I came across this EOC and was wondering if someone could explain. its a simple concept but i have one question on it…
statement: “Assume an emerging market country has restrictive monetary and fiscal policies under low capital mobility conditions. Are these policies likely to lead to currency appreciation, depreciation, or have no impact?”
Answer is currency appreciation. My question is why is it this and not “no impact”? wont restrictive monetary policy raise rates, and restrictive fiscal policy lower rates, thus canceling each other out? any explanation is appreciated, thanks
Your expectations would have been true in case of high capital mobility.
The EOC question clearly states “emerging country with low capital mobility”. In case of restrictions on capital flows, fiscal and monetary policies affect the exchange rates primarily through trade balance. If trade balance is improved, the domestic currency appreciates.
Excerpt from the official curriculum.
"When capital mobility is low, the effects of monetary and fiscal policy on exchange rates will operate primarily through trade flows rather than capital flows. The combination of expansionary monetary and fiscal policy will be bearish for a currency. Earlier we said that expansionary fiscal policy will increase imports and hence the trade deficit, creating downward pressure on the currency. Layering on an expansive monetary policy will further boost spending and imports, worsening the trade balance and exacerbating the downward pressure on the currency.
The combination of restrictive monetary and fiscal policy will be bullish for a currency. This policy mix will tend to reduce imports, leading to an improvement in the trade balance."