ECS3703 Assignment
2 (COMPLETE
ANSWERS) Semester
1 2025 - DUE April
2025
NO PLAGIARISM
[Pick the date]
[Type the company name]
, 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
Effectiveness of Monetary and Fiscal Policy in an Open Economy Under Perfect
Capital Mobility
(a) Flexible Exchange Rate System
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policy is influenced by the Mundell-Fleming model, which extends the IS-LM framework to an
open economy setting.
Monetary Policy Under a Flexible Exchange Rate
Highly Effective: Monetary policy is powerful in influencing output.
Mechanism:
o When the central bank increases the money supply (expansionary monetary
policy), interest rates fall.
o Capital outflows occur because investors seek higher returns elsewhere.
o The currency depreciates, making exports cheaper and imports more expensive.
o This improves the trade balance, increasing aggregate demand and output.
Example: If the South African Reserve Bank (SARB) lowers interest rates, the rand
depreciates, boosting exports.
Fiscal Policy Under a Flexible Exchange Rate
Ineffective: Fiscal policy has little to no impact on output due to exchange rate
adjustments.
Mechanism:
o When the government increases spending or reduces taxes, demand for goods
and services rises, pushing interest rates up.
o Higher interest rates attract capital inflows, causing the currency to appreciate.
o The appreciation makes exports more expensive and imports cheaper, leading to
a trade deficit that offsets the fiscal stimulus.
Example: If South Africa increases government spending, the rand appreciates, reducing
net exports and negating the fiscal expansion.
,Conclusion
Monetary policy is highly effective under a flexible exchange rate because exchange
rate depreciation reinforces expansionary measures.
Fiscal policy is ineffective because exchange rate appreciation offsets the increase in
demand.
In an open economy with perfect capital mobility, monetary and fiscal policy operate
differently depending on the exchange rate regime in place. Let's focus on (a) a flexible
exchange rate system:
✅ Key Assumptions:
Open economy: Trade and capital flows with the rest of the world.
Perfect capital mobility: Investors can move capital freely across borders in search of
the highest returns; any interest rate differential is quickly offset by capital flows.
Flexible exchange rate system: Exchange rates are determined by market forces (supply
and demand) without central bank intervention.
(a) Under a Flexible Exchange Rate System
💰 Monetary Policy – Effective
Mechanism:
o When the central bank increases the money supply (expansionary monetary
policy), interest rates fall.
o With lower domestic interest rates, capital flows out to countries with higher
returns.
o This causes the domestic currency to depreciate.
o A weaker currency makes exports cheaper and imports more expensive,
improving the net export position.
o This leads to higher aggregate demand and boosts output and employment.
✅ Conclusion: Highly effective in influencing output and employment under flexible exchange
rates and perfect capital mobility.
💸 Fiscal Policy – Ineffective
Mechanism:
, o When the government increases spending or cuts taxes (expansionary fiscal
policy), aggregate demand initially rises.
o This leads to higher interest rates due to increased demand for money.
o Capital inflows occur as foreign investors seek higher returns, causing the
domestic currency to appreciate.
o The appreciation makes exports more expensive and imports cheaper,
worsening the trade balance.
o The fall in net exports offsets the increase in government spending.
❌ Conclusion: Fiscal policy becomes ineffective because any expansionary effect is
neutralized by currency appreciation and reduced net exports.
Summary Table:
Effectiveness (Flexible
Policy Type Explanation
Exchange Rate)
Monetary Causes depreciation → boosts exports →
✅ Effective
Policy increases output
Causes appreciation → reduces exports →
Fiscal Policy ❌ Ineffective
offsets stimulus
(b) A fixed exchange rate system
(b) Fixed Exchange Rate System
Under a fixed exchange rate system, the central bank intervenes in foreign exchange markets to
maintain the currency at a predetermined level. The effectiveness of monetary and fiscal policy
changes significantly compared to a flexible exchange rate system.
Monetary Policy Under a Fixed Exchange Rate
Ineffective: The central bank loses control over monetary policy because it must
maintain the exchange rate.
Mechanism:
o If the central bank increases the money supply to lower interest rates, capital
flows out in search of higher returns elsewhere.
o This causes pressure on the currency to depreciate, but the central bank must
intervene by selling foreign reserves and buying back domestic currency to
maintain the fixed exchange rate.
2 (COMPLETE
ANSWERS) Semester
1 2025 - DUE April
2025
NO PLAGIARISM
[Pick the date]
[Type the company name]
, 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
Effectiveness of Monetary and Fiscal Policy in an Open Economy Under Perfect
Capital Mobility
(a) Flexible Exchange Rate System
In an open economy with perfect capital mobility, the effectiveness of monetary and fiscal
policy is influenced by the Mundell-Fleming model, which extends the IS-LM framework to an
open economy setting.
Monetary Policy Under a Flexible Exchange Rate
Highly Effective: Monetary policy is powerful in influencing output.
Mechanism:
o When the central bank increases the money supply (expansionary monetary
policy), interest rates fall.
o Capital outflows occur because investors seek higher returns elsewhere.
o The currency depreciates, making exports cheaper and imports more expensive.
o This improves the trade balance, increasing aggregate demand and output.
Example: If the South African Reserve Bank (SARB) lowers interest rates, the rand
depreciates, boosting exports.
Fiscal Policy Under a Flexible Exchange Rate
Ineffective: Fiscal policy has little to no impact on output due to exchange rate
adjustments.
Mechanism:
o When the government increases spending or reduces taxes, demand for goods
and services rises, pushing interest rates up.
o Higher interest rates attract capital inflows, causing the currency to appreciate.
o The appreciation makes exports more expensive and imports cheaper, leading to
a trade deficit that offsets the fiscal stimulus.
Example: If South Africa increases government spending, the rand appreciates, reducing
net exports and negating the fiscal expansion.
,Conclusion
Monetary policy is highly effective under a flexible exchange rate because exchange
rate depreciation reinforces expansionary measures.
Fiscal policy is ineffective because exchange rate appreciation offsets the increase in
demand.
In an open economy with perfect capital mobility, monetary and fiscal policy operate
differently depending on the exchange rate regime in place. Let's focus on (a) a flexible
exchange rate system:
✅ Key Assumptions:
Open economy: Trade and capital flows with the rest of the world.
Perfect capital mobility: Investors can move capital freely across borders in search of
the highest returns; any interest rate differential is quickly offset by capital flows.
Flexible exchange rate system: Exchange rates are determined by market forces (supply
and demand) without central bank intervention.
(a) Under a Flexible Exchange Rate System
💰 Monetary Policy – Effective
Mechanism:
o When the central bank increases the money supply (expansionary monetary
policy), interest rates fall.
o With lower domestic interest rates, capital flows out to countries with higher
returns.
o This causes the domestic currency to depreciate.
o A weaker currency makes exports cheaper and imports more expensive,
improving the net export position.
o This leads to higher aggregate demand and boosts output and employment.
✅ Conclusion: Highly effective in influencing output and employment under flexible exchange
rates and perfect capital mobility.
💸 Fiscal Policy – Ineffective
Mechanism:
, o When the government increases spending or cuts taxes (expansionary fiscal
policy), aggregate demand initially rises.
o This leads to higher interest rates due to increased demand for money.
o Capital inflows occur as foreign investors seek higher returns, causing the
domestic currency to appreciate.
o The appreciation makes exports more expensive and imports cheaper,
worsening the trade balance.
o The fall in net exports offsets the increase in government spending.
❌ Conclusion: Fiscal policy becomes ineffective because any expansionary effect is
neutralized by currency appreciation and reduced net exports.
Summary Table:
Effectiveness (Flexible
Policy Type Explanation
Exchange Rate)
Monetary Causes depreciation → boosts exports →
✅ Effective
Policy increases output
Causes appreciation → reduces exports →
Fiscal Policy ❌ Ineffective
offsets stimulus
(b) A fixed exchange rate system
(b) Fixed Exchange Rate System
Under a fixed exchange rate system, the central bank intervenes in foreign exchange markets to
maintain the currency at a predetermined level. The effectiveness of monetary and fiscal policy
changes significantly compared to a flexible exchange rate system.
Monetary Policy Under a Fixed Exchange Rate
Ineffective: The central bank loses control over monetary policy because it must
maintain the exchange rate.
Mechanism:
o If the central bank increases the money supply to lower interest rates, capital
flows out in search of higher returns elsewhere.
o This causes pressure on the currency to depreciate, but the central bank must
intervene by selling foreign reserves and buying back domestic currency to
maintain the fixed exchange rate.
