Fiscal policy refers to the term of government policy and it is considered as one of the main methods of state intervention into the national economy in order to reduce the business cycles fluctuations and provide a stable economic system in the short term. The main instruments of fiscal policy are the revenues and expenditures of the state budget, taxes, transfers, and government purchases of goods and services. The main goal of fiscal policy is to control aggregate demand by changing the rates of taxation and government spending. Government fiscal policy is able to affect the following objectives: changes in real national output and employment, inflation control and economic growth. Therefore, the fiscal policy means the regulation and taxation of the state budget in order to stabilize and revive the economy.
Internal and External Equilibrium
In the open economy the challenge of macroeconomic management is to achieve internal and external equilibrium. It requires taking into account the mutual influence of both internal and external variables. The problem is complex because of the existence of the variables simultaneous feedback effect that can be both immediate and long run.
Internal equilibrium involves supply and demand at the level of full employment without inflation (or a stable low level). In a short period of time problem of internal balance can be solved by regulating an aggregate demand through fiscal and monetary policy. External balance refers to the maintenance of the zero payments balances in particular exchange rate regime. Sometimes the problem can be divided into two independent variables: the achievement of a current account and maintaining a given level of foreign currency reserves. Governmental requirements remain the same: monetary and fiscal policy, but sometimes they can be shown as an independent exchange rate policy. The task to achieve external balance is influenced by a wide range of factors. Among them is mobility of capital that can be described as the intensity of the first inter-country transfer of capital in response to fluctuations in domestic interest rates, which relates to its world-class. In fact, the maintenance of the external and internal balance is the problem of three markets functioning namely commodity, money and foreign exchange.
In case of the regime of the floating exchange rate fiscal policy is very important trade variable, and therefore the balance of payments should be used in order to achieve external balance The internal balance, on the other hand, should be regulated by the monetary policy. The expansion of the money supply lowers the interest rate and leads to higher costs. The increase of spending stimulates the growth of imports and the trade balance deteriorates. Account deficit contributes to capital flight, which in turn lowers interest rates. Growth of import and the outflow of capital increase the demand for foreign currency and thus cause local currency devaluation.
This depreciation enhances the competitiveness of the exporters, leading to the improvement of the trade balance. Export growth means an increase in demand for the inner products, which increases economic growth, caused by the initial increase in the money supply. Thus, monetary policy has a significant impact on domestic income, both directly through the monetary growth and indirectly through the reduction of the exchange rate and the increase of exports. Thus, the effectiveness of monetary policy in an open economy depends on the exchange rate and the degree of capital mobility and their impact on the degree of currency depreciation.
However, thinking about the complex transmission mechanism of monetary policy, it can be assumed that it has positive effect on the level of net export, rather than on internal incentives to expand production (lower interest rates). An increase in demand for domestic products will occur due to the decrease in demand for exports against the outflow of capital and currency depreciation. Therefore, the positive impact of monetary policy on the internal balance will be quite specific.
The Mundell-Fleming Model
The Mundell-Fleming model is the example of the integrated macroeconomic theory of international trade and financial policy. It was developed in 1960s by the British economist J.M. Fleming and Canadian R. Mundell. The main aim of the model is to show that fiscal policy cannot affect the output, at the same time the monetary policy is very effective under the regime of flexible exchange rate. The model shows that growth of government spending affects the internal and external balance in two ways: through income and through the interest rate. Income growth (through the multiplier effect) increases import; the trade balance deteriorates and lowers the currency.
The same increase in government spending means that the government increases borrowing, which leads to higher interest rates. Higher rates stimulate the inflow of capital from abroad, which increases the rate of the national currency and improves the capital account. The final result will depend on the degree of capital mobility. Low capital mobility will dominate the first channel of fiscal expansion influence, i.e. through the income. Insignificant capital inflows cannot compensate the trade deficit, and hence the fall in the exchange. Cheaper currency will create favorable conditions for export growth, which will eliminate the deficit of the balance of payments.
Export growth will have a positive impact on the increase of the domestic production budget. However, capital mobility will strengthen the impact on the capital account balance of payments and the exchange rate. This will lead to the exports decrease and cause even greater deficit of the trade balance. Large capital inflows will offset the deficit and equilibrate the overall balance of payments.
Thus, in contrast to the clear positive impact on domestic income of the monetary policy, fiscal policy can be effective only for the low mobility of capital, which confirms the assumption of the different roles in economic policy under a floating exchange rate.