How does capital mobility impact exchange rate stability?

High capital mobility can lead to exchange rate instability due to sudden inflows or outflows of capital.

Capital mobility refers to the ease with which investors can move their capital across borders. In a world of high capital mobility, investors can quickly move their investments from one country to another in response to changes in economic conditions. This can have significant implications for exchange rate stability.

When capital flows into a country, it increases the demand for that country's currency, causing its value to rise. This is because foreign investors need to purchase the local currency to invest in that country. Conversely, when capital flows out of a country, it increases the supply of that country's currency on the foreign exchange market, causing its value to fall. Therefore, sudden large-scale movements of capital can cause significant fluctuations in exchange rates.

Moreover, high capital mobility can exacerbate the impact of speculative attacks on a currency. If speculators believe that a currency's value is going to fall, they may sell off that currency en masse. In a world of high capital mobility, this can lead to a rapid outflow of capital, causing the currency's value to plummet. This can lead to a self-fulfilling prophecy, where the expectation of a currency devaluation leads to an actual devaluation.

However, it's important to note that capital mobility is not the only factor that affects exchange rate stability. Other factors, such as economic fundamentals, monetary policy, and political stability, also play a crucial role. For example, a country with strong economic fundamentals and sound monetary policy may be able to maintain exchange rate stability despite high capital mobility.

In conclusion, while high capital mobility can lead to exchange rate instability, its impact can be mitigated by other factors. Therefore, policymakers need to consider a range of factors when trying to maintain exchange rate stability.