mundell fleming under high capital flow

CFA Level II
#1

OK i think i understand the low capital flow situation…

For high capital flows… i understand the effect of expansionary/restrictive monetary policy. Where I get confused is when fiscal policy comes into play… and why expansionary/expansionary = indeterminate, restrictive/restrictive = indeterminate.

Could someone explain the reasoning behind that?

thanks

#2

The way I think of it under high capital flows:

  • Expansionary fiscal: as the government needs to borrow more money they drive interest rates up, increasing exchange rates (crowding out effect)
  • Restrictive fiscal: the opposite, no government borrowing, no crowding out, lower interest rates, lower exchange rates
#3

The way I think about it is monetary policy dominates with borrowing rates. Expansionary monetary poilcy will always cause a cureency to depreciate. It’s the combination that’s tricky.

Expansionary monetary lowers rates to induce borrowing and spending. With low rates, capital flows out and causes the currency to depreciate. Easy peasy.

With expansionary fiscal policy, tax rates are lowered and causes economic expansion. Expansion would cause capital flows into the country appreciating the currency. These two contradict each other so it is uncertain for high capital mobility.

For low capital mobility in this scenario, currency would depreciate. As monetary policy always dominates.