Question

In a Mundell-Fleming model with floating exchange rates and perfect capital mobility, discuss effectiveness of monetary and fiscal policy.

Answer 1

In a Mundell-Fleming model with floating exchange rates and perfect capital mobility, monetary policy is highly effective, as monetary policy will lead to increase in output; trade balance improves; exchange depreciation will takes place which lead to increased exports. In the figure B, A monetary expansion will shift the LM curve to LM'. At point E' the goods and money markets clear, but our interest rate is below the world level. Therefore capital will tend to flow out, the balance of payment will go into deficit and therefore exchange rate depreciates. With depreciation means that we become more competitive and therefore net exports will increase and IS curve shifts out and to the right. The process will continue until IS curve reaches E". Interest rate will be again at world level. Monetary policy will be effective by increasing net exports.

Whereas fiscal policy is ineffective in changing output, it will reduce net exports and exchange rate will appreciate. Suppose there is a rise in foreign demand for our goods. In figure A , Therefore IS curve shifts out to IS' and new equilibrium will be reached at E'. But at E' our interest rate exceeds that of world. This means capital will flow into home country and resulting balance of payment surplus and as a result it will lead to currency appreciation. This means we become less competitive. Thus IS curve will start to shift back as a result of this appreciation , and this will continue until we reach back at initial equilibrium E. In the end, increased exports will not change output. This will lead only to currency appreciation. Therefore fiscal policy doesn't have any effect.