Policy under Flexible Exchange Rates and Extensions of the Mundell–Fleming Model

In the previous chapter, we examined fiscal and monetary policy under fixed exchange rates. The analysis generated an important new result. For a small country under fixed exchange rates, at best monetary policy can only be effective temporarily, that is when the country sterilizes foreign currency reserve flows. Eventually, however, a country must forsake monetary policy when it commits to a fixed exchange rate regime, because sterilization is only feasible as long as the country’s foreign currency reserves are not exhausted. Capital mobility was shown to amplify the effect of fiscal policy on output.