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Father of Euro

International Economics

Robert A. Mundell, New York: Macmillan, 1968, pp. vii-xi.



Part I: The Theory of Exchange

Chapter 1. The Classical System 3

  Analytical Procedure 5
  The Method of Comparative Statics 6
  The Free-Trade Model 8
  Conditions of Stability 11
  Price and Income Effects 15

Chapter 2. Transfers, Productivity, and Taxes 17

  The Transfer Problem 17
  Productivity Changes 22
  Taxes and Subsidies on Trade 26
  Commodity Taxes Other Mechanisms of Adjustment 38
  Summary 41

Chapter 3. Generalization of the Classical Model 43

  Productivity Changes 46
  Tariff Changes 48
  Consumption and Production Tax Changes 50
  Unilateral Payments 50
  Comparison of Two-Country and Multiple-Country Models 51

Chapter 4. Tariff Preferences and the Terms of Trade 54

  A Geometric Model of Three Countries 54
  The Basic Proposition 58
  Zone of Mutual Improvement 59
  Conclusions and Qualifications 60
  Appendix: The N-Country Case 62

Chapter 5. A Geometry of Transport Costs in International Trade Theory 65

  The Geometry 65
  The F.O.B. and C.I.F. Terms of Trade 71
  The Transfer Problem 73
  The Optimum Tariff 80
  Real Factor Returns 83
  Concluding Remarks 84

Chapter 6. International Trade and Factor Mobility 85

  Trade Impediments and Factor Movements 85
  Effect of Relative Size 90
  Factor Mobility Impediments and Trade 94
  An Argument for Protection? 95
  Concluding Remarks 99

Chapter 7. The Laws of Comparative Statics and Homogeneity 100

  Relative Prices and Absolute Incomes 101
  Two-Region and Multiple-Region Metzleric Models 102
  Mathematical Analysis 103

Part II: Monetary Equilibrium and Adjustment Processes

Chapter 8. Barter Theory and the Monetary Mechanism of Adjustment 111

  Income, Expenditure, and the Quantity of Money 114
  The Anatomy of Disequilibrium and Dynamics 119
  The Classical Case and Devaluation 121
  Budgetary Policy 123
  The Transfer Problem 125
  Growth and Liquidity 126
  Conclusions 129
  Appendix: Three Monetary Standards 130

Chapter 9. Growth and the Balance of Payments 134

  Money, Trade, and Growth 135
  Allowance for Credit Creation 137
  Defects of Traditional Theory 138

Chapter 10. The Balance of Payments 140

  Definition 141
  International Consistency 143
  The Exchange Market 147
  Analytical Approach 149

Chapter 11. The Monetary Dynamics of International Adjustment under Fixed and Flexible ExchangeRates 152

  The Static System 153
  The Dynamic Systems 157
  The Importance of Capital Mobility 160
  The Stock of Reserves 163
  Speculation and Stability 166
  The Principle of Effective Market Classification 169
  Appendix 170

Chapter 12. A Theory of Optimum Currency Areas 177

  Currency Areas and Common Currencies 178
  National Currencies and Flexible Exchange Rates 179
  Regional Currency Areas and Flexible Exchange Rates 180
  A Practical Application 181
  Upper Limits on the Number of Currencies and Currency Areas 182
  Concluding Argument 184

Chapter 13. The Proper Division of the Burden of International Adjustment 187

  The Internal Stability Criterion 187
  The Relative Cost Criterion 188
  Exchange-Rate Adjustment 190
  The Relative Size Criterion 192
  Normative Aspects of the Relative Size Criterion 194
  Appendix: The Redundancy Problem and the World Price Level 195

Part III. Disequilibrium and Economic Policy

Chapter 14. The Nature of Policy Choices 201

  Employment and the Balance of Payments 204
  Mathematical Aspects of the Theory of Policy 207

Chapter 15. The International Disequilibrium System 217

  Hume's Law and the Process of Adjustment 218
  Monetary Policy and Sterilization Operations 222
  Alternative Means to Equilibrium 228

Chapter 16. The Appropriate Use of Monetary and Fiscal Policy under Fixed Exchange Rates 233

  The Conditions of Equilibrium 233
  Two Systems of Policy Response 237
  Principles of Policy 239

Chapter 17. Flexible Exchange Rates and Employment Policy 240

  Stability Conditions of the Model 241
  Fiscal Policy and Employment 243
  Monetary Policy and Employment 245
  Commercial Policy and Employment 246
  Conclusions 247
  Appendix 248

Chapter 18. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates 250

  Sectoral and Market Equilibrium Conditions 251
  Policies under Flexible Exchange Rates 253
  Policies under Fixed Exchange Rates 254
  Other Policy Combinations 256
  Diagrammatic Illustration 257
  Conclusions 261
  Appendix: The World Economy 262

Chapter 19. The Cost of Exchange Crises and the Problem of Sterling 272

  Definition of Cost 272
  The Short-Run Cost 272
  Analogy to a Depreciating Exchange Rate 276
  Saving the Cost 277
  Adjustment Policies 280

Chapter 20. The Crisis Problem 282

  Meaning of Crisis 282
  Rules of the System 283
  Operation of the System 284
  Control Crisis 285
  Reversal of Control 286
  Conclusions 286
  Appendix A: Alternative Dynamic Mechanisms 287
  Appendix B: A Monetary Truce 288

Chapter 21. Hicksian Stability, Currency Markets, and the Pure Theory of Economic Policy 298

  The Hicks Conditions and Sliding Parities 302
  The Asymmetrical Position of the Standard Currency 304
  Generalization of the Hicks Conditions 308
  Currency Areas 310
  General Conditions and Dynamic Stability 312
  Hicksian Stability and the Theory of Economic Policy 313
  Literature Cited 319


Robert A. Mundell

  This book brings together, and to a certain extent integrates, my theoretical writings on international economics over the past decade. All the major topics are touched on, and I have organized them into a pattern that seemed to me to make them most useful to the student. Part I analyzes the classical theory and covers such topics as the terms of trade, income transfers, productivity changes, tariffs, consumption taxes, production taxes, transport costs, tariff preferences, factor mobility, and policy analysis in the context of general equilibrium systems. Part II introduces monetary-dynamic elements into the theory of exchange and develops the theory of adjustment, the balance of payments, growth, the distribution of the burden of adjustment, optimum currency areas, monetary standards, and fixed and flexible exchange rate systems. Part III treats international macroeconomic theory from the standpoint of the theory of policy and develops the principle of effective market classification, the appropriate mix of monetary and fiscal policy under fixed and flexible exchange systems, capital mobility, the international transmission of cycles, commercial policy, the welfare cost of exchange crises, the crisis problem, and multiple-currency systems.

  The book, looked upon as a text, is perhaps most suitable in courses of international economics for graduate students, or, in those institutions where undergraduates receive substantial instruction in theory and money, for seniors. But just as international economics cannot be studied independently of value and monetary theory, so value theory and monetary theory cannot be divorced from the subject matter that is studied in trade theory. The theory of exchange and general equilibrium, treated in Part I of this book and in the final chapter, are as much a part of general theory as optimum currency area theory and the monetary-fiscal policy mix are part of the theory of money. For this reason some teachers may find various chapters useful as supplementary reading for students of courses in general theory or in monetary theory.

  Many of the topics covered in this book have a bearing on the great controversies that have raged in the economics profession since the publication of Keynes' General Theory. Keynes' attempt to integrate real and monetary phenomena was only partially successful, but he gave new scope to economic thinking about theory and policy. Just as theorists in the nineteenth century eventually settled their differences over which blade of the scissors did the cutting, so economists today are becoming increasingly impatient with analysis based solely on multiplier or on velocity approaches to income determination. What emerges is a richer and more useful theory based on general equilibrium analysis. To accelerate this end, in the field of international economics, I trust this book makes a contribution.

  A complete list of acknowledgments to teachers, friends, students, and colleagues would be too long and would detract from the special indebtedness I owe to select individuals. My earliest indebtedness is to two great teachers at the University of British Columbia, Joseph A. Crumb in the Economics Department and William J. Rose of the Slavonic Studies Department. I owe a general debt in 1953-54 to members of the Economics Department at the University of Washington and especially to Donald F. Gordon.

  I had the good fortune in the three years from 1954 to 1957 to benefit from personal association with C. P. Kindleberger, P. A. Samuelson, J. E. Meade, S. A. Ozga, L. Robbins, H. G. Johnson, M. Friedman, A. C. Harberger, and L. A. Metzler. Their influence on my work will, it is hoped, not have escaped detection. Subsequently, K. J. Arrow greatly encouraged my interest in general equilibrium theory.


Chapter 18. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates


  The world is still a closed economy, but its regions and countries are becoming increasingly open. The trend, manifested in both freer movement of goods and increased mobility of capital, has been stimulated by the dismantling of trade and exchange controls in Europe, the gradual erosion of the real burden of tariff protection, and the stability, unparalleled since 1914, of the exchange rates. The international economic climate has changed in the direction of financial integration2 and this has important implications for economic policy.

  My paper concerns the theoretical and practical implications of the increased mobility of capital. To present my conclusions in the simplest possible way, and to bring the implications for policy into sharpest relief, I assume the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. This assumption will overstate the case, but it has the merit of posing a stereotype toward which international financial relations seem to be heading. At the same time it might be argued that the assumption is not far from the truth in those financial centers of which Zurich, Amsterdam, and Brussels may be taken as examples, where the authorities already recognize their lessening ability to dominate money market conditions and insulate them from foreign influences. It should also have a high degree of relevance to a country like Canada, whose financial markets are dominated to a great degree by the vast New York market.

Sectoral and Market Equilibrium Conditions

  The assumption of perfect capital mobility can be taken to mean that all securities in the system are perfect substitutes. Because different currencies are involved, this implies that existing exchange rates are expected to persist indefinitely (even when the exchange rate is not pegged) and that spot and forward exchange rates are identical. All the complications associated with speculation, the forward market, and exchange-rate margins are thereby assumed not to exist.

  To focus attention on policies affecting the level of employment, we assume unemployed resources, constant returns to scale, and fixed money wage rates; this means that the supply of domestic output is elastic and its price level constant. We assume further that saving and taxes rise with income, that the balance of trade depends only on income and the exchange rate, that investment depends on the rate of interest, and that the demand for money depends only on income and the rate of interest. Our last assumption is that the country under consideration is too small to influence foreign incomes or the world level of interest rates.

  Monetary policy will be assumed to take the form of open market purchases of securities, and fiscal policy the form of an increase in government spending (on home goods) financed by an increase in the public debt. Floating exchange rates result when the monetary authorities do not intervene in the exchange market, and fixed exchange rates when they intervene to buy and sell international reserves at a fixed price.

  It will be helpful, in the following discussion, to bear in mind the distinction between conditions of sectoral and market equilibria (illustrated in Table 18-1). There is a set of sectoral restraints (described by the rows in the table) that show how expenditure in each sector of the open-economy is financed: A budget deficit (G - T) in the government sector is financed by an increase in the public debt or a reduction in government cash balances (dishoarding); an excess of investment over saving (I - S) in the private sector is financed by net private borrowing or a reduction in privately held money balances; a trade balance deficit (M - X) in the foreign sector3 is financed by capital imports or a reduction in international reserves; and, finally, an excess of purchases over sales of domestic assets of the banking sector is financed by an increase in the monetary liabilities of the banking system (the money supply) or by a reduction in foreign exchange reserves. For simplicity of exposition, we shall assume that there is, initially, no lending between the sectors.

  There is also a set of market restraints (described by columns in the table) that refer to the condition that demand and supply of each object of exchange be equal. The goods-and-services market is in equilibrium when the difference between investment and saving is equal to the sum of the budget surplus and the trade balance deficit. The capital market is in equilibrium when foreigners and domestic banks are willing to accumulate the increase in net debt of the government and the public. The foreign exchange market is in equilibrium when the actual increase in reserves is equal to the rate (which may be positive or negative) at which the central bank wants to buy reserves.4 And the money market is in equilibrium when the community is willing to accumulate the increase in the money supply offered by the banking system. We shall assume also that, initially, each market is in equilibrium.

Policies under Flexible Exchange Rates

  Under flexible exchange rates the central bank does not intervene to fix a given exchange rate, although this need not preclude autonomous purchases and sales of foreign exchange.


  Consider the effect of an open market purchase of domestic securities in the context of a flexible-exchange-rate system. This results in an increase in bank reserves, a multiple expansion of money and credit, and downward pressure on the rate of interest. But the interest rate is prevented from falling by an outflow of capital, which causes a deficit in the balance of payments, and a depreciation of the exchange rate. In turn, the exchange-rate depreciation (normally) improves the balance of trade and stimulates, by the multiplier process, income and employment. A new equilibrium is established when income has risen sufficiently to induce the domestic community to hold the increased stock of money created by the banking system. Because interest rates are unaltered, this means that income must rise in proportion to the increase in the money supply, the factor of proportionality being the given ratio of income and money (income velocity).

  In the new equilibrium private saving and taxes will have increased as a consequence of the increase in income, and this implies both net private lending and retirement of government debt. Equilibrium in the capital market then requires equality between the sum of the net private lending plus debt retirement, and the rate of capital exports, which in conjunction with the requirement of balance-of-payments equilibrium, implies a balance of trade surplus. Monetary policy therefore has a strong effect on the level of income and employment, not because it alters the rate of interest, but because it induces a capital outflow, depreciates the exchange rate, and causes an export surplus.5

  It will now be shown that central bank operations in the foreign exchange market ("open market operations" in foreign exchange) can be considered an alternative form of monetary policy. Suppose the central bank buys foreign reserves (gold or foreign currency) with domestic money. This increases bank reserves, causing a multiple expansion of the money supply. The monetary expansion puts downward pressure on the interest rate and induces a capital outflow, further depreciating the exchange rate and creating an export surplus, which in turn increases, through the multiplier effect, income, and employment. Eventually, when income has increased sufficiently to induce the community to hold the increased stock of money, the income-generating process ceases and all sectors are again in equilibrium, with the increased saving and taxes financing the capital outflow. This conclusion is virtually the same as the conclusion earlier reached regarding monetary policy, with the single important difference that foreign assets of the banks are increased in the case of foreign exchange policy while domestic assets are increased in the case of monetary policy. Foreign exchange policy, like monetary policy, becomes a forceful tool of stabilization policy under flexible exchange rates.


  Assume an increase in government spending financed by government borrowing. The increased spending creates an excess demand for goods and tends to raise income. But this would increase the demand for money, raise interest rates, attract a capital inflow, and appreciate the exchange rate, which in turn would have a depressing effect on income. In fact, therefore, the negative effect on income of exchange-rate appreciation has to offset exactly the positive multiplier effect on income of the original increase in government spending. Income cannot change unless the money supply or interest rates change, and because the former is constant in the absence of central bank action and the latter is fixed by the world level of interest rates, income remains fixed. Since income is constant, saving and taxes are unchanged, which means, because of the condition that the goods market be in equilibrium, that the change in government spending is equal to the import surplus. In turn, the flexible exchange rate implies balance-of-payments equilibrium and therefore a capital inflow equal to the import surplus. Thus, both capital and goods market equilibria are assured by equality between the rate of increase in the public debt and the rate of capital imports, and between the budget deficit and the import surplus. Fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate and the money supply is held constant. Just as monetary policy derives its importance as a domestic stabilizer from its influence on capital flows and the exchange rate, so fiscal policy is frustrated in its effects by these same considerations.

Policies under Fixed Exchange Rates

  Under fixed exchange rates the central bank intervenes in the exchange market by buying and selling reserves at the exchange parity; as already noted the exchange margins are assumed to be zero.


  A central bank purchase of securities creates excess reserves and puts downward pressure on the interest rate. But a fall in the interest rate is prevented by a capital outflow, and this worsens the balance of payments. To prevent the exchange rate from falling, the central bank intervenes in the market, selling foreign exchange and buying domestic money. The process continues until the accumulated foreign exchange deficit is equal to the open market purchase and the money supply is restored to its original level.

  This shows that monetary policy under fixed exchange rates has no sustainable effect on the level of income. The increase in the money supply arising from open market purchases is returned to the central bank through its exchange stabilization operations. What the central bank has in fact done is to purchase securities initially for money, and then buy money with foreign exchange, the monetary effects of the combined operations canceling. The only final effect of the open market purchase is an equivalent fall in foreign exchange reserves: The central bank has simply traded domestic assets for foreign assets.


  Assume an increase in government spending superimposed on the foreign exchange policy of pegging the exchange rate. The increased spending has a multiplier effect upon income, increasing saving, taxes, and imports. Taxes increase by less than the increase in government spending, so the government supplies securities at a rate equal to the budget deficit, whereas the private sector absorbs securities at a rate equal to the increase in saving.

  After the new equilibrium is established, both the goods and capital markets must be in balance. In the goods market the budget deficit has as its counterpart the sum of the excess private saving over investment and the balance-of-trade deficit, which implies that the induced balance-of-trade deficit is less than the budget deficit. In the capital market the private and foreign sectors must be willing to accumulate the new flow of government issues. But, because the excess private saving is equal to the flow of private lending, and because the budget deficit equals the flow of new government issues, capital market equilibrium requires that the import deficit be exactly balanced by a capital inflow, so that there is balance-of-payments equilibrium after all adjustments have taken place.

  There will nevertheless be a change in foreign exchange reserves. Before the flow equilibrium is established the demand for money will increase, at a constant interest rate, in proportion to the increase in income. To acquire the needed liquidity the private sector sells securities and this puts upward pressure on the interest rate and attracts foreign capital. This improves the balance of payments temporarily, forcing the central bank to intervene by buying foreign reserves and increasing the money supply. The money supply is therefore increased indirectly through the back door of exchange rate policy. Foreign exchange reserves accumulate by the full amount of the increased cash reserves needed by the banking system to supply the increased money demanded by the public as a consequence of the increase in income.

Other Policy Combinations

  Other cases deserve attention in view of their prominence in policy discussion. In the following cases it is assumed that exchange rates are fixed.


  An important special case of combined operations of monetary, fiscal, and exchange policies is central bank financing of budget deficits (deficit finance) under fixed exchange rates. As before, the increase in government spending yields a multiplier effect on income. In the new equilibrium there is a budget deficit, an excess of saving over investment, and a balance-of-trade deficit. The government issues securities at a rate equal to the budget deficit and these are (by assumption) taken up by the central bank. Capital market equilibrium therefore requires that the net flow demand for securities on the part of the private sector be equal to the net capital outflow.

  It is easy to see that in the new equilibrium the balance-of-payments deficit and the consequent rate at which reserves are falling is exactly equal to the budget deficit and to the rate at which the central bank is buying government securities. Because the capital outflow is equal to the excess of saving over investment, and the loss of reserves is equal to the balance-of-payments deficit, which is the sum of the trade deficit and the capital outflow, reserves fall at a rate equal to the sum of the import deficit and the excess of saving over investment. Then because this sum equals the budget deficit, by the condition of equilibrium in the goods market, it follows that reserves fall at a rate equal to the budget deficit. The budget is entirely at the expense of reserves.

  There is, however, in this instance, too, an initial stock-adjustment process. As income increases the demand for money grows, and the private sector dispenses with stocks of securities, causing a capital inflow and an increase in reserves. This increase in reserves is a once-and-for-all inflow equal to the increase in cash reserves necessary for the banks to satisfy the increased demand for money. The rate of fall in reserves takes place, therefore, from a higher initial level.


  Sterilization (or neutralization) policy is a specific combination of monetary and exchange policy. When the central bank buys or sells foreign exchange the money supply increases or decreases. The purpose of sterilization policy is to offset this effect. The mechanism is for the central bank to sell securities at the same rate that it is buying foreign exchange, and to buy securities at the same rate that it is selling foreign exchange. In reality, therefore, neutralization policy involves an exchange of foreign reserves and bonds. The exchange rate is stabilized by buying and selling reserves in exchange for securities.

  Suppose the government increases spending during a time when neutralization policy is being followed. The increase in spending would normally have a multiplier effect on income. But this would increase the demand for money and put upward pressure on interest rates as the private sector dispenses with holdings of securities; this would cause a capital inflow and induce a balance-of-payments surplus. But now the authorities, in their rate-pegging operation, buy foreign exchange and simultaneously sell securities, thus putting added pressure on interest rates and accelerating the inflow of capital without satisfying the increased demand for money. The system has now become inconsistent, for goods market equilibrium requires an increase in income, but an increase in income can take place only if either the money supply expands or interest rates rise. The capital inflow prevents interest rates from rising and the neutralization policy inhibits the money supply from expanding. Something has to give, and it must either be the money supply or the exchange rate. If the central bank sells securities at the same rate as it is buying reserves, it cannot buy reserves at a rate fast enough to keep the exchange rate from appreciating. And if the central bank buys reserves at a rate fast enough to stabilize the exchange rate, it cannot sell securities fast enough to keep the money supply constant. Either the exchange rate appreciates or money income rises.

  In a similar way it can be shown that, from an initial position of equilibrium, open market operations (monetary policy) lead to an inconsistent and overdetermined result. A purchase of securities by the central bank would cause a capital outflow, balance-of-payments deficit, and sales of foreign exchange by the central bank. The restrictive monetary impact of the foreign exchange sales are then offset by further open market purchases that induce further sales of foreign exchange. The process repeats itself at an accelerating speed. There is no new equilibrium because the public wants to hold just so much money, and the central bank's attempt to alter this equilibrium simply results in a fall in reserves. The sterilization procedures merely perpetuate the self-generating process until exchange reserves are exhausted, or until the world level of interest rates falls.

Diagrammatic Illustration (ommitted)

Figure 18-1. Monetary Policy.
Figure 18-2. Fiscal Policy.

  These results can be illustrated by diagrams similar to those I have used for analysis of related problems.6 ´

  Certain qualifications or extensions to the analysis should be mentioned. The demand for money is likely to depend upon the exchange rate in addition to the interest rate and the level of income; this would reduce the effectiveness of a given change in the quantity of money, and increase the effectiveness of fiscal policy on income and employment under flexible exchange rates, while, of course, it has no significance in the case of fixed exchange rates.

  Another possible influence is the real balance effect, but this cannot alter in any essential way the final result: Income rises, under flexible exchange rates, in proportion to the increase in the money supply, whereas income remains unchanged, in the case of fixed exchange rates, because the quantity of money does not increase.

  A further factor that might be considered is the negative effect of changes in the exchange rate upon the level of saving. Again there is no important alteration in the results: Although the budget deficit arising from increased government spending under flexible exchange rates is then partly financed by an increase in saving of the private sector, the conclusions regarding changes in the level of output and employment are unaltered.

  The conclusions, of course, have not made any allowance for growth. Because of growth, the money supply will normally be increased at a rate more or less commensurate with the growth of the economy; my conclusions are, so to speak, superimposed on the growth situation. Moreover, many of our actual observations about the economic world are observations of disequilibrium positions; it is clearly possible to alter the money supply (under fixed exchange rates) if there is excess or deficient liquidity, although even this is in practice unnecessary since we can be assured, as we were as long ago as the days of Ricardo, that the money supply will automatically settle down to its equilibrium level. In any case these observations do not vitiate the principles we have been trying to elucidate.


  We have demonstrated that perfect capital mobility implies different concepts of stabilization policy from those to which we have become accustomed in the post-World War II period. 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. Under fixed exchange rates, open market operations by the central bank result in equal changes in the gold stock, open market purchases causing it to decline and open market sales causing it to increase. And under flexible exchange rates, budget deficits or surpluses induced by changes in taxes or government spending cause corresponding changes in the trade balance.

  Gold sterilization policies make no sense in a world of fixed exchange rates and perfect capital mobility and will ultimately lead to the breakdown of the fixed exchange system. In the absence of gold sterilization, as we have seen, an attempt of the central bank to alter the money supply is frustrated by capital outflows and automatically offsetting monetary changes through the exchange equalization operations; this is running water into a sink that is filled to the brim, causing the water to spill over the edges at the same rate that it is coming out of the tap.7 But sterilization operations are analogous to trying to prevent the water from spilling out, even though the sink is full and water is still pouring out of the tap.

  If my assumptions about capital mobility were valid in Canada,8 it would mean that expansive fiscal policy under flexible exchange rates was of little help in increasing employment because of the ensuing inflow of capital, which kept the exchange rate high and induced a balance of trade deficit: We should have observed a zero or very small multiplier. By the same token, now that Canada has adopted a fixed exchange system, we should not reason from earlier negative experience about the size of the multiplier and conclude that the multiplier is now low: Although a reduction in the budget deficit under flexible rates would have helped the trade balance without too much damage to employment, a reduction in the budget deficit today could be expected to have a sizable impact on excess demand and unemployment.

  Of course, the assumption of perfect capital mobility is not literally valid; my conclusions are black and white rather than dark and light grey. To the extent that Canada can maintain an interest-rate equilibrium different from that of the United States, without strong capital inflows, fiscal expansion can be expected to play some role in employment policy under flexible exchange rates, and monetary policy can have some influence on employment and output under fixed exchange rates. But if this possibility exists for us today, we can conjecture that it will exist to a lesser extent in the future.