Forex: Monetary and Fiscal Policy

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quiteawesome

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Hi everyone I’ve got 2 related questions hope you can help thanks in advance!
1) The schweser text states that for high capital mobility countries: “Expansionary fiscal policy will also increase economic activity (growth) and inflation, leading to deterioration of the current account and a decrease in the demand for the domestic currency”.
Why is it that economic growth and inflation adversely affects the current account?
2) Also the text states that for low capital mobility countries: “…expansionary fiscal or mentary policy leads to increases in net imports”.
I can understand how fiscal policy would lead to more imports due to increased spending. How would monetary policy increase net imports?
 
quiteawesome wrote:
Hi everyone I’ve got 2 related questions hope you can help thanks in advance!
1) The schweser text states that for high capital mobility countries: “Expansionary fiscal policy will also increase economic activity (growth) and inflation, leading to deterioration of the current account and a decrease in the demand for the domestic currency”.
Why is it that economic growth and inflation adversely affects the current account?
Click to expand...
Because imports get higher.
Under low capital movility, exchange rates are not much affected by the level of interest rates (as it occurs under high capital movility), but rather by the sell/buy of goods and services (trade balance) between countries. An expansionary fiscal policy tends to increase national imports reducing the trade account (also the current account). Note that when you import goods from abroad you use foreign currency and hence the quantity of foreign currency in the domestic country becomes lower making the domestic currency to depreciate (lower demand on the domestic currency). An expansionary fiscal policy increases demand and hence inflation.
quiteawesome wrote:
2) Also the text states that for low capital mobility countries: “…expansionary fiscal or mentary policy leads to increases in net imports”.
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Be careful, expansionary fiscal policy increases imports, so decreases net imports.
quiteawesome wrote:
How would monetary policy increase net imports?
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Under low capital movility, again, the goods and services flow will determine the movement of exchange rates.
If it is an expansionary monetary policy, the more money in pocket will tend the people to spend in goods from abroad (more imports) and make the domestic currency to depreciate.
If it is an contractionary monetary policy, people has less money in pocket, so imports decrease and net imports increase. As less foreign currency flows out the country because imports decreased, the domestic currency appreaciates.
Hope this helps!
 
Hi Harrogath thanks for the replies
1) Was asking question 1 with regards to high capital mobility rather than low capital mobility
2) The Schweser textbook indeed states that is is a net increase and not decrease, that’s why is it confusing. I’m not sure if it is a typo? Can someone verify perhaps?
 
When capital mobility is high, monetary policy dominates.
When capital mobility is low, fiscal policy dominates.
That’s about it.
 
S2000magician wrote:
When capital mobility is high, monetary policy dominates.
When capital mobility is low, fiscal policy dominates.
That’s about it.
Click to expand...
So high capital mobility - Expansionary monetary/ Retrictive or Expanionary fiscal –> currency depreciation??????????
Low capital mobility - Expansionary or restrictive monetary/Restrictive fiscal –> Currency appreciation? ??
 
Yup and so I’m a little confused over the matrix. Brackets denote high or low capital mobility.
  • expansionary monetary /expansionary fiscal -> uncertain (high), deprecation (low)
  • expansionary monetary /restrictive fiscal -> deprecation (high), uncertain (low)
  • restrictive monetary /expansionary fiscal -> appreciation (high), uncertain (low)
  • restrictive monetary /restrictive fiscal -> uncertain (high), appreciation (low)
Can someone familiar explain it simply?
 
Uncertain exactly means that outcome (appreciation or depreciation) depends on other factors specific for certain country.
Countries with limited capital inflows/outflows may establish monetary/fiscal policy with level of autonomy in the short term (in the long term these limits may cause limited growth).
Small economy monetary authorities (mostly in emerging countries) may have sufficient amount of foreign currency reserves so may defend local currency exchange rate at least in the short term. Monetary authorites in big countries cannot defend exch. rate by selling currency reserves or buying own currency simply because such reserves should be in extremly large amount. So mostly monetary and fiscal authorities in developed and big countries use different approcahes in FX rate direction compared to small or/and developing economy authorities.
 
quiteawesome wrote:
Yup and so I’m a little confused over the matrix. Brackets denote high or low capital mobility.
  • expansionary monetary /expansionary fiscal -> uncertain (high), deprecation (low)
  • expansionary monetary /restrictive fiscal -> deprecation (high), uncertain (low)
  • restrictive monetary /expansionary fiscal -> appreciation (high), uncertain (low)
  • restrictive monetary /restrictive fiscal -> uncertain (high), appreciation (low)
Can someone familiar explain it simply?
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This method never let me down. Takes about 20 seconds to answer a question by drawing the matrix.
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91350110
 
I just have to remember my country trends in monetary/fiscals policies in period 2003 - 2007 and FX rate movement and eveything is clear.
 
Flashback wrote:
I just have to remember my country trends in monetary/fiscals policies in period 2003 - 2007 and FX rate movement and eveything is clear.
Click to expand...
Mario Draghi also helps a lot with his QE and his fight against deflation.
 
Small open economy.
2003- 2007
Fiscal policy: No tax on dividend, no tax on capital gains, big infrastructural projects (highways construction)
Monetary policy: Ultra restrictive with several levels of penalty for banking credit activity over certain level
Result: strong local currency appreciation, moderate high growth, stock market and RE market bubbles with growth over 60 % annualy, rapidly increase of debt share in GDP.
 
krokodilizm wrote:
Flashback wrote:
I just have to remember my country trends in monetary/fiscals policies in period 2003 - 2007 and FX rate movement and eveything is clear.
Click to expand...
Mario Draghi also helps a lot with his QE and his fight against deflation.
Click to expand...
QE is Ben Bernanke and his predecessor Greenspan’s invention. Yankees are more effective and productive than Europeans in such games.
 
RIght, you just have to know about China in 2015/6 -
Low capital mobility - Expansionary monetary and Expansionary Fiscal –> currency depreciation
Australia:
High capital mobility - Expansionary monetary, Restrictive fiscal –> currency depreciation
 
Correct. When you will be asked just start thinking about real situation and in recent history there are many situations or this is not even history, these are current global econ issues.
When you mentioned Australia, just remember that Ossie will start rapid appreciate whenever Aluminium (iron oyre) turn in rapidly positive up trend. This may be an example of Dutch desease.
 
Right, but the positive correlation in iron ore prices and AUD/USD has worked quite well for the Australian economy.
 
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