Exchange Rate Economics: Theories and Evidence

The sticky-price monetary model 113
mobility ensures that the effects of a foreign interest rate shock are transmitted to
the domestic economy.
5.1.4 Imperfect capital mobility and the MF model
With perfect capital mobility and flexible exchange rates the MF model suggests
that monetary policy is extremely powerful and fiscal policy is completely impotent.
If,however,capital is less than perfectly mobile (i.e. C i < ∞) it can be demonstrated
that both monetary and fiscal policy are efficacious with floating exchange rates
(although the former policy will now be less effective). Thus the policy multipliers
dy/dg and dy/dm are both positive. The effect of less-than-perfect capital mobility
on our MF diagrams is to render the slope of the FF curve less than perfectly
elastic,since a small rise in the domestic interest rate no longer leads to a massive
capital inflow,swamping the trade balance: the trade account is no longer a mere
appendage to the balance of payments,as it is when capital is perfectly mobile.
In Figures 5.5 and 5.6 FF is the locus of i and y consistent with equilibrium in
the balance of payments and its slope can be understood by considering points A
and B in Figure 5.5 and an initially fixed exchange rate. At point B,income is
relatively high and thus the trade balance deficit will be greater than at point A; to
keep the overall balance of payments in equilibrium we require a relatively large
capital account surplus at B and thus a relatively higher interest rate. FF has been
drawn with a flatter slope than the LM schedule implying that,even with imperfect
capital mobility,capital flows are more elastic than money demand to the rate of
interest (i.e. ϑ 3 >β 1 ). Points above the FF schedule represent points of balance of
payments surplus with fixed exchange rates and an appreciated exchange rate with
floating rates. Points below the FF schedule represent balance of payments deficit
with fixed exchange rates and a depreciated exchange rate with floating exchange
rates. In Figures 5.5 and 5.6 we consider the two policy shocks discussed earlier
for the perfect capital mobility case,namely,an increase in the money supply and
a fiscal expansion.
i
LM
LM9
FF
FF9
A
B
C
D
E
O
IS9
IS
y
Figure 5.5 Monetary expansion and imperfect capital mobility.