Question on how to look at Mundell-Fleming. When you have high cap mobility and an expansionary monetary policy it says interest rates drop, which I understand but it also says it reduces the inflow in physical and financial assets. Is this from the point of view of the country? Seems like it would be the other way around.
If interest rates fall, less foreign investors are willing to invest in the country, so the inflow of assets, specially financial assets, is reduced.
Doesn’t it also depend on fiscal policy? I’ve noticed they ask a few questions like this in EOC but how can you pick without it taking about both monetary and fiscal policy? It is a 2x2 matrix after all
Broadly, Mundell-Fleming says that with high capital mobility, monetary policy outweighs fiscal policy, and with low capital mobility, fiscal policy outweighs monetary policy.
I have an additional question about this:
In a Low Capital Mobility-situation, it says Expansionary Fiscal Policy Drives up imports (the goods flow effect), and therefore a depreciation of the currency will be likely.
This is opposite to the effect assumed under a High Capital Mobility-situation, where expansionary fiscal policy will need more borrowing from the Gov’t, driving up interest and appreciating the currency.
Both make sense, but where does a government get its funding when it is limited in obtaining cash from foreign sources in the Low Capital Mobility-situation? The money for importing needs to come from somewhere right?
What am I missing?
Who said the government is limited to obtaining funding in the form of external debt in the low capital mobility scenario? On the contrary, it says an expansionary fiscal policy will increase spending (at least on the short term) which will widen, or create a trade deficit, and depreciate the currency as the balance of payments adjusts to a worsening current account, especially in the presence of low capital mobility where the financial and capital accounts are mostly stale. The funding comes from local banks, the foreign currency is traded on the open market, if it’s a floating regimen.
In a high capital mobility scenario, the increase in government borrowing should do the exact same as above, but the difference this time is the increase in domestic interest rates (whether due to lower liquidity by the government’s actions, or a monetary policy tightening to support the exchange rate, and indirectly, the expansionary fiscal policy) will attract foreign inflow of funds as they seek higher returns and carry trades. However, on the long run, this will eventually lead to a currency crisis, and a sharp devaluation as the level of government debt becomes too high, and investors lose confidence in the domestic currency, leading to sudden capital flight.
Thanks MrSmart, that sounds logical.
So to summarize:
In the first case the currency effect is influenced mostly by the deficit in the Current (trade) account and NOT (or less) in the Capital Account. Governments will not allow fast movement of capital in and out of the country, thereby protecting the currency more or less.
And in the second case, in the shorter term, high demands of funding through the capital account create increasing interests and investment returns on these flows. And because these flows are not restricted, the capital balance will be affected and the currency appreciates. But as situations worsen, in a high mobility situation, the currency can sharply depreciate due to loss of confidence.
Is this correct?