Monetary vs Fiscal Policy: Implications for FX Markets

Fiscal and monetary policy are often seen as a key driver of volatility in foreign exchange (FX) markets, and the different approaches in managing policy can lead to major trends in currency markets.

Mundell-Fleming Model

The Mundell-Fleming Model, which is widely known for the ‘impossible trinity theory,’ attempts to ‘addresses the short-run effects of monetary and fiscal policy in an open economy.’

The model portrays capital mobility for an open economy that operates under an independent monetary authority and compares a flexible exchange rate system to a fixed exchange rate system.

Source: RobertMundell.net

According to the model, ‘monetary policy has no impact on employment under fixed exchange rates, whereas fiscal policy has no effect on employment under flexible exchange rates. On the other hand, fiscal policy can have an effect on employment under fixed exchange rates (if the Keynesian model is valid), whereas monetary policy has a strong effect on employment under flexible exchange rates (classical quantity theory conclusions hold).

Another implication of the analysis is that monetary policy under fixed exchange rates becomes a device for altering the levels of reserves, whereas fiscal policy under flexible exchange rates becomes a device for altering the balance of trade, both policies leaving unaffected the level of output and employment.’

Based on this theory, changes in monetary policy are likely to have a greater influence on macroeconomic trends compared to fiscal policy as most countries operate under a flexible exchange rate along with free capital mobility.

Interest Rate Differentials & Foreign Exchange Markets

Interest rates are one of the primary tools used by central banks to manage monetary policy and are generally moved around to balance the risks surrounding an economy.

Interest rates not only affects an economy but also impacts foreign exchange markets as it shapes how a currency’s value is perceived. As central banks adjust monetary policy based on economic conditions, the interest rate spread between different countries often influences FX markets.

Central banks that operate under a flexible exchange rate system allow market dynamics to influence their currency, but excessive moves over short periods of time have led to FX interventions by government officials.

FX Carry Trade

A currency carry trade is where a trader borrows or sells a low interest rate currency in order to purchase another currency with a higher interest rate.

Carry trades may be popular where the interest rate spread between the two currencies is high. This is because paying a low rate on the borrowed currency potentially allows for a return on the higher rate of the purchased currency.

Source: TradingView

In simple terms, if a trader goes long on a pair like AUD/JPY, where the Australian Dollar has a higher interest rate than the Japanese yen, the trader has initiated a carry trade. In effect, the trader is borrowing money from Japan to invest in the Australian dollar where the money will earn more interest than it would if it was held in yen.

The broker pays the interest rate differential between the two currencies, minus the spread. It’s important to keep in mind that this interest rate differential will be added to whatever gains or losses the Australian dollar experiences in value against the yen.

--- Written by David Song, Senior Strategist

Follow on Twitter at @DavidJSong