Briefly explain why perfect capital mobility with fixed exchange rates limits the effectiveness of the use of contractionary monetary policy to influence interest rates or the domestic economy.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Capital is considered perfectly mobile when an unlimited amount of international capital flows in or out of a country in response to even slight changes in interest rates. When international capital flows are highly sensitive to interest rate changes, inflows or outflows in response to changes in a county's interest rates effectively determine that country's money supply. For an initial contractionary monetary policy intended to influence the domestic economy, a reduction in the money supply would cause an increase in interest rates. Higher interest rates would draw a large international capital inflow. Under a floating exchange-rate regime the domestic currency would appreciate as foreign investors exchanged their currency for the domestic currency to purchase investments denominated in the domestic currency. Since exchange rates are fixed, however, the monetary authority's necessary intervention to defend the fixed exchange rate would require buying foreign, and selling domestic currency to keep the domestic currency from appreciating. Selling the domestic currency would re-expand the money supply. With perfect capital mobility the large capital inflow would also negate any of the monetary authority's attempts at sterilization. Since the monetary authority must intervene to defend the fixed exchange rate, the balance of payments effectively determines the money supply. In the case of perfect capital mobility, monetary policy intended to impact the domestic economy is subordinated to the defense of the fixed exchange rate.