Monetary and Fiscal Policy under Floating Exchange Rates: A Two-Country Simulation Analysis

Monetary and Fiscal Policy under Floating Exchange Rates: A Two-Country Simulation Analysis

This paper develops a two-country model with sticky nominal wages and prices to examine the effects of monetary and fiscal policy in a variable output floating exchange rate framework. The model is an extension of the single country framework developed by Dornbusch [5] in the appendix to his seminal paper on exchange rate dynamics. Such a model permits one to derive short-run policy impacts in the context of the asset market approach to exchange rate determination. The major conclusions of this paper are that monetary expansion in the home country causes the home currency to depreciate, output at home to expand, and output abroad to move in an uncertain direction. Also, the current account may either improve or deteriorate. Moreover, in most cases fiscal expansion in the home country causes the home currency to appreciate, output at home and abroad to expand, and the current account to deteriorate.