Question
According to the Mundell-Fleming Model under a regime of
perfect capital mobility and a fixed exchange rate, which policy tool is rendered completely ineffective for influencing domestic output (Y)?Solution
Solution: In the Mundell-Fleming Model with perfect capital mobility (a horizontal BP curve, where the domestic interest rate i must equal the world interest rate i∗) and a fixed exchange rate, the central bank loses control of its domestic money supply:
- Expansionary Monetary Policy (Attempt): The central bank increases the money supply (LM curve shifts right). This initially puts downward pressure on the domestic interest rate (i
- Capital Flows: Perfect capital mobility means investors immediately move capital out of the country (capital outflow) seeking the higher world interest rate (i∗).
- Central Bank Intervention: To maintain the fixed exchange rate, the central bank must sell foreign currency reserves and buy back domestic currency. This action immediately reverses the initial increase in the money supply (the LM curve shifts back left) until i=i∗.
pF value of hygroscopic coefficient isÂ
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