analyze the effect of an expansionary monetary policy under perfect capital mobility and fixed exchange rate...

analyze the effect of an expansionary monetary policy under perfect capital mobility and fixed exchange rate regime on an economy

Expert Solution

Graphically, the assumption of perfect capital mobility makes the BP schedule horizontal.

With fixed exchange rates and perfect capital mobility, an expansionary monetary policy will be ineffective. This can be explained with the help of the following diagram.

Equilibrium interest rate is r* and equilibrium income is Y* . Equilibrium is determined by the intersection of LM curve , IS curve and BP curve.

When central bank implements an expansionary monetary policy, it will result in a shift in the LM curve. LM curve shifts to right. LM1 is the new LM curve.

Intersection of LM1, BP and IS curve leads to an increase in income from Y* to Y1 and fall in interest rate from r* to r*

Since perfect capital mobility exists, fall in the interest rate will be followed by a decrease I'm capital inflow and balance of payment deficit.

Deficit makes depreciation necessary. But, in order to keep the exchange rate fixed, central bank intervenes In the market. Central bank sells foreign currencies .

Money supply has two components- foreign component and domestic component. Sale of foreign currencies leads to a decline in foreign component. As a result, money supply is decreased.

LM1 curve shifts back to LM .income falls from Y1 to Y* and interest rate increases from r1 to r* .

Therefore, expansionary monetary policy is of no use under conditions of fixed exchange rate with perfect capital mobility

Rahul Sunny answered 8 months ago

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