Hi, can someone please explain to me how and why this model works? I memorized when the currency appreciates/depreciates, but don’t understand it too well. Also, if you know how fixed-currency regime and floating-currency regime tie in, that would be great. Much appreciated, Jason
Under fixed exchange regime, the government has to interfere to maintain the level of exchange rage by buying (selling) currenies in case of expansionary monetary policy (expansionary fiscal policy) that results in currency depreciation (appreciation)
Under floating there is no such case becasue exchange rates re determined by market. So in case of expansionary monetary policy currency depreciates (becasue this causes interest rates to go down and funds flow out of the country) and expansionary fiscal policy currency appreciates (because of inflow of funds demand for currency rises) causing opposite effects. So here is the summary:
Expansionary Monetary/Restrictive Fiscal => Currency Appreciates
Restrictive Fiscal/Expansionary Fiscal => Currency Depreciate
In other cases, the currency appreciation/depreciation is undertain
This was the case when capital can flow without bounds across the border, what if government has limitation on capital flow (example emerging markets).
In such cases the impact of goods flow (current account) or trade balance (export/import) is more than the impact of capital flow (capital account)
So, expansionary monetary or expansionary fiscal policy will lead to higher imports due to lots of money available leading to depreciation of currency and opposite is true for restrictive moneray and fiscal policies
Hope that helps!