Do you think that perfect capital mobility under fixed exchange rate improves the effectiveness of fiscal and monetary policies? Explain.
Under a fixed exchange rate regime with perfect capital mobility, the effectiveness of fiscal and monetary policies differs sharply, as shown by the Mundell-Fleming model.
Monetary policy becomes largely ineffective. Suppose the central bank expands the money supply by lowering interest rates. Even a slight fall below the global rate triggers large capital outflows as investors seek higher returns abroad. To maintain the fixed exchange rate, the central bank must intervene by buying domestic currency in exchange for foreign reserves. This contraction offsets the initial expansion, restoring the money supply and interest rates to their original levels. Output and employment remain unchanged, leaving monetary policy powerless. The central bank effectively loses control over domestic interest rates.
Fiscal policy, however, becomes highly effective. An expansionary fiscal policy—such as higher government spending or lower taxes—raises aggregate demand and pushes up domestic interest rates. Even a small increase attracts large capital inflows. To prevent currency appreciation, the central bank intervenes by selling domestic currency and purchasing foreign assets. This intervention expands the money supply, reinforcing the fiscal stimulus. As a result, output and employment rise significantly. The fiscal expansion is fully accommodated by induced monetary expansion, making it highly potent under fixed exchange rates with capital mobility.
In short, the fixed exchange rate system neutralizes monetary policy but amplifies fiscal policy, as the central bank’s priority to stabilize the exchange rate ensures fiscal actions are automatically supported by monetary adjustments.
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