Using the Mundell-Fleming model, compare and contrast the impact of monetary expansion with low capital mobility under fixed and flexible exchange rates.
To compare and contrast the impact of monetary expansion with low capital mobility under fixed and flexible exchange rates using the Mundell-Fleming model, we need to understand the basic concepts and implications of this model.
The Mundell-Fleming model analyzes the interaction between monetary and fiscal policies, exchange rates, and capital flows in an open economy. It consists of two main components: the IS-LM framework, which focuses on the goods and money market, and the balance of payments equilibrium, which considers the foreign exchange market.
First, let's define low capital mobility. In this context, it means that a country's capital flows are relatively restricted, and there are barriers or regulations that limit the movement of capital in and out of the country.
Under a fixed exchange rate regime:
1. Monetary Expansion: When a country adopts a fixed exchange rate, it commits to maintaining the value of its currency relative to another currency or a basket of currencies. In this case, a monetary expansion (increasing the money supply) has limited impact on the economy as it cannot directly affect the exchange rate. The central bank must intervene in the foreign exchange market to maintain the fixed rate by buying or selling its currency.
- Impact on Output and Interest Rates: As the money supply increases, it leads to a rise in aggregate demand, which increases output (GDP) in the short run. This is shown by a shift in the IS curve to the right (IS1 to IS2). However, since capital mobility is low, the increased money supply does not lead to significant capital outflows or interest rate adjustments.
- Impact on the Exchange Rate: With low capital mobility and a fixed exchange rate, the central bank intervenes in the foreign exchange market to maintain the fixed rate. It will sell foreign currency reserves to buy the domestic currency, to prevent depreciation caused by increased money supply.
Under a flexible exchange rate regime:
1. Monetary Expansion: In this case, a monetary expansion can have a more pronounced impact on the economy. The central bank increases the money supply, which affects interest rates and exchange rates.
- Impact on Output and Interest Rates: The increased money supply shifts the LM curve downward (LM1 to LM2), lowering interest rates. This stimulates investment and consumption, leading to an increase in output. The lower interest rates can also result in capital outflows, as investors seek higher returns abroad.
- Impact on the Exchange Rate: With low capital mobility, the impact on the exchange rate is limited. The increase in money supply can lead to a depreciation of the currency, but the effect may be dampened because capital flows are restricted. In the short run, the exchange rate depreciates slightly, but it is not as significant as in a scenario with high capital mobility.
In summary:
- Under a fixed exchange rate and low capital mobility, monetary expansion stimulates output but has limited effect on interest rates and exchange rates due to central bank intervention in the foreign exchange market to maintain the fixed rate.
- Under a flexible exchange rate and low capital mobility, monetary expansion has a more pronounced impact on output and interest rates. The effect on the exchange rate is limited due to restricted capital flows, but there may be a slight depreciation in the short run.