I’m struggling with questions that give scenarios of a country that has expansionary monetary policy and restrictive fiscal policy. The question is…
“Nance receives a report from Jamshed Banaji, Chief Economist at Central City Bank providing broad U.K and U.S. macro-economic forecasts. Nance notes that the Bank of England is expected to pursue an expansionary monetary policy while the Federal Reserve monetary policy is expected to be neutral. Also, the British parliament is expected to reduce the budget deficits more aggressively as compared to the U.S.”
“Assuming high capital mobility in the U.K. and the U.S., according to the Mundell Fleming model, the £/$ is most likely expected to:”
Increase/Decrease/Remain the Same
The correct answer here is increase but I don’t quite understand why exactly…My understanding is expansionary monetary policy would depreciate the pound relative to the dollar while a restrictive fiscal policy would cause an appreciation. How can I discern the net effect of these decisions without knowing the degree of their policies?
The answer to your question depends on whether the country allows free capital flows coming in and out of the country. If they do, then expansionary monetary policy in combination with restrictive fiscal policy will depreciate the currency.
Exhibit 7 and 8 in Reading 13 perfectly summarize what happens in each case. Take a look at that and see if that answers your question.
There are 2 boxes showing the relationship of currency exchange under Mundel Fleming model. You should take a look
What really helped for me with these sorts of problems was simply memorising the Mundel-Fleming summary table. The table will help you get the right answers and actually helps to solidify the concepts in your mind as well as you review the curriculum.
Also, according to uncovered interest rate parity, higher interest rates would mean the currency will depreciate.
According to, Impact of balance of payments and monetary and fiscal policies : Higher interest rates will lead to higher demand of the currency, thereby appreciating it.
So, are these two contradicting each other on the impact on currency or the former is talking about the long term impact and the latter more about the short term, and that eventually uncovered interest rate parity would hold?
Thanks for the help everyone, I feel more confident about this topic now!