With flexible exchange rates however, while monetary policy has bite, fiscal actions do not. The only effect of fiscal expansion is to drive up local interest rates attracting capital from abroad and hence appreciating the exchange rate. This reduces our exports and nullifies the effects of the fiscal expansion. The standard theory result is that fiscal actions have zero effect if exchange rates care flexible. Monetary policy is a preferred means of expanding an economy.
As Ergas states:
"Australia is a small, open economy with a flexible exchange rate. There is consequently a real possibility that any increase in demand caused by fiscal easing will merely raise interest rates, induce capital inflow from abroad, appreciate the currency and reduce net exports.
With growth in China and Japan slowing significantly, why implement measures that could exacerbate Australia's expected export downturn?
In the Keynesian framework, monetary policy, on the other hand, is actually more effective in an open economy. A monetary policy-induced reduction in interest rates boosts aggregate demand and induces capital outflow, leading to a depreciation of the exchange rate and a reduction imports.
As a result, even if we take the Keynesian approach seriously, fiscal stimulus may not only be ineffective, but by impeding or slowing further reductions in interest rates may stand in the way of a more effective response. As Treasury concluded in 2002, "higher budget deficits (or lower surpluses) can have a significant effect on interest rates in Australia", with the result that the "automatic stabilisers are likely to be relatively more effective than discretionary changes in policy". The federal Government must explain why those findings no longer apply".Of course the Mundell-Fleming approach is only a simplified model - macroeconomists have a range of Ripley-Believe-It-or-Not macroeconomic models that justify any sort of policy action - but I would like to know why the effects the MF model stresses are not appropriate here. The argument that we might be in a liquidity trap where monetary policy is ineffective does not improve the case for expansionary fiscal actions. IMoreover if monetary expansions are taken to keep the exchange rate low then it is these expansions not the debt-incurring fiscal actions that are providing the stimulus. If the fiscal actions are funded using debt as they will be then although huge debts will be imposed on future generations there will be no immediate stimulus now as would be the case were they money-financed.
The standard objection to the Mundell-Fleming model that it is designed for settings where inflation and inflationary expectations don't have a role is not relevant. We have close to zero inflation. Another objection might be that capital mobility is low because of the financial crisis itself. That might be true right now but not so if and when the international economy recovers - and the effects of these fiscal measures will operate with long lags.
Those on the left seem to me to support the Rudd fiscal expansion because they support Rudd not because they understanding Keynesian macroeconomics in an open economy. I wish to know why expenditures of $42 billion by Rudd and his mates - which look likely to leave Australia with a huge eventual debt - were so self-evidently correct. Debate itself - and even quibbling about the size of the package - was portrayed by Rudd as something unpatriotic and unreasonable. Was it that the $42 billion package was primarily designed to threatrically demonstrate that the government was 'doing something'? Indeed to save one job - Kevin Rudd's? The handouts of course appealed to those who simply like handouts.
We will live with the consequences of ineffective fiscal actions which raise debt, but which do not stimulate economic activity, for decades. If the current measures fail there will be inevitable calls by the Keynesian slobs for more and more and our debts will mount. I am pessimistic.