ECS3703
Assignment 2 Semester 1 2025
Unique #:
Due Date: April 2025
Detailed solutions, explanations, workings
and references.
+27 81 278 3372
, QUESTION 1
(a) Appropriate Macroeconomic Policies under Flexible and Fixed
Exchange Rate Systems
Under the Mundell-Fleming framework with perfect capital mobility, Sub-Saharan
African countries—assuming they are small open economies—will experience
capital inflows and outflows in response to interest rate differentials. These capital
flows significantly influence the effectiveness of monetary and fiscal policies,
depending on whether the exchange rate is flexible or fixed.
1. Flexible Exchange Rate Regime: Use Monetary Policy
Under a flexible exchange rate system, expansionary monetary policy is the most
effective tool. When the central bank increases the money supply, the LM curve
shifts rightward, reducing interest rates. With perfect capital mobility, lower
domestic interest rates lead to capital outflows and currency depreciation.
Depreciation boosts net exports by making exports cheaper and imports more
expensive, which increases aggregate demand and output. The IS curve shifts
rightward due to higher net exports, leading to a new equilibrium with higher
output and stable interest rates. The current account also improves due to
increased exports. Thus, monetary policy is highly effective in addressing both
unemployment and current account balance in this regime.
Conclusion: Under a flexible exchange rate, Sub-Saharan African countries
should rely on monetary policy to stabilise the economy and correct external
imbalances.
2. Fixed Exchange Rate Regime: Use Fiscal Policy
Under a fixed exchange rate regime, monetary policy becomes ineffective. Any
attempt to expand the money supply leads to a balance of payments deficit (LM
shifts right), causing downward pressure on the currency. To maintain the fixed
exchange rate, the central bank must intervene by buying domestic currency,
which reduces the money supply and shifts the LM curve back—nullifying the
effect of the initial expansionary policy.
Varsity Cube 2024 +27 81 278 3372
Assignment 2 Semester 1 2025
Unique #:
Due Date: April 2025
Detailed solutions, explanations, workings
and references.
+27 81 278 3372
, QUESTION 1
(a) Appropriate Macroeconomic Policies under Flexible and Fixed
Exchange Rate Systems
Under the Mundell-Fleming framework with perfect capital mobility, Sub-Saharan
African countries—assuming they are small open economies—will experience
capital inflows and outflows in response to interest rate differentials. These capital
flows significantly influence the effectiveness of monetary and fiscal policies,
depending on whether the exchange rate is flexible or fixed.
1. Flexible Exchange Rate Regime: Use Monetary Policy
Under a flexible exchange rate system, expansionary monetary policy is the most
effective tool. When the central bank increases the money supply, the LM curve
shifts rightward, reducing interest rates. With perfect capital mobility, lower
domestic interest rates lead to capital outflows and currency depreciation.
Depreciation boosts net exports by making exports cheaper and imports more
expensive, which increases aggregate demand and output. The IS curve shifts
rightward due to higher net exports, leading to a new equilibrium with higher
output and stable interest rates. The current account also improves due to
increased exports. Thus, monetary policy is highly effective in addressing both
unemployment and current account balance in this regime.
Conclusion: Under a flexible exchange rate, Sub-Saharan African countries
should rely on monetary policy to stabilise the economy and correct external
imbalances.
2. Fixed Exchange Rate Regime: Use Fiscal Policy
Under a fixed exchange rate regime, monetary policy becomes ineffective. Any
attempt to expand the money supply leads to a balance of payments deficit (LM
shifts right), causing downward pressure on the currency. To maintain the fixed
exchange rate, the central bank must intervene by buying domestic currency,
which reduces the money supply and shifts the LM curve back—nullifying the
effect of the initial expansionary policy.
Varsity Cube 2024 +27 81 278 3372
