Floating Exchange Rates - Fiscal v. Monetary Policy

Monetary policy with floating exchange rates
A reduction in the money supply increases interest rates (by shifting the LM curve to the left) and reduces price inflation (as explained by the quantity theory of money). Under floating exchange rates, higher interest rates will increase the value of the currency. A higher exchange rate will reduce both cost push inflation and demand pull inflation (by reducing net exports). Thus, floating exchange rates make monetary policy more effective at controlling price rises.

Fiscal policy with floating exchange rates
An increase in government expenditure tends to increase interest rates (as the IS curve shifts to the right). Under a floating exchange rate the rise in interest rates will lead to an increase in the value of the currency. The increase in the value of the domestic currency will reduce net exports, worsening the effects of crowding out. Thus fiscal policy is less effective with floating exchange rates.


In both cases interest rates increase. But why does crowding out occur only in the case of fiscal policy??

 

'Crowding out' represents the government hogging the money market when increased interest rates on Government bonds is attractive for bond investors to invest in Government bonds as compared with Corporate bonds.

In effect, the lower uptake of corporate bonds means a lower access to funds for companies, which in turn is linked directly to lower private investment (in inventory and capital goods).

The monumental fiscal equation Y = C + I + G + X - Z hence gets affected. I believe due to the effect of I on Y, which in turn follows from government bond supply, 'crowding out' is a fiscal phenomenon, and not a monetary one.

 

You considered a contractionary monetary policy and an expansionary fiscal policy, so you were not comparing like with like. If you consider an expansionary monetary policy, you will find that an increase in the money supply causes a reduction in interest rates and a reduction in the exchange rate so that aggregate demand increases. Monetary policy is therefore effective with floating rates.

On the other hand, an expansionary fiscal policy will increase interest rates (causing crowding out of consumption and investment) and also increase the exchange rate (causing crowding out of net exports) so that fiscal policy is less effective with floating rates.