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11.k Mundell Fleming and capital mobility

High Capital Mobility

Expansionary monetary policy and expansionary fiscal policy are likely to have opposite effects on exchange rates. Expansionary monetary policy will reduce the interest rate and, consequently, reduce the inflow of capital investment in physical and financial assets.

If interest rates go down, then it becomes cheaper to borrow money, which encourages more investing. Why would the book state that inflow of capital investment is reduced?

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Because as an offshore source of capital my incentive would be to seek a return in a higher-yielding market given the reduction in your domestic interest rates. 

startuppivot wrote:

High Capital Mobility

Expansionary monetary policy and expansionary fiscal policy are likely to have opposite effects on exchange rates. Expansionary monetary policy will reduce the interest rate and, consequently, reduce the inflow of capital investment in physical and financial assets.

If interest rates go down, then it becomes cheaper to borrow money, which encourages more investing. Why would the book state that inflow of capital investment is reduced?

In a small country, for example, there are trillion of dollars already invested (factories, buildings, transportation, navy, army, human capital, infrastructure, houses, hospitals, colleges and schools, etc) through decades of production. Let’s see this as a stock capital.

What we are talking about in Mudell-Flemming theory is capital flows.

In an expansionary monetary policy, local currency is issued to decrease its price (interest rate) in order to promote consumption and investment as you said above (which is positive). Additionally to those effects, some capitals are meant to go out of the country because portfolio adjustments.

Suppose you are a portfolio manager of a fund or a bank. Your optimal allocation is 70% equity and 30% fixed income. Both asset classes are expected to decrease in value when interest rates fell, but fixed income is more sensitive to changes in interest rates. So, as soon as an expansionary monetary policy is expected to take place, portfolio managers will adjust their positions and will probably change asset allocations that includes sending funds to foreign markets to purchase instruments with better rates.

The final question is: what effect is higher? a higher consumption and investment from the private market, or capital outflows. The answer will depend on many other factors, but when accurately applied, expansionary monetary policy will lead to GDP growth (or recovery, because is a measure of economy reactivation).

Hope this helps.

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