ECS3703 Assignment 2 Semester 1 Memo | Due April 2025 Course • International Finance (ECS3703) • Institution • University Of South Africa (Unisa) • Book • International Economics

ECS3703 Assignment
2 Semester 1 Memo |
Due April 2025
NO PLAGIARISM
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, Exam (elaborations)
ECS3703 Assignment 2 Semester 1 Memo |
Due April 2025
Course
 International Finance (ECS3703)
Institution

 University Of South Africa (Unisa)
 Book
 International Economics

ECS3703 Assignment 2 Semester 1 Memo | Due April 2025. All questions
fully answered.

QUESTION 1 [40 MARKS] Assume that Sub-Saharan African countries are
small countries with perfect capital mobility and a desire to maintain a
balanced current account and correct unemployment or inflation. (a) Explain
which macroeconomic policy these countries should use to achieve this
under a scenario of a flexible and fixed exchange rate systems and why.
……………………………………………………………….……….………(10)

Introduction

Sub-Saharan African countries are often considered small open economies, meaning their
economic policies and interest rates do not influence global markets. Given perfect capital
mobility, capital can move freely across borders in response to interest rate differentials. These
countries aim to maintain a balanced current account (CA = 0) while also correcting for either
unemployment (requiring expansionary policies) or inflation (requiring contractionary
policies).

The effectiveness of macroeconomic policy—monetary or fiscal—differs under flexible and
fixed exchange rate regimes. The appropriate choice of policy depends on the interaction
between capital flows, interest rates, and exchange rate movements as explained in the Mundell-
Fleming model.




Flexible Exchange Rate System
Policy Choice: Use Monetary Policy

In a flexible exchange rate regime, the exchange rate is determined by market forces and adjusts
automatically to correct imbalances in the balance of payments. This allows the central bank to
pursue independent monetary policy to target domestic goals (e.g. unemployment or inflation).

, Scenario: Correcting Unemployment

1. The central bank implements expansionary monetary policy by lowering interest rates.
2. Lower interest rates stimulate investment and consumption, increasing aggregate
demand and national income.
3. However, lower interest rates trigger capital outflows as investors seek higher returns
abroad.
4. This causes the currency to depreciate (exchange rate falls).
5. A weaker currency improves the trade balance by making exports cheaper and
imports more expensive.
6. This improves the current account, helping to maintain external balance.

Conclusion: The depreciation of the exchange rate offsets the capital outflows, while the
monetary stimulus boosts domestic output and employment. Both internal and external balance
are achieved.

Scenario: Correcting Inflation

1. The central bank uses contractionary monetary policy by raising interest rates.
2. Higher interest rates reduce consumption and investment, reducing aggregate demand
and inflation.
3. Capital inflows occur due to higher returns, appreciating the currency.
4. A stronger currency reduces import prices, further helping to control inflation.
5. The current account may worsen, but the capital account surplus offsets it.

Conclusion: Exchange rate appreciation works in tandem with monetary policy to lower
inflation while maintaining balance of payments equilibrium.

Why Not Fiscal Policy?

 Expansionary fiscal policy (e.g., increased government spending) raises income, which
increases imports.
 The current account worsens, leading to currency depreciation.
 Depreciation may fuel inflation, undermining domestic stability.
 Moreover, fiscal policy leads to crowding out of private investment due to higher
interest rates.

Summary: Under flexible exchange rates, monetary policy is the most effective tool to achieve
internal (employment/inflation) and external (current account) balance.




Fixed Exchange Rate System
Policy Choice: Use Fiscal Policy