Answer to Question #282466 in Macroeconomics for ABEX

Question

Consider two small open economies A and B which opted to adopt a

floating exchange rate regime, and a fixed exchange rate regime, respectively. While Country A wants to exercise fiscal policy, Country B

wants to exercise monetary policy.

(a) What are the possible reasons for Country A to adhere to exercising fiscal policy instead of monetary policy?

(b) According to the Mendel-Fleming model and the monetary approach to the balance of payment, what should be the position

of Country A on the policy of liberalizing its (foreign) capital account, i.e. capital mobility? Discuss the reason.

(c) What should be the position of Country B on the policy of liberalizing its (foreign) capital account, i.e. capital mobility? Discuss

the reason.

Answer 1

a) Fiscal policy helps to reduce the budget deficit for country A and most economies have only used monetary policy for the 'fine-tuning' of the economy. Fiscal policy has a greater impact on consumers than monetary policy since it leads to increased employment and income. For example, by increasing taxes, governments pull money out of the economy and this slows business activity.

b) Mundell–Fleming argued that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy and that it can only maintain two of the these at the same time. From this, country A should allow free movement of capital as it applies a floating exchange rate and a fiscal policy hence according to Mundell it can maintain.

c) For country B it cannot allow free movement of capital because it maintains a fixed exchange rate and an independent monetary policy and therefore adding a free capital movement is against Mundell- Fleming argument that a country can only maintain two of the three policies.