The Stability of Monetary and Fiscal Policies
If monetary and fiscal policies could smoothly stabilize the domes of the economy, then the question posed would seem to have been answered by the discussion just completed.
It is hard for officials to know how great or how prompt an effect a given policy action will have. Lacking this knowledge, they have difficulty in deciding just what policy actions they should take at any given moment.
A current recession, for example, might or might not call for stimulative action. If the authorities expected the recession to reverse itself in the near future, they would not want to provide a stimulus to the economy that would start to raise aggregate demand only with a long lag, since the stimulus could then end up just heating up inflation and making the economy less stable.
Such are the knotty practical considerations of stabilization policy.
Given the difficulties of stabilization policy, it would help a lot if institutions could be designed in such a way as to make stabilization 'more automatic and less dependent on officials' fallible discretion.
One such design would be a progressive tax structure that builds "automatic stabilizers" into aggregate demand by automatically siphoning off a large share of any extra income into extra taxes. International economists have been debating whether fixed or flexible exchange rates are more likely to play the role of automatic stabilizer.
Which exchange-rate regime would tend to cushion outside issues to the economy, thereby lessening the size of the disequilibrium that policy has to contend with? The answer turns out to hinge critically all kinds of issues to which the economy is most liable.
A common source of major issues to many economies is the variability of foreign demand for exports. This variability is particularly acute for countries specializing in exporting a narrow range of products the demand for which is highly sensitive to the business cycle in importing countries.
This instability of export demand has plagued exporters of metals, such as Chile (copper), Malaysia (tin), and to a lesser extent, Canada. Although these countries could react to unpredictable shifts in export demand with offsetting macroeconomic policies stabilizing aggregate demand, the fact that discretionary stabilization policies are hard to design means, again, that it would help very much to have an exchange-rate system that obviated the necessity of correct discretionary policies.
Flexible exchange rates seem to perform better in the face of shifts in export demand. To see why, suppose that foreign demand for Malaysian tin drops off sharply. There is no exchange-rate policy that can shield Malaysia from income losses when this happens, but some policies cushion the shock better than others.
An intermediate degree of income loss occurs in the simplest case, in which Malaysia rides out the slump with a fixed exchange rate and monetary sterilization.
In this case, the export sector suffers a loss of incomes and jobs in the usual Keynesian way and the multiplier process transmits this income loss through the economy.
If Malaysia does not sterilize the new payments deficit, the loss of export revenues and the accompanying out flow of money will reduce the money supply, causing still further contraction of the economy.