy to the investment target. To see how the system might respond to this
assignment, imagine that the economy is initially at point a, where GNP is
below Y* and investment spending below its target level, I*. This situation
calls for both monetary and fiscal expansion, which eventually move the
economy to the output target at b. However, since investment spending
remains below I*, the monetary expansion continues, pushing GNP above Y*.
Consequently, the fiscal authorities begin to reduce government spending,
thus reinforcing the decline in interest rates produced by the monetary expan-

7 The relevant multipliers from the model are d r / d G = L v / A ; and d r / d Q - - s / A .

8 It is conceivable that fiscal expansion could lead to an increase in investment spending despite
its effect on interest rates. For the increased GNP could cause firms to revise their sales forecasts
upwards, thus favoring higher investment spending. In the event that fiscal expansion did have this
effect, the II schedule would be downward sloping and flatter than the YY schedule. Monetary
policy would have a comparative advantage over investment spending and should always be
assigned to that target.
 MONETARY-FISCAL POLICY ASSIGNMENT 471

sion. The upshot is that the investment target is eventually achieved at c; but
the on-going fiscal contraction continues to lower interest rates, eventually
causing investment spending to rise above I*. The system proceeds in this
oscillatory fashion until both targets are eventually attained. 9
In Fig. lb monetary policy is assigned to the GNP target, and fiscal policy to
investment spending. Suppose again that GNP is initially below Y* and
investment spending below I* at point d. The GNP shortfall now calls for
monetary expansion, but the investment shortfall elicits fiscal contraction.
Consequently, as the result of lower interest rates, the investment target is
now the first one to be achieved. The fiscal contraction then ceases at point e,
but the monetary expansion continues because of the GNP shortfall. Interest
rates thus continue to decline, now pushing investment spending above I* and
inducing fiscal expansion. With both monetary and fiscal policy now operating
in an expansionary direction, GNP eventually reaches Y* at point f. Here the
monetary expansion comes to an end, but the continued fiscal expansion now
forces GNP above its target level. Once again, the system proceeds in an
oscillatory manner until both targets are ultimately reached, m
In choosing investment spending as a target, the government must be aware
of one potential limitation. To illustrate, imagine that investment is initially
below its target level by the amount I* - Io, but that GNP is at Y*. The solution
requires a decline in interest rates in the amount ( I * - I o ) / I r, leading to a
reduction in sustained capital inflows in the amount Kr(I* - I o ) / I r. Thus the
current account deficit must decline by this amount, and from equation (1)
government spending must be reduced by the amount ( K , - I,) (1" - Io)/I ,. to
keep GNP on target. The potential problem is that these required changes in
the current account and government spending increase with the degree of
capital mobility. So if capital is highly mobile, the solution may involve a vast
change in the current account position and an even larger change in govern-
ment spending (or taxes) that would be regarded as unacceptable. Indeed, if
capital is perfectly mobile, no amount of change in the current account and
government spending will matter since interest rates are tied to the outside
world level, completely fixing investment spending. The moral is that high
capital mobility may limit the government's ability to alter investment spend-
ing by a significant amount, and perfect capital mobility eliminates it com-
pletely. Of necessity, the current account then becomes the second target.

9 It is certainly possible that the system will converge without oscillations from points b or c, as
shown in section 1 of the Appendix. For example, a high interest sensitivity of the demand for
money tends to enlarge the fiscal policy multiplier on output. Since fiscal policy is being assigned to
GNP, this increased leverage favors direct convergence of the system.
10. Again, the system need not converge with oscillations, as shown in the Appendix. For
example, a high degree of capital mobility would increase the leverage of monetary policy over
GNP. Since monetary policy is being assigned to the output target, the chances for direct
convergence are increased.
472 J.H. LEVIN

3 POLICY ASSIGNMENT WHEN THE CURRENT ACCOUNT IS A TARGET

N o w c o n s i d e r the a s s i g n m e n t of m o n e t a r y a n d fiscal policy w h e n the structure

of the b a l a n c e of p a y m e n t s and G N P are the policy targets u n d e r the floating
rate system. Fig. 2a a n d 2b again c o n t a i n a d o w n w a r d sloping Y Y schedule,
given the a s s u m p t i o n of imperfect capital mobility, u T h e C C schedule shows
c o m b i n a t i o n s of G a n d Q for which the c u r r e n t a c c o u n t is at its target level.
This schedule is u p w a r d sloping b e c a u s e fiscal a n d m o n e t a r y e x p a n s i o n have
o p p o s i t e effects o n the c u r r e n t account. By raising G N P a n d thus interest
rates, fiscal e x p a n s i o n increases net sustained capital inflows a n d t h e r e f o r e
p r o d u c e s an increase in the c u r r e n t a c c o u n t deficit. 12M o n e t a r y e x p a n s i o n , o n
the o t h e r h a n d , lowers interest rates, leading to a decline in net sustained
capital inflows a n d t h e r e f o r e a decrease in the c u r r e n t a c c o u n t deficit via
c u r r e n c y d e p r e c i a t i o n . ~s

Figure 2a - Monetary Policy Assigned to the Figure 2b - Fiscal Policy Assigned to the
Current Account Current Account

11 If capital is perfectly mobile, fiscal policy becomes powerless to affect GNP, and the YY
schedule becomes horizontal. However, the two assignments discussed in this section still remain
feasible. The only modification is that the fiscal policy-current account assignment necessarily
converges without oscillations.
12 In the case of perfect capital mobility, it is well known that the tendency for interest rates to
rise leads to a currency appreciation and an increase in the current account deficit that exactly
offsets the fiscal expansion. With imperfect capital mobility, the offset is only partial. The relevant
multiplier is d ( X - (1/Tr)M)/dG = - K r L r / A , decreasing algebraically to -1 as K,,-+~c.
13 In the case of perfect capital mobility too. the tendency for interest rates to decline causes a
depreciation of the currency and a smaller current account deficit. Indeed. the latter is the
mechanism by which aggregate demand expands: but with imperfect capital mobility, the current
account deficit decreases by a smaller amount. Here d ( X - (1/rr)M)/dQ = K,s/A, increasing to
s / L r as K,.--+:c.
 M O N E T A R Y - F I S C A L POLICY ASSIGNMENT 473

Once again the policy instruments do not possess a comparative advantage

with respect to the policy targets, and both assignments are feasible. In Fig. 2a,
fiscal policy is assigned to the GNP target and monetary policy to the current
account. Starting at point a, where GNP is below target and the current
account deficit is too large (or surplus too small), the government undertakes
both fiscal and monetary expansion, and the economy eventually reaches the
GNP target at b. 14 However, the current account deficit is still above target
here, and the expansionary monetary policy therefore continues, pushing
GNP above its target level. Consequently, the fiscal authorities now begin to
contract government spending, and both policies operate to eventually move
the current account deficit to its desired level at point c. However, with GNP
still above target, the fiscal contraction continues, and the current account
deficit now moves below its target level. This oscillatory behavior of the
system continues until both targets are eventually achieved. 15
In Fig. 2b monetary policy is assigned to the GNP target, and fiscal policy to
the current account. Starting again in a situation of a GNP shortfall and the
current account deficit above its target level at d, the current account position
now calls for fiscal contraction, while the central bank undertakes monetary
expansion. Consequently, with the policies conflicting with each other with
respect to the level of GNP, the current account target is the first to be
achieved at e. However, the monetary expansion continues because of the
GNP shortfall, and the current account deficit now moves below target.
Consequently, the fiscal authorities begin to increase government spending,
and with both policies operating in an expansionary direction, the target level
of GNP is eventually reached at f. Here the monetary expansion ceases, but
the continued fiscal expansion now causes GNP to move above its target level.
This cyclical movement continues until both targets are attained.16
Although both assignments have been shown to be feasible when the
current account is one of the targets, a complication now arises when interest
payment flows are incorporated into the model. As is well known, the re-
sponse of these flows to interest rates is in the direction opposite to the
response of the sustained capital flowsJ 7 Consequently, monetary and fiscal
policy will have an uncertain effect on the trade balance, which depends on the

14 The government might incorrectly believe that the current account position calls for monetary
contraction, on the grounds that the latter's deflationary effect on the economy would help correct
the external situation. However, this belief ignores the overwhelming effect that the resulting
exchange rate appreciation eventually would have on the current account. Following such an
incorrect policy would cause the system to diverge explosively front point a in a south-easterly
direction.
15 As before, the path of the system need not be oscillatory, as shown in section 2 of the
Appendix.
16 Once again, the system can be noncyclical. High capital mobility favors this possibility, and
indeed it is easy to show that perfect capital mobility guarantees it.
17 See, for example, Willett and Forte [12].
474 J.H. LEVIN

response of sustained capital flows and interest payment flows combined; and
the trade balance, therefore, cannot be used reliably as a target. Nevertheless,
the current account, including interest payment flows, remains a feasible
target since its response to monetary and fiscal policy depends only on the
latters' effect on sustained capital flows. The implication then is that the
government must have data on the entire current account, and not just the
trade balance, when setting its policies according to the assignment rules
discussed above. Fortunately, from a welfare viewpoint, the current account is
the proper measure of the net resources being lent to or borrowed from
foreigners, and therefore it is a more appropriate target than the trade balance
anyway.

4 CONCLUSIONS
This paper has developed a model in which monetary and fiscal policy can be
used to achieve a target level of economic activity and either an investment
spending or current account target. A choice may have to be made between
the latter two objectives because, for a given level of economic activity, a
trade-off exists between them as the monetary-fiscal policy mix changes.
Specifically, an easier monetary and tighter fiscal policy combination increases
investment spending and reduces the current account deficit. However, as the
degree of capital mobility increases, so does the rate of trade-off between
these targets, and the case for choosing the current account as a target becomes
stronger.
Once the choice between investment spending and the current account has
been made, assigning monetary and fiscal policy leads to a convergence of the
system, although possibly an oscillatory one, because the policies are always in
a tug of war with respect to one of the targets. Furthermore, either monetary or
fiscal policy can be assigned to the GNP target, and the other policy to the
second target.
Finally, the reader is reminded that these conclusions are derived from a
very simple open economy Keynesian model, in which capital flows depend
only on the interest differential between domestic and foreign assets. How-
ever, if one drops this Occam's Razor approach, a more elaborate represen-
tation of the capital account under conditions of imperfect capital mobility is
possible, including a specification of exchange rate expectations, 18although I
would conjecture that the policy models would remain stable under either
inelastic or rational expectations. A second simplification is the absence of lags
in the model, an approach that is standard in the assignment problem litera-
ture. However, as Phillips [9] demonstrated long ago, too forceful an appli-
cation of integral stabilization policy - the type considered in assignment
models - can produce explosive movements in a macroeconomic system when

18 For example, see my paper [6].

 MONETARY-FISCALPOLICY ASSIGNMENT 475

outside lags are present. Consequently, if the assignment rules in this paper
were followed, monetary and fiscal changes might have to be made quite
gradually in order for the system to converge.

APPENDIX

1 G N P and Investment Spending as Targets"

When monetary policy is assigned to the investment target and fiscal policy to
GNP, the dynamic system may be represented as follows:

dQ-fijr[dr + ~ r ( G - G*)] (/3,<0)

dt d Q (Q - Q*) dG (al)
dG [dY + dY (G_G,) ] @_~<0)
dt -/32 d-Q (Q - Q*) d G -

where 13~and 132 are speed of adjustment coefficients, and Q* and G":"denote
the unknown optimal levels of Q and G, respectively. The characteristic
equation of this system is

dr dY dr d Y ) = 0 . (A2)
22+2 (-/J* I"do
dr _ / ~ 2d ~Y ) + filfi21,.(d_Q dG dG dQ

From system (1)-(3) in the text, dr/dQ = - s / A ; dr/dG = Ly/A; dY/dQ =

(K, - I,)/A); and dY/dG = - L J A , where A = - sL, + L~,(K, - 1,). Thus, the
coefficient of 2 and the constant term are positive, and the system is therefore
dynamically stable. Furthermore, the system is noncyclical if and only if the
discriminant of (A2) is positive, and this condition reduces to

(fi,l,.s - fixL,.) 2 + 4t3' fix 1,.Ly ( K,. - /,.)>0, (A3)

which can be satisfied if, for example, [L,.! is sufficiently large.
The reverse assignment is given by

dr dr ( G - G'~)] (9~>0)
dGdt - fi3I" -dQ (Q - Q*) + d G
(A4)
dQ dY + dY
~4<0)

the characteristic equation of which is

476 J.H. LEVIN

,~2_~2 [--/~3 , ~ dY I ( dr dY dr dY =0. (A5)

/ l d r - f i a d - O ) +fi~fi4 "kdG dQ dO dG)

The coefficient of 2 and the constant term are again positive, and the system is
stable. It is noncyclical if and only if

[fl3I,.L,, - t34( K,. - I,)12 + 4fi3fl 4sL, l_.>O, (A6)

which is guaranteed, for example, by a large enough value of the capital

mobility parameter, K r.

2 GNP and the Current Account as Targets"

When monetary policy is assigned to the current account and fiscal policy to
GNP, the dynamic system becomes

dQ _ 01[( B~ d~r m d V t (Q - Q*) +

dt dQ dQ ]
( d~r dY) (G - G*)] (0,<0)
B,~ d G - m d-G-
dG_07[dY + dY ( G - G * ) I (A7)
(02<0)
dt - d O - ((2 - Q*) dG

where from system (1)-(3), drr/dQ = (-K,.(s + m) + mI,)/-B~A); and

d~r/dG = (KrL Y + mL,.)/-B,A). B~ denotes X~ - M~ + M (<0 by virtue of the
Marshall-Lerner condition) and m represents DM/DY. The characteristic
equation of this system reduces to

[OK dr__o d Y ] ( d Y dr dY 2 ; )
,v +,z t ' 'dO 27d~/+ 0,0~K, dQ dG dG = 0. (as)

This system is clearly dynamically stable, and it is noncyclical if and only if

(01Krs + 02L,) 2 - 4010~(K, - I,)K, L y > O . (A9)

This condition can be satisfied if, for example, ]L,.I is sufficiently large.
The reverse assignment is given by
 MONETARY-FISCAL POLICY ASSIGNMENT 477

d G - 0 3 [ B ~ - dTr
--m dY ) (Q-Q*)+
dt dQ dQ
(B, drr rn dY ] ( G - G*)] (03>0)
dQ -dG-J

d O _ 04 [ d Y d Y (G - G*)] (04<0) (Am)

dt d Q (Q - Q*) + d - G

the characteristic e q u a t i o n of which reduces to

( dr - 0 dY] (dr dY dr dY)

=0. (All)
470 + O<Xr dO dC dC dQ

This system is also dynamically stable, and it is noncyclical if and only if

[03K,L v + 04(K, - 1,,)]2 - 40304K,.L,£>O. (A12)

This condition is fulfilled, if, for example, II,.l is sufficiently large.

REFERENCES

Dornbusch, R., Open Economy Macroeconornics, New York, 1980.

Dornbusch, R., 'Real Interest Rates, Home Goods, and Optimal External Borrowing,' Journal of
Political Economy, February, 1983, pp. 141-153.
Fleming, J.M., 'Domestic Financial Policies under Fixed and under Floating Exchange Rates,'
I.M.F. Staff Papers, No. 3, 1962, reprinted in: R.N. Cooper (ed.), International Finance,
Harmon&worth, 1969.
Gordon, R.J., Macroeconomics, Boston and Toronto, 1984.
Johnson, H.G., 'Theoretical Problems of the International Monetary System,' Pakistan Develop-
ment Review (1967), reprinted in: R.N. Cooper (ed.), b~ternationalFinance, EIarmondsworth,
1969.
Levin, J.H., 'The Dynamics of Stabilization Policy under Flexible Exchange Rates: A Synthesis of
the Asset and Neo-Keynesian Approaches,' Oxford Economic Papers, November, 1980, pp.
411-427.
Mundell, R.A., 'The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange
Rates,' I.M.F. Staff Papers, March, i962, reprinted as Chapter 16 in: R.A. Mundell, Interna-
tional Economics, London, 1968.
Mundell, R.A., 'Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange
Rates,' reprinted as Chapter 18 in: R.A. Mundell. International Economics, London, 1968.
Phillips, A.W., 'Stabilization Policy in a Closed Economy,' Economic Journal, June, 1954.
Sachs, J,D., 'The Current Account and Macroeconomic Adjustment in the 1970's,' Brookings
Pape~ on Economic Activity, 1: 1981, pp. 201-282.
Salop, J. and E. Spitfiller, 'Why Does the Current Account Matter.'?'I. M. F. Staff Papers, March,
1980, pp. 101-134.
478 J.H. LEV[N

Willett, T.D. and F. Forte, 'Interest Rate Policy and External Balance,' QuarterlyJournal of
Economics, May, 1969, pp. 242--262.

Summary

MONETARY-FISCAL POLICY ASSIGNMENT UNDER FLOATING EXCHANGE

RATES

This paper examines the use of monetary and fiscal policy in a small country model under floating
exchange rates. The government attempts to achieve a target level of economic activity and either
an investment spending (output composition) or current account target. However, a choice may
have to be made between the latter two objectives because a trade-off exists between them as the
monetary-fiscal policy mix changes. It is shown that either monetary or fiscal policy can be
assigned to the GNP target, and the second policy to one of the other targets, although the path
may be oscillatory.