It has been argued that Free capital flows, exchange rate regime and autonomous independent monetary policy do not fit well along the economic cycle. In fact, those targets cannot be achieved simultaneously .Sooner or later,one of those variables has to be modified for keeping monetary policy effective enough such that the aggregate economic activity stay stable. This is the impossibility triangle, based upon fiscal policy fully effective with fixed exchange rate, and monetary policy fully effective with flexible exchange rate, ruling out the chance of both a coordination and complementary policy mix. If an economy want to achieve an autonomous interest rate policy, and stabilize the exchange rate at the same time, it has to introduce capital controls. Mundell(1963)
But what a difference does it make the Budget Surplus rule ?.Capital flows have an impact on exchange rates in smaller economies. From the financial point of view, keeping everything else constant, exchange rate fluctuations depend on capital inflows(appreciation) ,or outflows (depreciation). These exchange rate variations are not neutral. Leaving aside distributive effects, these variations have an impact on both those firms with heavy foreign currency debt after the depreciation,and the competitiveness of the exports sector due to appreciation.
Thus ,given exchange rate fluctuations,the monetary policy should change the interest rate to cope with its implications, but as long as it lacks complementary fiscal policy, it has to deal with key constraints which affect its independence and effectiveness. Given floating exchange rate regime, the options are increasing interest rates(exchange rates depreciation) or reducing interest rates(exchange rates appreciation), and along with it the risk of deeper aggregate demand contraction in the former case(increasing interest rates), or an over expansion of aggregate demand in the latter case(reducing interest rates).In both cases, external surplus adjust itself to the new foreign relative prices . But monetary policy, is constrained in its ability to reduces volatility on aggregate demand sector arising from exchange rates fluctuations, so the magnitude of interest rate adjustment must be evaluated beyond its target of external balance, to deal with internal balance or domestic economic stability which is the scope of Fiscal Policy .-
In a case contractive monetary policy(higher interest rate) is applied, a fiscal policy rule (Structural budget surplus rule) can mitigate the impact on domestic economic activity, because it allows self-stabilizing factors to take place,allowing monetary policy to focus only in its own target. Previous public saving are available for countercyclical spending, reducing the impact on domestic activity of higher interest rates and along with it a better risk control of a recession.In the other case (lower interest rate), the rule of saving the excess of income over the cyclical adjusted expenditures,compensates the expansionary pressures in aggregate demand, allowing such a countercyclical action to keep internal balance.
Therefore, with this fiscal policy rule, monetary policy has a back up for more flexibility and autonomy to manage the effect of capital flows fluctuations. The argument can go even further with the “sudden stop” scenario. Calvo (2003).The expected reaction of monetary policy in such a case, can be complemented in the short run with the Structural Budget surplus rule, softening the impact on growth. Piasecki & Wulf, (2013)
The Chilean evidence,support that the fiscal policy became less correlated with the economic cycle after the structural budget surplus was applied, decreasing from 0.77 (1990-2000) to 0.57 (2001-2011). Therefore, a countercyclical fiscal policy ,complements properly monetary policy in such a way that output volatility decreases (Larraín, 2011).Furthermore, it make work the three variables of the triangle: exchange rate regime, the capital flow and the independent monetary policy, in such a way that it ends up reducing the welfare loses arising from unexpected capital flow fluctuations.
In the Chilean economy, the gross debt/GDP ratio,decreased from 23%(1990-2000) to 9% (2001-2011). Besides, a responsible fiscal policy demonstrated public commitment to stability. That reputation for responsible fiscal policies ,translated into the ability to borrow money at favorable (lower) rates, since lenders look at the overall health of the economy, and its ability to manage its resources wisely as a proxy for lower risk level.(Frankel ,2011).In Chile, between 1999-2011 borrowing costs, went down from 7% ( 1999), to 3.35% (2011) (Larrain, 2011).
Furthermore, Fiscal policy rules improves international credit worthiness as long as it decreases risk level of the economy. .(Graph 10 below country risk,Chile ;Latin America and EMBI).In fact when fiscal surplus was 4,5% , the EMBI for Chile was the lowest(2005) ,while with fiscal deficit of -4,2, the EMBI was the highest (2009) with a correlation coefficiente of -0,63.(Graph 11 below,EMBI (Blue line) ;Fiscal deficit/surplus Red line).This correlation coefficient is higher, than with those other variables,such as Debt/ GDP,International reserves or economic growth. Salas (2018)
From the above, it follows that within the Mundell –Fleming framework, fiscal polciy may get external funds at a lower cost, instead of internal borrowing to finance an expansionary stand .This means that quite on the contrary to what that model expect, domestic interest rate do not rise up, as well as neither the external rate .The external rate of interest stay the same level, because in the international financial markets a small government borrowing, means a tiny amount of financial resources with a small share to have any impact on that rate within trillions of daily transaction.
The interest rate parity conditions do not change,as well as it does not the exchange rate.It follows that the fiscal policy expansion impact positively on output.The foreing borrowed funds into domestic foreign market couple with those which normally outflow. Besides the channel of impact arising from higher output(everything else constant), may adjust downward the magnitude of output increase but still on the positive side. Thus with structural budget surplues rule, fiscal polciy may have an impact on output even with flexible exchange rate.So in this case, policy makers have a their disposal both policy instrument, allowing the Tinberger rule to be fully considered, and the monetary policy to have more autonomy .
Finally, following fiscal policy rules fully pay off over time.It fits better with unstable external conditions both financial and real ones , and it disminishes the welfare losses arising from volatility in economic growth.-
From the above, it follows that within the Mundell –Fleming framework, fiscal polciy may get external funds at a lower cost, instead of internal borrowing to finance an expansionary stand .This means that quite on the contrary to what that model expect, domestic interest rate do not rise up, as well as neither the external rate .The external rate of interest stay the same level, because in the international financial markets a small government borrowing, means a tiny amount of financial resources with a small share to have any impact on that rate within trillions of daily transaction.
The interest rate parity conditions do not change,as well as it does not the exchange rate.It follows that the fiscal policy expansion impact positively on output.The foreing borrowed funds into domestic foreign market couple with those which normally outflow. Besides the channel of impact arising from higher output(everything else constant), may adjust downward the magnitude of output increase but still on the positive side. Thus with structural budget surplues rule, fiscal polciy may have an impact on output even with flexible exchange rate.So in this case, policy makers have a their disposal both policy instrument, allowing the Tinberger rule to be fully considered, and the monetary policy to have more autonomy .
Finally, following fiscal policy rules fully pay off over time.It fits better with unstable external conditions both financial and real ones , and it disminishes the welfare losses arising from volatility in economic growth.-
