Page 15 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.k: Explain the potential effects of READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
monetary and fiscal policy on exchange rates.

MODULE 11.3: EXCHANGE RATE DETERMINANTS, CARRY TRADE, AND
MUNDELL-FLEMING MODEL CENTRAL BANK INFLUENCE

Evaluates the impact of monetary and fiscal policies on interest rates—and consequently on exchange rates. It assumes that
there is sufficient slack in the economy to handle changes in aggregate demand, and that inflation is not a concern (hence model
excludes changes in inflation rates due to changes in monetary or fiscal policy): 2 Implications:

Flexible Exchange Rate Regimes – 2 scenarios – International capital flows are relatively:
1. Unrestricted (high mobility of capital); versus
2. Restricted (low mobility of capital).

1. High Capital Mobility: Expansionary monetary and fiscal policy are likely to have opposite effects on exchange rates.
• EMP reduces interest rate and, hence, reduce capital inflow for investment in physical and financial assets (deterioration
of the financial account). This reduces the demand for the domestic currency, resulting in its depreciation. RMP has the
opposite effect, increasing interest rates, hence domestic currency appreciation!
• EFP will increase government borrowing and, consequently, interest rates; this will attract foreign investment, improve the
financial account, and consequently, increase the demand for the domestic currency.

2. Low Capital Mobility: In developed markets, we can assume free flow of capital, but in emerging markets, this may be
restricted. The impact of trade imbalance on exchange rates (goods flow effect) > the impact of interest rates (financial
flows effect). In such a case, EMP/EFP leads to increases in net imports, leading to depreciation of the domestic currency.
Similarly, RMP/RFP to an appreciation of domestic currency.

Any confusion between Mundell-Fleming model (higher-interest-rate currency
will appreciate), and the opposite per uncovered interest rate parity (UCIRP)?

UCIRP assumed that real interest rates are equal globally, and thus that
nominal interest rates merely mirror expected inflation.

That is no longer true under the Mundell Fleming model, as it does not
consider inflation.