Answer to Question #48924 in Macroeconomics for Akinyi
(iii) What is the effect of monetary policy in an economy where capital mobility is perfectly elastic?
Given the differences in timing of the preparation of the Main Estimates and the Budget, it is not always possible to include emerging priorities and items announced in the Government's Budget in the Main Estimates. Additional requirements for initiatives included in the 2013 Budget will be presented in future Estimates.
The Estimates and Budget use different accounting methodologies. Estimates, with the focus on authority for payments in a fiscal year, are prepared on a near-cash basis. The Budget's economic forecast is prepared on a full accrual basis. A more complete explanation of the differences in methodology and a reconciliation between the annual results and amounts included in Estimates are presented in the Notes to the Financial Statements of the Government of Canada included in the Public Accounts. Volume II of Public Accounts presents government expenditures on the same basis as the Estimates, while Volume I of Public Accounts provides financial information corresponding to the Budget.
(iii) Under a flexible exchange rate regime with perfectly elastic capital flows monetary policy is effective and fiscal policy is not. The logical validity of the statement requires that the effect of an exchange rate change on the domestic price level be ignored. The price level effect is noted in some textbooks, but not formally analysed. When it is subjected to a rigorous analysis, the interaction between changes in the exchange rate and the domestic price level significantly alters the standard policy rule. The logically correct statement would be, under a flexible exchange rate regime with perfectly elastic capital flows the effectiveness of monetary policy depends on the values of the import share and the sum of the trade elasticities. Inspection of data from developing countries indicates the effectiveness of monetary policy under flexible exchange rates can be quite low even if capital flows are perfectly elastic.
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