In situation of high capital mobility and floating FX,
why does a restrictive monetary policy combined with expansionary fiscal policy cause domestic currency to depreciate? And why is the currency direction indeterminate if the monetary policy above is expansionary?
Would the effect change if the FX wasn’t floating?
Domestic currency would appreciate (not depreciate) under the conditions of high capital mobility, restrictive monetary policy, and expansionary fiscal policy. But excessive debt levels may eventually cause downward pressure on currency in the long-run.
Under a fixed exchange rate, the monetary authority would have to sell the domestic currency on the FX market to prevent appreciation. The expansion of the domestic money supply would reinforce the aggregate demand impact of the expansionary fiscal policy.