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      Question

      According to the Mundell-Fleming Model under a regime of

      perfect capital mobility and a fixed exchange rate, which policy tool is rendered completely ineffective for influencing domestic output (Y)?
      A Fiscal Policy (e.g., increased government spending) Correct Answer Incorrect Answer
      B Monetary Policy (e.g., open market operations) Correct Answer Incorrect Answer
      C Trade Policy (e.g., tariffs on imports) Correct Answer Incorrect Answer
      D International Reserve Policy (e.g., central bank sterilization) Correct Answer Incorrect Answer

      Solution

      Solution: In the Mundell-Fleming Model with perfect capital mobility (a horizontal BP curve, where the domestic interest rate i must equal the world interest rate i∗) and a fixed exchange rate, the central bank loses control of its domestic money supply:

      • Expansionary Monetary Policy (Attempt): The central bank increases the money supply (LM curve shifts right). This initially puts downward pressure on the domestic interest rate (i
      • Capital Flows: Perfect capital mobility means investors immediately move capital out of the country (capital outflow) seeking the higher world interest rate (i∗).
      • Central Bank Intervention: To maintain the fixed exchange rate, the central bank must sell foreign currency reserves and buy back domestic currency. This action immediately reverses the initial increase in the money supply (the LM curve shifts back left) until i=i∗.
      Conclusion: The net effect on the money supply and, therefore, on output (Y) is zero. Monetary policy is completely ineffective under this regime. Fiscal Policy, however, is highly effective.

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