Re-examining the Effectiveness of Stabilisation Policy

Abstract

This paper develops an alternative international macroeconomic model for evaluating the effectiveness of fiscal and monetary policy in stabilizing national income under fixed and floating exchange rates. It encompasses national output and income, saving, investment, the current account, interest rates and the money supply, while incorporating long-recognised linkages between the exchange rate, price levels and real interest rates, consistent with conventional international parity conditions. It concludes that the exchange rate regime is ultimately not a critical determinant of the effectiveness of fiscal and monetary policy. Importantly, it predicts that fiscal expansion in the form of reduced public saving is counterproductive as a means of stabilising national income, irrespective of exchange rate choice. Contrary to standard international macroeconomic theory, the model implies that fiscal consolidation strengthens the balance of payments, exchange rates and national income.