Model Answer
0 min readIntroduction
In an increasingly interconnected global economy, understanding the interplay between monetary policy, exchange rates, and economic activity is crucial. Perfect capital mobility, characterized by the free flow of capital across borders without restrictions, significantly alters the effectiveness of monetary policy. An increase in the money supply, a common tool used by central banks to stimulate economic growth, will have differing consequences on a nation’s Gross Domestic Product (GDP) depending on whether the country operates under a fixed or flexible exchange rate regime. This difference stems from the exchange rate’s ability to absorb or amplify the initial monetary shock.
Perfect Capital Mobility: A Foundation
Perfect capital mobility implies that capital can move freely and instantaneously across national borders in response to interest rate differentials. This assumption is crucial because it eliminates the possibility of maintaining independent monetary policies under a fixed exchange rate regime. Any attempt to deviate from the interest rate parity condition will lead to massive capital flows that offset the policy change.
Impact under a Fixed Exchange Rate Regime
Under a fixed exchange rate regime, the central bank commits to maintaining a specific exchange rate against another currency or a basket of currencies. With perfect capital mobility, the central bank loses its independent monetary policy. Let's analyze the impact of an increase in the money supply:
- Initial Shock: An increase in the money supply lowers domestic interest rates.
- Capital Outflow: Due to perfect capital mobility, investors will move their capital to countries with higher interest rates.
- Balance of Payments Pressure: This capital outflow creates a deficit in the balance of payments, putting downward pressure on the domestic currency.
- Central Bank Intervention: To maintain the fixed exchange rate, the central bank must intervene in the foreign exchange market by selling foreign reserves and buying domestic currency.
- Monetary Offset: The central bank’s intervention effectively sterilizes the initial monetary expansion. The purchase of domestic currency reduces the money supply, offsetting the initial increase.
- GDP Impact: Consequently, the increase in the money supply has no impact on GDP. The economy remains at its initial level of output. The fixed exchange rate and perfect capital mobility prevent any real effect.
Impact under a Flexible Exchange Rate Regime
Under a flexible (or floating) exchange rate regime, the exchange rate is determined by market forces of supply and demand. Here’s how an increase in the money supply affects GDP:
- Initial Shock: An increase in the money supply lowers domestic interest rates.
- Exchange Rate Depreciation: Lower interest rates make domestic assets less attractive, leading to capital outflow and a depreciation of the domestic currency.
- Increased Net Exports: The depreciation of the currency makes exports cheaper and imports more expensive, leading to an increase in net exports (X-M).
- Aggregate Demand Increase: The increase in net exports boosts aggregate demand (AD).
- GDP Increase: The increase in AD leads to an increase in GDP. The magnitude of the increase depends on the slope of the aggregate supply curve.
In this scenario, the exchange rate acts as an adjustment mechanism, absorbing the monetary shock and translating it into a change in output. The economy experiences an expansionary effect.
Comparative Analysis: A Table
| Feature | Fixed Exchange Rate (Perfect Capital Mobility) | Flexible Exchange Rate (Perfect Capital Mobility) |
|---|---|---|
| Monetary Policy Independence | Lost | Retained |
| Impact of Money Supply Increase | No impact on GDP | Increase in GDP |
| Exchange Rate Adjustment | No adjustment – Central Bank intervenes | Depreciation |
| Central Bank Intervention | Required to maintain the fixed rate | Not required |
| Capital Flows | Significant, offset by intervention | Lead to exchange rate adjustment |
The Mundell-Fleming Model
The Mundell-Fleming model provides a formal framework for understanding these effects. Under perfect capital mobility, the LM curve becomes horizontal in both regimes. In the fixed exchange rate case, the IS curve intersects the horizontal LM curve at a point where there is no change in output. In the flexible exchange rate case, the IS curve shifts outward due to the increase in net exports, leading to an increase in output.
Conclusion
In conclusion, the impact of an increase in the money supply on GDP differs significantly under fixed and flexible exchange rate regimes when capital is perfectly mobile. Under a fixed regime, the central bank loses monetary policy independence, and the increase in money supply is sterilized, resulting in no change in GDP. Conversely, under a flexible regime, the exchange rate depreciates, boosting net exports and leading to an increase in GDP. This highlights the trade-off between exchange rate stability and monetary policy autonomy in an open economy. The assumption of perfect capital mobility is a strong one, but it provides a useful benchmark for understanding the constraints faced by policymakers.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.