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.