In this Que, why the ans is not A, in que. they are asking the reason for currency deprec. If price level increases, that means the inflation of the country increases. Thus surplus of cash in the economy, which will lead to depreciation of currency.
Please tell me where i am wrong.
Question 2: Assume a developed market (DM) country has an expansive fiscal policy under high capital mobility conditions. Why is its currency most likely to depreciate in the long run under an integrated Mundell-Fleming and portfolio balance approach?
Hi Suryansh. There is nothing wrong with your statement but in the question, it is mentioned that we have to assume a high capital mobility environment which means the capital A/C effect will dominate and the effect in the long run.
Under Mundell-Fleming model, if there is an expansionary fiscal policy, then Govt. Expenditure > Govt. Revenue which will lead to higher interest rates and the currency will appreciate. This is not the answer as we have to find out the reason for currency depreciation. The MF model is only applicable for the short run.
Portfolio Balance Approach is all about the long run effect of expansionary fiscal policy. An expansionary fiscal policy would mean that the Govt. is borrowing too much and therefore as a result of which the investors are concerned about how the debt obligations of the country would be met. Due to this, foreign investors might start pulling out money from the country which would ultimately result in currency depreciation.