Explain the short‑run impact of a sudden large capital outflow on (i) the exchange rate, (ii) the domestic interest rate, and (iii) national output in a small open economy operating under a flexible‑exchange‑rate regime, using the Mundell‑Fleming framework.
Answer
A sudden capital outflow causes the domestic currency to depreciate, the interest rate to rise temporarily, and output to fall due to a leftward shift of the IS curve and reduced investment.
Step-by-step solution
- Identify that a capital outflow means residents sell domestic assets for foreign assets, creating excess supply of the domestic currency in the forex market.
- Under a flexible exchange rate, excess supply leads to depreciation of the domestic currency (exchange rate rises).
- Explain that capital outflow puts upward pressure on the domestic interest rate because investors require a higher return to hold fewer domestic assets.
- Higher interest rates reduce investment and consumption, shifting the IS curve leftward, which lowers equilibrium output (Y).
- Note that the depreciation can improve net exports, providing a partial offset, but the net effect in the short run is a fall in output.
- Summarise: depreciation of the currency, rise in interest rate, and decrease in output.
Common mistake: Ignoring the immediate rise in interest rates or assuming that depreciation automatically raises output without considering the IS shift.
Concept tested: Impact of capital outflow
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