For the pure monetary model why is it that an expansionary fiscal policy also leads to a decrease in currency when the textbook also mentions under the high capital mobility section that expansionary fiscal leads to a currency appreciation?
Just saw a question I was going to ask, anyone knows the answer on this one? it is on page 272 and 273 of the Econ Book in Kaplan when they talk about the pure monetary model and Mundell Fleming model. Thanks!
Anyone has a thought on this?
Both theories are not meant to say the same thing or conclude the same thing.
The pure monetary approach is one of oldest theories to explain the movement of exchange rates. It states that PPP holds always, this means that the Exchange Rate at any point in time is equal to the relation of the prices between countries. An example:
The price of a Big Mac in USA is 2 USD and the price of the same Big Mac in Peru is 7 PEN. Then exchange rate PEN/USD would be just 7 PEN / 2 USD = 3.5
What happens when an expansionary fiscal policy takes place in Peru? The pure monetary model say that goods and services prices would rise, so as the believe is that PPP holds always, the exchange rate (PEN/USD) must be updated as prices change. Say that the Big Mac in Peru is 8 PEN now, the exchange rate would be 8 / 2 = 4. This means that PEN has depreciated against the USD.
The Mundell-Fleming theory uses other drivers to predict the exchange rates movements. They use interest rates (real and nominal), capital inflows and outflows, and the impacts of those factors in the supply and demand of each currency.
What happens when and expansionary fiscal policy takes place in Peru? The Mundell-Flemming theory, specifically under the high movility of capital scenario, states that the goverment will need to fund the higher public investment/spending via issuance of new sovereign debt. As the Gov start selling their bonds to the investors they will gradually claim higher bond yields. Those yields impact the whole market interest rates upward. Peru is now more attractive for money investors so a capital inflow takes place. The most common currency that enters to Peru is USD, so a higher amount of USD is now flowing to the peruvian economy and investors will need to exchange those USD to PEN creating and upward pressure on PEN and thus its value increases. This means that PEN appreciates and USD depreciates. Using above ER, the 3.5 PEN/USD would go 3.0 PEN/USD, this reflects the PEN appreciation relative to USD.
Summing up, don’t try to find a common idea between theories and models, they may be similar, dissimilar or ever contrary. However, it is useful to learn how each one works and which one could better explain the real world in a certain scenario.
Hope this helps!
This is great to know. Thanks a lot for your help! They mention quite a few similar concepts at different places, I think I will pay more attention now. Thanks!
Glad to help 
Hi Harrogath,
I just saw two statements below. Just want to confirm if my final statement is correct. Thanks in advance!
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" In Dornbusch model, any decrease in nominal money supply will induce an increase i n the domestic interest rate. This response will encourage capital inflows and cause the exchange rate to overshoot to the upside in the short run."
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Also, there is a statement in the Kaplan book saying " in the case of an expansionary monetary policy, prices increase over time. This leads to d ecrease in real interest rates and depreciation of hte domestic currency due to capital outflow. In the short term, exchange rates overshoot the long run PPP implied values.
Both situations OVERSHOOT in the short run. The first situation will appreciate quicker than the implied PPP apreciation in the short run. and the second situation will depreciate faster than the implided PPP decpreciation in the short run. Is that correct?