Mundell Flemming

[RajEco]

Which of the following is true under Mundell Flemming model with fixed exchange rate and changes in money supply?
i. In the very short run the money supply is normally predetermined by the past history of international payments flows.
ii. If the central bank is maintaining an exchange rate that is consistent with a balance of payments surplus, over time money will flow into the country and the money supply will rise (and vice versa for a payments deficit).
iii. If the central bank were to conduct open market operations in the domestic bond market in order to offset these balance-of-payments-induced changes in the money supply — a process called sterilization, it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country).
iv. But under perfect capital mobility, any such sterilization would be met by further offsetting international flows.
a) All except iii
b) All except iv
c) All except ii
d) All of the above

The answer is d. all of the above. can anyone explain me point ii., iii. and iv.   Thanks.

[RajEco]

Can any of the seniors help ?
@atika @vandita @singham.

[Atika Gupta]

option ii: If govt. is maintaining an exchange rate where there is surplus in BOP then it means that there is excess supply of foreign currency in the economy. This excess supply would lead to fall in exchange rate. So in order to prevent this fall under fixed exchange rate regime, central bank will intervene in the foreign exchange market and buy back the foreign exchange and give rupees(domestic money). This will lead to increase in money supply. Thus, if govt. maintains such exchange rate, overtime money will flow in the economy due to the intervention in foreign exchange market.

option iii: As explained above under fixed exchange rate regime if there is trade surplus then it leads to increase in money supply. In order to prevent this increase in money supply Central bank conducts open market operations where it issues govt. bonds which will reduce the money supply. This process is called as sterilization. And opposite will happen if there is trade deficit. As when there is trade deficit there is excess dd of foreign exchange. Hence, to maintain the exchange rate govt. sells foreign exchange which will reduce money supply. In sterilization, central bank. buys govt. bonds.

optioniv: If there is perfect capital mobility and there is trade surplus then there is increase in money supply which shifts LM curve rightwards , lowering the interest rate. Now, central bank can conduct sterilization to prevent this increase in money supply. But, since there is perfect capital mobility, lower interest rate will result into massive capital outflows. Again central bank intervenes by issuing foreign assets which reduces money supply. So LM curve shifts back to its original position. Hence, any such sterilization would be met by capital outflows caused by fall in the domestic interest rate.

[RajEco]

Thanks a lot atika :) Great help.