Under the Mundell Fleming Model with low capital mobility, why would a combination of expansionary monetary and expansionary fiscal policy result in currency depreciation?
On the other hand, why would a combination of restrictive approach for both monetary policy and fiscal policy results in curremcy appreciation?
Thx.
With low mobility of capital flow country, your trade imbalance have greater effect than interest rate impact.
Thus, if you have expansionary fiscal/monetary policy, this would result in increase in net import and currency would depreciate.
Because the current account effect dominates when there are capital controls. Expansionnary fiscal and monetary policies raise domestic demand and imports and drive up inflation so currency goes down. gov’t long-term borrowing costs are higher because of higher debt accumulation but foreign capital is not allowed to come take advantage of it so currency is weaker on net.
If policies are restrictive, domestic demand is slow and so are imports, inflation is lower compared to other countries and currency goes up. gov’t borrowing low so low borrowing costs (at least long-term) but domestic capital not allowed to exit to invest at higher rates elsewhere, so currency ends up higher.
That’s how I try to rationalize it, for whatever it’s worth. Of course whether that sort of stuff applies in the real world is extremely debatable.