n be hard to pin down. The theory provides a useful backdrop and guide for appropriate policy responses, but practical policymaking requires a thorough understanding of the characteristics of the economy in question, the exact nature of the capital flows, and the range of available policy options and tradeoffs. East Asian policymakers have been adept at pursuing reform until difficulties arise, then slowing or even backtracking a bit to reassess and make corrections before moving ahead once more. This pragmatism has proved its worth, as these countries have generally avoided major crises.
The basic theoretical models were initially developed to study the relative effects of monetary and fiscal policies in achieving domestic stabilization. Impacts on the external equilibrium were viewed as results and perhaps as constrains. Critical to the analysis if the exchange regime-fixed or floating-and the openness of the capital account (or the degree of substitutability between domestic and financial capital assets).
Under most conditions, the models indicate, that given a fixed nominal exchange rate regime, fiscal policy is relatively more powerful than monetary policy in affecting domestic output. Expansionary fiscal policy increases demand for domestic goods but also tends to raise interest rates as additional public borrowing is required. Higher interest rates attract more foreign capital, increasing reserves. The increase in domestic resources to that sector. The current account balance deteriorates, partly absorbing the increased capital flows. Real currency appreciation occurs as domestic prices rise, even though the nominal rate if fixed.
Conversely, monetary policy has a greater effect on the external account. Raising domestic interest rates attracts foreign capital and builds reserves, the amount depending on the substitutability of foreign and domestic assets. Attempts to stimulate domestic demand by lowering interest rates are diluted, as capital flows overseas to seek higher rates there, reducing any effect on domestic demand. The more substitutable foreign and domestic assets are, the less the interest rate change required for a given effect. Increased substitutability of assets leads to other problems, however. Where governments try to constrain domestic demand by raising interest rates, capital flows in, to benefit the higher rates, and counteracts the restraint. If sterilization is attempted-if, for example, governments sell bonds (tending to further increase domestic interest rates) to absorb the increase in the money supply associated with the influx overwhelm the authorities 'ability to continue to issue bonds to purchase foreign exchange. In such circumstance, it is hand to prevent a real currency appreciation.
For an economy dependent on export growth, as most East Asian countries are, the dangers of expansionary fiscal policy, combined with monetary constraint to keep inflation...
