Chartered Financial Analyst (CFA) Practice Exam Level 2

How does the Mundell-Fleming model apply to monetary regimes?

1. It only applies to fixed exchange rate regimes

2. It describes interactions in fluctuating exchange rate regimes

3. It ignores foreign investment impacts

4. It is only relevant for large economies

The correct answer is: It describes interactions in fluctuating exchange rate regimes

The Mundell-Fleming model is particularly relevant in describing how different monetary and fiscal policies operate under various exchange rate regimes. It highlights the interactions between the economy and exchange rates, emphasizing how these interactions change depending on whether a country has a fixed or flexible exchange rate. The model shows that under a flexible exchange rate regime, monetary policy is more potent because it can influence interest rates and thus affect capital flows and the exchange rate itself. In contrast, under a fixed exchange rate regime, monetary policy is less effective because the central bank must maintain the currency's value relative to another currency, which can restrict its ability to adjust interest rates. Moreover, the Mundell-Fleming model takes into account foreign investment and capital mobility, making it applicable to various economic contexts, and it provides insights into how different policies impact open economies. The importance of exchange rate volatility and capital mobility is key to understanding its applications, making the second option the most accurate reflection of the model's relevance across different monetary regimes.