Question

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

Answer 1

Mundell fleming model is an extension of the closed economy IS-LM model. It integrates the domestic economy to the rest of the world through two channels: Trade in goods and services and trade in financial assets.

Perfect capital mobility means that one country will transfer funds to another country when the rate of return on assets increases/decreases in one country more than another. The floating exchange rate means that the exchange rate in a country is not regulated by the government of the country but by the market forces.

a. Effect of monetary policy:

If the government adopts an expansionary monetary policy, LM1 curve will shift to the right to LM2. At the new point of intersection between IS1 and LM2, the balance of payment is in disequilibrium, and the domestic rate of return decreases. This will lead to capital outflow which will further lead to BOP (balance of payment) deficit. Due to the BOP deficit, the value of currency decreases (due to depreciation). The government will not intervene in this situation (due to the flexible exchange rate system) and leave it for the market forces. As domestic currency depreciates, net exports increase, and the IS curve shifts right to IS2. The new equilibrium is at the point where the previous rate of return is achieved but the level of output in the economy has increased.

Thus, we can say that monetary policy remains effective in the flexible exchange rate system and capital mobility.

b. Effect of fiscal policy:

In an expansionary fiscal policy, IS curve shifts to the right from IS1 to IS2. The balance of payment is not in equilibrium (the rate of return has increased). This will lead to capital inflow and there will be a BOP surplus. Domestic currency appreciates and net exports decrease. As a result, IS curve shifts back from IS2 to IS1.

Thus, we can say that fiscal policy remains ineffective in a flexible exchange rate system and perfect capital mobility.