If the monetary policy is constant and is not modified, higher level of government spending might entail the sharp rise in the demand for money which in turn may lead to higher interest rates. As one knows from the course in macroeconomics, capital inflows that, the nation can receive in this scenario, may strengthen the exchange rate to the level that it can hamper the export operations of the private companies and thus reduce or even stultify any positive expansionist effect of the government spending. The following graph illustrates the model; it also provides the illustration on the effect that fiscal policy under floating exchange regime might cause on the economy of the country.
Thus monetary policy is one of the most effective tools in the economic policy of the Government under floating exchange rate regime; if the government increases the supply of money, which leads to the reduction of the interest rates, which consequently entails capital outflow, that in turn depreciates exchange rates and consequently stimulates export activities in the country and leads to the expansion in the economy through higher level of net exports. 2 The opposite situation occurs under the regime of fixed exchange rates.
As one can see under floating exchange rates in the short time period, the interest rate is bound to decrease (which might take more positive effect on the economy and stimulate investment activities in the country...
First, there should be one "interest parity" condition. National interest rates on the bonds i should equal interest rates overseas i* with the expected rate of the depreciation of the exchange rate (Et (et+1 - et)).
In the above mentioned equitation, e is a logarithm of the exchange rate (foreign currency denoted in national one), whereas Et is the expectations of the markets based on the time t information. As one can conclude from the situation mentioned, there is no difference between the profitability of national and foreign bonds; however as in current economic system, the capital is highly mobile so the two bonds could pay various interest rates only if the investors expect to receive some compensation from the differences in exchange rates. It is assumed in this model that the country is comparatively small in the global capital market and the foreign interest rate i* is exogenous in this case.
(On this picture MM- short time equilibrium, whereas GM -goods market equilibrium, q long run equilibrium level of the real exchange rate, e exchange rate, C and B various levels of the economy). 3
The rate parity equitation in this case is written as the following: it +1 = i + Et (et +1- et), in this equation it +1 is the nominal exchange rate whereas (et +1- et) predicted rate of charge of exchange rate.
Dornbusch's model was based on the assumption that there was no uncertainty in the economy; many observers also claim that above mentioned equation of uncovered interest parity is rather an exception from the rule, and the interest parity situation rarely happens in practice.
According to equation of Dornbusch high interest rates might lead to the increase in the opportunity cost of keeping money and thus entail the decrease in the demand for money; the