Saturday, May 26, 2007

FE201-Q 6|FE102-Q 4

FE 201 Question 6
"In conditions of perfect capital mobility and a floating exchange rate, fiscal policy is likely to be ineffective, while monetary policy may be effective in achieving both internal and external balance." Discuss this statement with reference to the Mundell-Fleming Model.
Fiscal Policy expansion.
Suppose, instead the authorities attempt to expand output by an expansionary fiscal policy. The increased government expenditure shifts the IS schedule to the right, but the bond sales that finance the expansion lead to upward pressure on the domestic interest rate resulting in massive capital inflow and a appreciation of the exchange rate. The appreciation of the exchange rate results in a reduction of exports and an increase in imports, and thus forces the IS schedule back to its original position.

Monetary Policy expansion.
A monetary expansion shifts the LM schedule to the right, leading to downward pressure on the interest rate, a capital outflow and a depreciation of the exchange rate. The depreciation leads to an increase to an increase in exports and reduction in imports so shifting the IS curve to the right and the LM schedule to the left, so that final equilibrium is obtained at a higher level of income.



FE102-Q 4
4. Using the Mundell-Fleming model, explain the effect on internal and external equilibrium of a change in exchange rates. Explain and discuss the role of capital mobility in the model.
Let me start with the second part of the question, in a perfectly mobile capital then the BP curve would be horizontal and any change in interest rates would either cause capital flight or capital coming in that would be beyond the capacity of the Central Bank to control beyond the very limited short-run. But even if this is true in the short run we have to conclude that at some time capital can not just keep coming. As in:
Interaction of stocks and flow increases the stock of foreign liabilities owed by the country to the rest of the world.
Neglects the long-run budget constraints.
Treatment of capital flows/portfolio-balance approach. After allocation of the portfolio to changes in interest rates, then to get a further influx of funds then the rates would again have to change to again create a change in portfolio allocations.
Thus the model assuming short-run nature but is based n the Marshall-Lerner condition which is essentially a short-term model.

If there was an autonomous increase in exports or an increase in domestic consumption, the BP schedule will shift to the right, thus creating a surplus in BoP. There then would actually be a shortage in the domestic currency so the LM curve would be shifted to the right with an increase in Money Supply. And the IS curve will shift to the right with an increase in the absorption in the economy. Income will rise but interest rates may fall or rise depending on the BP/LM slope differential.

Links:
International Economics, Robert A. Mundell, New York: Macmillan, 1968, pp. 250-271

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