Effects of monetary/fiscal policy with low capital mobility

Regarding currency appreciation/depreciation in response to monetary/fiscal policy:

For high capital mobility, the effects of monetary/fiscal policy makes sense to me. However, I can’t understand why the effects turn out like this, when the capital mobility is low:

Monetary/Fiscal Policy - Currency value effect

  • Expansionary/Expansionary - Depreciation
  • Expansionary/Contractionary - Uncertain
  • Contractionary/Expansionary - Uncertain
  • Contractionary/Contractionary - Appreciation

When capital mobility is high (developed and liquid markets), the exchange rates are primarily affected by the inflow and outflow of money generated by financial instruments (deposits, bonds, stocks, etc). This means that interest rates have a lot to do with exchange rates because they are the yield of financial instruments, hence the motivation of investors to add or withdraw their funds to a specific market / country.

When capital mobility is low (developing and illiquid markets), the exchange rates are primarily affected by the trade balance (exports and imports of goods and services), which is the real market (production of physical goods). Most of developing countries are trade open so they export and import goods from abroad, hence they receive foreign currencies that affect their exchange rates. Interest rates here also have an important role which are the financial cost of projects: the higher the rate, the lower the national output and viceversa.

So, when you are under the low capital mobility case, think about the effects of those policies in the trade balance.

For example, the first case of Expansionary Monetary / Expansionary Fiscal. Expansionary monetary policy brings the interest rates down, making production higher in the middle term, however the short-term increase in money supply tends to increase imports in bigger amount than exports do (in the short-term only), so the outflow of foreign currency makes the local currency to depreciate (exchange rate depreciates). Expansionary fiscal policy do the same, it makes the imports to increase because most of that consumption is probably made in abroad markets (so outflow of foreign currency).

As you can see, financial assets here have not much to do here, they are little sensible.

You can follow the same logic for the other cases.

The uncertain cases are easy to understand now, if the policies are contrary to each other, then you can’t arrive to an exact final result on imports, you would need to do a quantitative calculation.

Hope this helps!

Yes, it really helped, thanks a lot smiley