Question

Suppose that the United Kingdom has no restriction on capital flows and wants to keep the value of GBP stable (i.e., no currency appreciation or depreciation). Under this framework, the United Kingdom also wants to adopt an expansionary monetary policy (i.e., lowering its interest rate) to stimulate its economy. Will the monetary policy be successful? Why? What would be the likely outcomes if the United Kingdom actually lowers its interest rate?

Answer 1

According to the Mundell-Fleming Model, a country with high capital mobility and expansionary monetary policy (i.e. lowering of interest rate) will lead to an increase in the GDP, but will also lead to Currency Depreciation. In this regard,

Will the monetary policy be successful?

Yes, as far as monetary policy is concerned, It will be successful. But the policymaker would not be able to keep the value of GBP stable.

Why?

Because the value of currency i.e. GBP would depreciate w.r.t other foreign currency. The explanation flow is as follow:

Interest Rate Decrease >> Lead to the net negative or lower foreign capital inflow for lesser competitive fixed income economy >> Again, this will lead to lower foreign reserve and capital & financial asset investment >> This again will lead to lower demand of domestic currency >> Hence, domestic currency i.e. GBP would depreciate.

What would be the likely outcomes if the United Kingdom actually lowers its interest rate?

As stated, lowering of interest rate might increase GDP but would also simultaneously depreciate the currency, thus the policy maker would not achieve the target of keeping the currency stable.