21.3.1 Monetary policy measures in the Mundell-Fleming model

Monetary policy measures, i.e. changes in interest rates or money supply, can be divided into two categories: restrictive and expansive monetary policy. Restrictive monetary policy reduces the money supply at higher interest rates. Expansive monetary policy increases the money supply with lower interest rates. Using the slider you can select both expansive and restrictive monetary policy measures.

In the case of restrictive monetary policy, the signs are reversed in comparison to expansive monetary policy: appreciation instead of depreciation, recession instead of growth, falling instead of rising interest rates. Therefore, in the following we only describe the interrelationships for expansive monetary policy measures.

Expansive monetary policy

If the money supply is increased from $M_0$ to $M_1$, slider to the right, the LM curve moves to the right. A new ISLM equilibrium $G{G}_Z$ with lower interest rates and higher GDP ($y_0$ rises to $y_Z$ and $r_0$ falls to $r_Z$) is reached in the domestic goods market. However, the increased income leads to a shift in the FF curve, as the current account balance deteriorates due to rising imports. (fictitious point B in the 3rd quadrant). This results in an imbalance on the foreign exchange market: at the old exchange rate $S_0$, interest rates would have to rise to as high as point A in the 4th quadrant to balance the current account deficit. However, due to the expansive monetary policy, they have actually fallen to $r_Z$ (point C). The opposing development of the current and capital account thus creates an obvious imbalance in the foreign exchange market: the interest rate gap between point A and point C, which represents a clearly negative balance of payments. This imbalance is also evident from the fact that in this situation the BP line does not run through the domestic goods market equilibrium.

Primary exchange rate effects

This imbalance is compensated by a market reaction: The exchange rate of the domestic currency depreciates significantly: it rises from $S_0$ to $S_1$. This primary reaction of the exchange rate is purely due to foreign exchange market reactions. Point $G{G}_Z$, in the fourth quadrant, lies on the FF curve to $y_Z$. Due to the substantial imbalance in the foreign exchange market (see explanation of the interest rate gap AC), the exchange rate must depreciate significantly to compensate this imbalance. Firstly, the currency’s quality as an investment declined due to low interest rates and secondly, the current account deficit led to an increased supply of domestic currency. All in all, the depreciation was so strong that the current account balance turned positive (point $G{G}_Z$ in the third quadrant). However, the economy is not yet totally in equilibrium.

Secondary exchange rate effects

The low exchange rate $S_1$ causes domestic exports to rise. This leads to a right shift of the IS curve, as export demand also affects the domestic goods market. Consequently, GDP continues to grow to $y_1$ while interest rates rise moderately to $r_1$. The BP-curve shifts to the right as the exchange rate rises due to the positive current account effect. Now it passes through the new final equilibrium $G{G}_1$. Moreover, the further increase of the GDP leads to a moderate upward shift in the FF curve. Therefore, an equilibrium $G{G}_1$ at $r_1$ and $S_1$ is established as well on the foreign exchange market.

Conclusion:

The expansive monetary policy causes a depreciation of the currency, which, by increasing exports, amplifies the growth impulse and lessens the interest impulse.

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