This paper examines the widely accepted proposition that the fiscal stimulus saved Australia from the worst effects of the Global Financial Crisis (GFC). It presents theoretical and empirical arguments supporting the view that fiscal stimulus is ineffective in a floating exchange-rate regime. It underlines this by comparing Australia’s experiences in the East Asian Crisis of 1997 and the GFC of 2008–09. It concludes that a depreciating exchange rate protected the Australian economy in the 1997 crisis, but was prevented from doing so in the 2008–09 crisis by the fiscal stimulus.
The Mundell-Fleming model (Mundell 1963) throws light on the relative ...view middle of the document...
If a budget deficit is expanded, the economy will be stimulated. That is, fiscal policy is effective.
Floating exchange rate: An increase in RA will cause an appreciation of the Australian dollar so that e* increases, maintaining the uncovered interest-rate parity relationship. This appreciation will reinforce the tightening of monetary policy. Monetary policy is effective.
An increase in the budget deficit, however, will cause an appreciation of the Australian dollar, increasing e*. This will offset the expansionary effect of the deficit.
The conclusion of this discussion is that fiscal stimulus is likely to be ineffective in an economy with a floating exchange rate. A fiscal stimulation is an accelerator connected to a brake (the appreciating currency). This point is underlined in the next section by a basic macroeconomic model.
A Macroeconomic Model Including Exchange-rate Effects
The following macroeconomic model illustrates the points made in the previous subsection.
Expenditure, C + I = A + aCP + b (Y – T)
CP = commodity price index
Exports, X = – eE + gCP
Imports, M = d (Y – T) + hE
Exchange Rate E = mD + nCP
D = budget deficit = G – T
The rationale for this equation is that increased government borrowing leads to capital inflow, which causes the currency to appreciate. An empirical equivalent of this equation is:
E = 0.517 + 0.00105CP + 4.75GB + 0.010IRD
(9.93**) (2.75*) (3.88**) –(2.07*)
R2 = 0.442 d = 1.38 1983–2008
E = A$/US$ exchange rate
CP = RBA commodity price index, in US dollars
GB = ‘net lending of all public authorities’ (RBA statistical tables)
IRD = interest-rate differential based on three-month US and Australian interest rates
The figures under the coefficients are t-values. Asterisks indicate the level of significance, with one asterisk indicating significance at the five percent level and two asterisks indicating significance at the one percent level. (The CUSUM of squares test indicates that the relationship is stable.)
To find the equilibrium income.
AS = AD
Y = A + aCP + bY – bT + G + (X – M)
Therefore, p37 image insert.jpg
Note first that the impact of commodity prices on equilibrium income is reduced by their impact on the exchange rate, then on exports and imports (= n[e + h]). This outcome illustrates the role that the exchange rate has in adjusting the economy to fluctuations in commodity prices. For example, an increase in commodity prices leads to an appreciation of the dollar, which reduces exports and increases imports. This reduction in net exports reduces the degree of overheating that the increase in commodity prices might otherwise engender. In this way, the floating exchange rate serves to insulate the Australian economy from overseas developments. Note also that the impact of the budget deficit is reduced by its effect on the exchange rate, then on exports and imports (= m[e + h]).
It is surprising...