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Final Conclusion

The depreciation of the exchange rate re-equilibrates the BOP after the expansionary monetary policy and removes the potential conflict between internal and external balance. The rise in income as a result ofthe expansionary monetary policy is greater when the exchange rate is flexible compared with when it is fixed. Monetary policy is therefore a more potent stabilization tool in a flexible exchange rate regime than in a fixes exchange rate regime.

Shifting BP curve

What causes the BP curve to shift? Changes in exports, imports. An increase in exports or a decrease in imports shifts the BP curve to the right, and vice versa.

Can you think of any other factors?

Open economy equilibrium
Equilibrium in an open economy occurs at the intersection of the IS, LM and BP curves.

What does the Mundell-Fleming model (when we have a fixed exchange rate system) say about the effectiveness of both monetary and fiscal policy:

Since the Mundell-Fleming model assumes perfect capital mobility the BP curve is therefore horizontal.


An increase in Ms shifts the LM curve down to LM1 causing domestic r to fall below the foreign interest rate (r*). Capital outflow results giving rise to an excess demand for foreign currency. Under a fixed exchange rate system, the central bank intervenes by selling foreign currency in exchange for domestic currency. This reduces the amount of domestic currency in circulation and hence reduces the Ms in the country. LM therefore shifts right back up to its original position. Monetary policy is hence totally ineffective under these circumstances of perfect capital mobility and a fixed exchange rate.

BP curve

The BP curve which shows the interest rate and income levels for which the balance of payment is balanced (CA + CU = 0), is positively sloped. Raising Y creates more demand for imports and
worsens the current account.

For the BOP to be balanced this has to be offset by an improvement in the capital account. The latter will happen at a higher interest rate, as this attracts capital from abroad.

The slope of the BP line depends on the degree of capital mobility. The greater the capital mobility the flatter is the BP line i.e. the more sensitive capital movement is to differences in interest rate, the flatter is the capital account schedule and the flatter is the BP line. At one extreme, when there is perfect capital mobility (which requires that domestic and foreign assets be perfect substitutes), the BP line is horizontal and at the other extreme, when capital isperfectly immobile, the BP line is vertical since changes in the domestic interest rate will have no direct effect on the BOP.

A second factor that determines the slope of the BP line is the marginal propensity to import (m). The higher the marginal propensity to import the steeper is the BP line and vice versa.

Open economy

In an open economy, we have to consider the impact of such policies on the country’s balance of payments. The current account , income and the real exchange rate. It is positively related to foreign income and the real exchange rate and negatively related to domestic income.

The capital account on the other hand, which records capital flows incurred in the purchase and sales of real and financial assets, is affected by differences between the domestic and the foreign interest rate. A wider spread between domestic and foreign interest rate results in a net capital inflow into the country. Net capital outflow results when there is a narrowing of the spread between domestic and foreign interest rate. Net capital inflows therefore depends positively on the difference between domestic interest rate minus the foreign interest rate.

The BP curve

The BP curve

In a closed economy we did not have to be concerned about what was happening in the rest of the world. For example, when the domestic economy adopted an expansionary fiscal policy, that
would have caused the IS curve to shift right resulting in an increase in interest rate and output.

Similarly, if an expansionary monetary policy was adopted, that would have shifted the LMcurve to the right resulting in a decrease in interest rate and an increase in output.

Explanation 2

If the country is on a fixed exchange rate system however, the central bank as we discussed earlier will intervene into the foreign exchange market to buy or sell foreign currency depending on the BOP position the country is in.

When there is an excess demand for foreign currency (BOP deficit), the central bank intervenes by selling foreign currency in exchange for domestic currency. This reduces the amount of domestic currency in circulation causing money supply in the country to decline and the LM curve therefore shifts left.

On the other hand, an excess supply of foreign currency (BOP surplus) means that the central bank will now buy foreign currency in exchange for domestic currency. As the amount of domestic currency in circulation increases, money supply in the country increases resulting in the LM curve shifting to the right.

The LM Curve for an Open economy

The LM Curve for an Open economy

Depending on the type of foreign exchange rate system the country is under, the LM curve for an open economy may be exactly the same as that of a closed economy.

If the economy is on a flexible exchange rate system, the exchange rate will always change to bring about a balance in the BOP. Therefore, under a flexible exchange rate system, there is no effect on the country’s money supply as net currency flows is zero.

Conclusions (applies to both exchange rate regimes)

Conclusions (applies to both exchange rate regimes):

An appreciation/revaluation of the domestic currency (i.e. a
decrease in E) makes domestic goods more expensive and
foreign goods cheaper. This decreases demand for the
country’s exports and increases its imports. NX therefore
decline causing planned expenditure to fall and the IS to
shift left.

Vice versa, a depreciation/devaluation of the
domestic currency (i.e. an increase in E) makes its exports
cheaper and its imports more expensive. This improves the
country’s NX and results in an increase in planned
expenditure and a shift of the IS to the right.
An increase in foreign income increases demand for the
domestic goods i.e. exports increase. The increase in
exports causes the IS curve to shift right and vice versa.

Earlier conclusion about closed economy

An earlier conclusion we arrived at when discussing the closed
economy was:

The bigger the multiplier the flatter the IS curve. Since the open economy multiplier is smaller than that of a closed economy, the IS curve for an open economy is therefore steeper than that for a closed economy.

The position of the IS curve is still affected by the autonomous expenditure components. Hence, when we are looking at an open economy changes in X and M will also affect the position of theIS curve. This therefore means that changes in the real exchange rate and the income of the foreign country which affects X and M also affects the position of the IS curve.

Derivation

In the simple closed economy which we looked at, the IS curve is
represented by:

Y = α (Ā – br)

For an open economy, equilibrium is still where Y = E, but E is
now C + I + G + X – M
and

X = Xo
M = Mo + mY

Therefore at equilibrium: Y = E
Y = Co + Io + Go+ Xo – Mo –br + c1Y –c1tY +mY
Y – c1Y + c1tY- mY= Co + Io + Go + Xo – Mo - br

Y = α ‘(Ā – br)

The open economy multiplier is:
1/(1-c1+ c1t-m) = α’

This multiplier is smaller than the multiplier for a closed economy:
1/(1-c1+ c1t-m) < 1/(1-c1 + c1t)

Some conclusions:

Some conclusions:

- The IS curve for an open economy will be steeper than
the one for a closed economy;

- The position of the IS curve will now also be affected by
changes in the real exchange rate as well as income in the
foreign country.

To understand why the open economy IS curve is steeper than that
of a closed economy, let’s compare the expenditure multiplier of a
closed economy with that of an open economy.

Explanation

X is not affected by domestic income (but by foreign income) but M
on the other hand is positively related to domestic income. Recall
that X are positively related to the real exchange rate (EP*/P) while
M are inversely related to the real exchange rate. The real exchange
rate measures a country’s competitiveness in international trade. An
increase in the real exchange rate, makes our exports more
competitive and vice versa.

Changes in the real exchange rate therefore shifts the NX line and the planned expenditure line.
With the addition of NX to planned expenditure, some changes will
have to be made to the IS curve as this is derived from the
Keynesian cross diagram. The position as well as the slope of the
IS curve will now be affected by this additional factor, net exports.

The IS Curve for an Open economy

The IS Curve for an Open economy

In introduction to Economics, we covered the open economy.
We saw that in an open economy, planned expenditure is now
C + I + G + X –M. (X-M) or net exports (NX) is affected by the
domestic country’s income (Y), income in the foreign country (Y*)
as well as the real exchange rate (EP*/P).

When plotted against income, the NX curve is negatively sloped. Why?

Fixed exchange rate system

In a fixed exchange rate system, as long as the central bank has the necessary reserves, it can continue to intervene in the foreign exchange market. Persistent BOP deficit means that the central bank will run dry of foreign currency reserves but before reaching such a point the central bank will have to decide that it can no longer maintain the exchange rate and it will have to devalue its currency.

Fixed exchange rate system

In a fixed exchange rate system, however, the central bank intervenes in the foreign exchange market to buy and sell foreign currency as it is committed to maintaining the country’s exchange rate at a particular level. A balance of payment surplus (an of excess supply of foreign currency) will see the central bankintervening and buying foreign currency.

As domestic currency is exchanged for foreign currency, there is now more currency in circulation hence increasing the money supply in the country. On the other hand, a balance of payment deficit (an excess demand for foreign currency) will see the central bank selling foreign currency in exchange for domestic currency. This reduces the amount of money in circulation and therefore the money supply in the country

Exchange Rate Systems

The two types of foreign exchange system we are looking
at are the fixed and the flexible exchange rate system. The nominal
exchange rate is the price of the domestic currency against the
foreign currency.

In a flexible exchange rate system, the exchange rate is allowed to
adjust to equate the demand for and supply of foreign currency.
Market forces therefore determine the exchange rate. In a clean
float, the exchange rate will adjust to make the current and capital
account sum up to zero. A BOP surplus will result in an
appreciation of the domestic currency i.e. a decrease in the nominal
exchange rate E, while a BOP deficit will result in a depreciation of
the domestic currency i.e. an increase in the nominal exchange rate,
E.

Capital Account

Note: The capital account is divided into two parts (i) the transactions of the private sector; and (ii) official reserves transactions, which corresponds to the central bank’s activities. Hence, a current account deficit can be financed by the private sector selling off their assets abroad or by borrowing abroad.

If this is insufficient, the current account deficit can also be financed by a rundown of the government’s foreign exchange reserves; and vice versa. A country having an overall BOP surplus will see an increase in its official reserves while a country having a BOP deficit will see a rundown of its official reserves.

Balance of Payment

The BOP is a systematic record of the transactions between
the residents of the country with the rest of the world. The two
main accounts in the BOP are the current account and the capital
account. The current account records international transactions in
goods and services, including transfers while the capital account
record international transactions in real and financial assets.

A nation, like individuals and firms must pay for what they buy
from abroad. Hence, if the current account is in deficit this needs to
be financed by selling assets or by borrowing abroad. Therefore
any deficit in the current account is financed by an offsetting
capital inflow or a surplus in the capital account, and vice versa i.e

Current Account + Capital Account = 0

Insight

Insight

When we look at the open economy we will need to look at not only trade in goods and services but also assets. These international transactions between the domestic country and the rest of the world are recorded in the balance of payments.

We therefore need to take a brief look at the balance of payments. In addition, since we are looking at international transactions we will also need to take a look at the exchange rate system a country is on.

Introduction

This is in fact an extension of the closed economy IS-LM model into what is often referred to as the IS-LM-BP or the Mundell –Fleming model. Bear in mind that when we look at an open economy, the government’s role is now one of achieving both internal balance and external balance.

Some of our objectives:

The implications of an open economy on the IS and LM curves?

Deriving the BP curve under different assumptions about the Degree of capital mobility.

Analysing the effectiveness of fiscal and monetary policies in an open economy

Welcome

Welcome to the IS-LM / Mundell -Fleming Model. In this blog we will discuss many various factors and underlying reasons to deal with the topic. Feel free to browse around.