Answer: interest rates.

## Explanation The Mundell-Fleming model analyzes the relationship between: - Fiscal policy - Monetary policy - Exchange rates - Capital mobility **Key mechanism when capital mobility is high:** - Expansionary monetary policy → Lower domestic interest rates - Lower interest rates → Capital outflows (investors seek higher returns abroad) - Capital outflows → Increased supply of domestic currency in foreign exchange markets - Increased supply → **Currency depreciation** **When capital mobility is low**, monetary policy affects exchange rates primarily through trade flows (Option A). But when capital mobility is **high**, the interest rate channel (Option B) dominates. Inflation rates (Option C) are a secondary effect that may influence exchange rates through purchasing power parity, but this is not the primary transmission mechanism in the Mundell-Fleming framework. **Correct Answer: B** - Interest rates.

Author: LeetQuiz Editorial Team