Question

Discuss the impotence and potency of policies under various exchange rate regimes

Answer 1

The Mundell-Fleming model illustrates that the power of fiscal policy and monetary depends on the exchange rate regime to influence aggregate demand. The model reflects that the effect on a small open economy of almost any economic policy depends on whether the exchange rate is fixed or floating.

Under a floating exchange rate and perfect capital mobility, fiscal policy is impotent because it is unable to increase income. However under a floating exchange rate and perfect capital mobility, monetary policy is potent because it allows huge cash outflow and improve trade balance.

Under fixed exchange rates monetary policy is impotent because not influence aggregate income. Any attempt for the expansion of the supply of money is futile, because the money supply have to adjust to ensure that the exchange rate remains at its announced level. However a nation with fixed exchange rates may conduct a type of monetary policy by deciding at which the exchange rate is fixed for changing the level. Any increase in the value is termed revaluation and reduction in the official value of the currency is termed devaluation.