Question

In a Mundell–Fleming small open economy with perfect capital mobility and fixed price level $\bar P$, the goods market is $Y=C(Y)+I(r^\ast)+G+NX(e)$ and the money market is $\dfrac{M}{\bar P}=kY-\ell r^\ast$. Which policies are {ineffective} (no impact on income) in the short run?

• A. Expansionary fiscal policy under {floating} exchange rate
• B. Expansionary monetary policy under {floating} exchange rate
• C. Expansionary fiscal policy under {fixed} exchange rate
• D. Expansionary monetary policy under {fixed} exchange rate

Hint:

Rule of thumb in Mundell–Fleming with perfect capital mobility: \textbf{Floating}—Monetary works, Fiscal doesn’t. \textbf{Fixed}—Fiscal works, Monetary doesn’t.

Answer 1

The Correct Option is A, D

Step 1: Perfect capital mobility. With free capital flows, the domestic interest rate is pinned at the world rate: $r=r^\ast$. Hence any deviation triggers capital flows and exchange-rate adjustment (under floating) or reserve flows/sterilisation (under fixed).
Step 2: Floating exchange rate. {Fiscal expansion} shifts IS $\Rightarrow$ tends to raise $r$, but $r$ cannot exceed $r^\ast$. Capital inflow appreciates the currency ($e$ falls), $NX$ decreases, shifting IS back until $Y$ returns to its initial level. $\Rightarrow$ Fiscal policy is ineffective. {Monetary expansion} shifts LM right, $rMonetary policy is effective. 
Step 3: Fixed exchange rate. {Monetary expansion} initially lowers $r$, causing depreciation pressure; to defend the peg the central bank sells foreign reserves and contracts $M$, shifting LM back $\Rightarrow$ no change in $Y$ (ineffective). {Fiscal expansion} raises $r$ and creates appreciation pressure; to keep the peg the central bank buys foreign currency, increasing $M$, shifting LM right so $Y$ rises (effective). 
Final Answer: (A), (D)