Question

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

Second Question: If the British price level rises by 5 percent relative to the price level in the European Union, what does the theory of purchasing power parity predict will happen to the value of British pound in terms of Euro?

Answer 1

Answer 1: In a Mundell-Fleming model with floating exchange rates and perfect capital mobility, monetary policy is effective but fiscal policy is ineffective.

Monetary policy:

An increase in the money supply shifts the LM curve to the right. This directly reduces the local interest rate relative to the global interest rate. That being said, capital outflows will increase which will lead to a decrease in the real exchange rate, ultimately shifting the IS curve right until interest rates equal global interest rates (assuming horizontal BOP). A decrease in the money supply causes the exact opposite process.

Fiscal policy:

An increase in government expenditure shifts the IS curve to the right. This will mean that domestic interest rates and GDP rise. However, this increase in the interest rates attracts foreign investors wishing to take advantage of the higher rates, so they demand the domestic currency, and therefore it appreciates. The strengthening of the currency will mean it is more expensive for customers of domestic producers to buy the home country's exports, so net exports will decrease, thereby canceling out the rise in government spending and shifting the IS curve to the left. Therefore, the rise in government spending will have no effect on the national GDP or interest rate.

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Answer 2: Purchasing power parity is a measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the country's currencies. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciate in order to return to PPP.

So if British price level rises by 5% then British pound will depreciate by 5% in terms of euro.