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ECS3703 Assignment
2 (COMPLETE
ANSWERS) Semester
1 2025 - DUE April
2025
NO PLAGIARISM
[Pick the date]
[Type the abstract of the document here. The abstract is typically a short summary of the contents of
the document. Type the abstract of the document here. The abstract is typically a short summary of
the contents of the document.]
, Book
International Economics
QUESTION 1
Discuss the effectiveness of monetary and fiscal policy in an open economy under perfect
capital mobility with:
(a) A flexible exchange rate system
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policies is influenced significantly by the exchange rate system in place. In this case, let's
examine how these policies work under a flexible exchange rate system.
(a) Flexible Exchange Rate System
A flexible exchange rate system means that the value of a country’s currency is determined by
market forces (supply and demand) without direct intervention by the central bank. The
exchange rate can fluctuate based on a variety of factors, including interest rates, inflation, and
trade balances. In this context, let's analyze the effectiveness of monetary and fiscal policies.
1. Monetary Policy Under a Flexible Exchange Rate System
Monetary policy involves the control of money supply and interest rates by the central bank to
influence aggregate demand and economic activity. Under a flexible exchange rate system with
perfect capital mobility, monetary policy is generally very effective for influencing the
economy.
Mechanism:
Interest Rates and Capital Flows: When the central bank changes interest rates (for
example, by lowering rates), it affects the return on investments in the country. With
perfect capital mobility, capital will flow freely in and out of the country. A reduction in
interest rates will typically cause capital to flow out, leading to a depreciation of the
currency.
Depreciation of Currency: A depreciated currency makes exports cheaper and imports
more expensive, improving the trade balance. This is known as the expenditure-
switching effect.
Expansion of Net Exports: With a weaker currency, foreign demand for domestic goods
increases, which can lead to an increase in aggregate demand. This boost in exports can
stimulate overall economic activity, offsetting some of the negative effects of lower
interest rates (such as reduced investment).
Effectiveness: Monetary policy is effective in influencing both output and the exchange
rate. If the central bank lowers interest rates, it stimulates exports and helps the economy
, recover from a recession or boost growth. The trade balance improvement can
compensate for lower investment, which makes monetary policy effective in this setting.
Conclusion: Highly effective—Monetary policy can effectively stimulate demand through
depreciation and increased exports, especially in an open economy with capital mobility.
2. Fiscal Policy Under a Flexible Exchange Rate System
Fiscal policy involves changes in government spending and taxation to influence aggregate
demand. Under a flexible exchange rate system, fiscal policy can be less effective compared to
monetary policy, primarily due to the currency’s response to changes in government spending.
Mechanism:
Government Spending and Capital Flows: If the government increases spending,
aggregate demand rises, which could lead to an increase in interest rates (as the
government borrows to finance its spending). With perfect capital mobility, this rise in
interest rates attracts foreign capital, leading to currency appreciation.
Appreciation of Currency: As the currency appreciates, the price of exports rises on
international markets, while imports become cheaper. This reduces net exports,
counteracting the initial boost from government spending. This is known as the
expenditure-reducing effect.
Crowding Out: The appreciation of the currency and the reduction in net exports can
partially or completely offset the effects of fiscal expansion, especially in the short term.
Additionally, higher interest rates can reduce private investment (crowding out), which
further weakens the effectiveness of fiscal policy.
Effectiveness: Fiscal policy in this scenario is less effective compared to monetary policy
because the currency appreciation and reduced exports can offset the expansionary
effects of increased government spending. Moreover, the crowding-out effect of higher
interest rates may reduce private sector investment.
Conclusion: Less effective—Fiscal policy may be less effective in boosting aggregate
demand due to the offsetting effects of currency appreciation and crowding out.
Comparison of Effectiveness:
Monetary policy: In an open economy with perfect capital mobility and a flexible
exchange rate system, monetary policy is highly effective. It can influence the exchange
rate, which, in turn, stimulates net exports and boosts aggregate demand.
Fiscal policy: Fiscal policy is less effective in this setting because any increase in
government spending may lead to an appreciation of the currency, which harms net
exports and reduces the overall impact of the policy. Moreover, higher interest rates may
crowd out private investment.
Conclusion:
, In an open economy with perfect capital mobility and a flexible exchange rate system, monetary
policy is much more effective than fiscal policy. Monetary policy can use the exchange rate
channel to stimulate demand, while fiscal policy faces challenges like currency appreciation and
crowding out, which reduce its overall effectiveness.
(b) A fixed exchange rate system
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policies can differ significantly under a fixed exchange rate system. In a fixed exchange rate
system, a country’s currency value is pegged to another currency (or a basket of currencies), and
the central bank actively intervenes in the foreign exchange market to maintain this fixed rate.
Let’s analyze the effectiveness of monetary and fiscal policies in this context.
(b) Fixed Exchange Rate System
Under a fixed exchange rate system with perfect capital mobility, the central bank is committed
to maintaining the value of the domestic currency at a predetermined rate relative to another
currency. This means the central bank must buy or sell its own currency in the foreign exchange
market to maintain the peg. Now, let’s look at the effectiveness of monetary and fiscal policies.
1. Monetary Policy Under a Fixed Exchange Rate System
In a fixed exchange rate system, monetary policy is generally ineffective because the central
bank’s ability to control the money supply and interest rates is constrained by the need to
maintain the fixed exchange rate.
Mechanism:
Interest Rates and Capital Flows: If the central bank attempts to use monetary policy to
change interest rates (for example, by lowering interest rates to stimulate the economy),
capital flows will respond accordingly. With perfect capital mobility, lower interest rates
will typically lead to capital outflows, as investors seek higher returns elsewhere.
Exchange Rate Pegging: To maintain the fixed exchange rate, the central bank will have
to sell foreign reserves and buy its own currency to defend the peg. However, this can
only be sustained as long as the central bank has sufficient foreign reserves. If the capital
outflows are large enough, the central bank may run out of reserves, forcing it to abandon
the peg or devalue the currency. Essentially, the central bank loses control over domestic
monetary conditions.
Effectiveness: Since the central bank must maintain the fixed exchange rate, it cannot
freely adjust interest rates or money supply in response to domestic economic conditions.
ECS3703 Assignment
2 (COMPLETE
ANSWERS) Semester
1 2025 - DUE April
2025
NO PLAGIARISM
[Pick the date]
[Type the abstract of the document here. The abstract is typically a short summary of the contents of
the document. Type the abstract of the document here. The abstract is typically a short summary of
the contents of the document.]
, Book
International Economics
QUESTION 1
Discuss the effectiveness of monetary and fiscal policy in an open economy under perfect
capital mobility with:
(a) A flexible exchange rate system
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policies is influenced significantly by the exchange rate system in place. In this case, let's
examine how these policies work under a flexible exchange rate system.
(a) Flexible Exchange Rate System
A flexible exchange rate system means that the value of a country’s currency is determined by
market forces (supply and demand) without direct intervention by the central bank. The
exchange rate can fluctuate based on a variety of factors, including interest rates, inflation, and
trade balances. In this context, let's analyze the effectiveness of monetary and fiscal policies.
1. Monetary Policy Under a Flexible Exchange Rate System
Monetary policy involves the control of money supply and interest rates by the central bank to
influence aggregate demand and economic activity. Under a flexible exchange rate system with
perfect capital mobility, monetary policy is generally very effective for influencing the
economy.
Mechanism:
Interest Rates and Capital Flows: When the central bank changes interest rates (for
example, by lowering rates), it affects the return on investments in the country. With
perfect capital mobility, capital will flow freely in and out of the country. A reduction in
interest rates will typically cause capital to flow out, leading to a depreciation of the
currency.
Depreciation of Currency: A depreciated currency makes exports cheaper and imports
more expensive, improving the trade balance. This is known as the expenditure-
switching effect.
Expansion of Net Exports: With a weaker currency, foreign demand for domestic goods
increases, which can lead to an increase in aggregate demand. This boost in exports can
stimulate overall economic activity, offsetting some of the negative effects of lower
interest rates (such as reduced investment).
Effectiveness: Monetary policy is effective in influencing both output and the exchange
rate. If the central bank lowers interest rates, it stimulates exports and helps the economy
, recover from a recession or boost growth. The trade balance improvement can
compensate for lower investment, which makes monetary policy effective in this setting.
Conclusion: Highly effective—Monetary policy can effectively stimulate demand through
depreciation and increased exports, especially in an open economy with capital mobility.
2. Fiscal Policy Under a Flexible Exchange Rate System
Fiscal policy involves changes in government spending and taxation to influence aggregate
demand. Under a flexible exchange rate system, fiscal policy can be less effective compared to
monetary policy, primarily due to the currency’s response to changes in government spending.
Mechanism:
Government Spending and Capital Flows: If the government increases spending,
aggregate demand rises, which could lead to an increase in interest rates (as the
government borrows to finance its spending). With perfect capital mobility, this rise in
interest rates attracts foreign capital, leading to currency appreciation.
Appreciation of Currency: As the currency appreciates, the price of exports rises on
international markets, while imports become cheaper. This reduces net exports,
counteracting the initial boost from government spending. This is known as the
expenditure-reducing effect.
Crowding Out: The appreciation of the currency and the reduction in net exports can
partially or completely offset the effects of fiscal expansion, especially in the short term.
Additionally, higher interest rates can reduce private investment (crowding out), which
further weakens the effectiveness of fiscal policy.
Effectiveness: Fiscal policy in this scenario is less effective compared to monetary policy
because the currency appreciation and reduced exports can offset the expansionary
effects of increased government spending. Moreover, the crowding-out effect of higher
interest rates may reduce private sector investment.
Conclusion: Less effective—Fiscal policy may be less effective in boosting aggregate
demand due to the offsetting effects of currency appreciation and crowding out.
Comparison of Effectiveness:
Monetary policy: In an open economy with perfect capital mobility and a flexible
exchange rate system, monetary policy is highly effective. It can influence the exchange
rate, which, in turn, stimulates net exports and boosts aggregate demand.
Fiscal policy: Fiscal policy is less effective in this setting because any increase in
government spending may lead to an appreciation of the currency, which harms net
exports and reduces the overall impact of the policy. Moreover, higher interest rates may
crowd out private investment.
Conclusion:
, In an open economy with perfect capital mobility and a flexible exchange rate system, monetary
policy is much more effective than fiscal policy. Monetary policy can use the exchange rate
channel to stimulate demand, while fiscal policy faces challenges like currency appreciation and
crowding out, which reduce its overall effectiveness.
(b) A fixed exchange rate system
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policies can differ significantly under a fixed exchange rate system. In a fixed exchange rate
system, a country’s currency value is pegged to another currency (or a basket of currencies), and
the central bank actively intervenes in the foreign exchange market to maintain this fixed rate.
Let’s analyze the effectiveness of monetary and fiscal policies in this context.
(b) Fixed Exchange Rate System
Under a fixed exchange rate system with perfect capital mobility, the central bank is committed
to maintaining the value of the domestic currency at a predetermined rate relative to another
currency. This means the central bank must buy or sell its own currency in the foreign exchange
market to maintain the peg. Now, let’s look at the effectiveness of monetary and fiscal policies.
1. Monetary Policy Under a Fixed Exchange Rate System
In a fixed exchange rate system, monetary policy is generally ineffective because the central
bank’s ability to control the money supply and interest rates is constrained by the need to
maintain the fixed exchange rate.
Mechanism:
Interest Rates and Capital Flows: If the central bank attempts to use monetary policy to
change interest rates (for example, by lowering interest rates to stimulate the economy),
capital flows will respond accordingly. With perfect capital mobility, lower interest rates
will typically lead to capital outflows, as investors seek higher returns elsewhere.
Exchange Rate Pegging: To maintain the fixed exchange rate, the central bank will have
to sell foreign reserves and buy its own currency to defend the peg. However, this can
only be sustained as long as the central bank has sufficient foreign reserves. If the capital
outflows are large enough, the central bank may run out of reserves, forcing it to abandon
the peg or devalue the currency. Essentially, the central bank loses control over domestic
monetary conditions.
Effectiveness: Since the central bank must maintain the fixed exchange rate, it cannot
freely adjust interest rates or money supply in response to domestic economic conditions.
