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ECS3703 Assignment 2
(COMPLETE ANSWERS)
Semester 1 2025 - DUE
April 2025
NO PLAGIARISM
[Year]
, 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.
(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.
o This intervention reverses the monetary expansion, making monetary policy
ineffective.
Example: If the South African Reserve Bank (SARB) tries to lower interest rates, capital
outflows put downward pressure on the rand, forcing SARB to intervene and restore the
original money supply.
Fiscal Policy Under a Fixed Exchange Rate
Highly Effective: Fiscal expansion leads to higher output without being offset by
exchange rate movements.
Mechanism:
o When the government increases spending or reduces taxes, demand and interest
rates rise.
o Higher interest rates attract capital inflows, increasing demand for the domestic
currency.
o To maintain the fixed exchange rate, the central bank buys foreign currency and
increases the domestic money supply, reinforcing the fiscal expansion.
, Example: If South Africa increases government spending, capital inflows support the
exchange rate while expanding the money supply, further boosting output.
Conclusion
Monetary policy is ineffective because the central bank must prioritize maintaining the
fixed exchange rate.
Fiscal policy is highly effective because capital inflows reinforce the policy's impact on
output.
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
[Year]
, 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.
(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.
o This intervention reverses the monetary expansion, making monetary policy
ineffective.
Example: If the South African Reserve Bank (SARB) tries to lower interest rates, capital
outflows put downward pressure on the rand, forcing SARB to intervene and restore the
original money supply.
Fiscal Policy Under a Fixed Exchange Rate
Highly Effective: Fiscal expansion leads to higher output without being offset by
exchange rate movements.
Mechanism:
o When the government increases spending or reduces taxes, demand and interest
rates rise.
o Higher interest rates attract capital inflows, increasing demand for the domestic
currency.
o To maintain the fixed exchange rate, the central bank buys foreign currency and
increases the domestic money supply, reinforcing the fiscal expansion.
, Example: If South Africa increases government spending, capital inflows support the
exchange rate while expanding the money supply, further boosting output.
Conclusion
Monetary policy is ineffective because the central bank must prioritize maintaining the
fixed exchange rate.
Fiscal policy is highly effective because capital inflows reinforce the policy's impact on
output.
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.
