Chapter VIII. Open Macroeconomics: is-lm-bp model



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Macroeconomics Ch VIIII. Open Macroeconomics



Chapter VIII. Open Macroeconomics: IS-LM-BP Model
So far we have used the IS-LM model as it is by assuming that there is no other force interfering with its operation. However, there is a force of modification of the operation of the IS-LM model in the open macro-economics. The degree of mobility of international capital flows and the choice of foreign exchange policy modify the operation of IS-LM.
No country other than the might U.S. can claim that the IS-LM model works as itself.

All other countries should take into consideration the effects from international capital flows and foreign exchange policy.


Bob Mundell and Marcus Fleming have argued that an increase in capital mobility can qualify fiscal and monetary policies as we have so far learned and the choice of foreign exchange rate policy matters enormously with respect to the effectiveness of economic policies as listed above.
This fits our time well: Globalization has brought with it a freer capital flow across the national borders. And in this environment of international finance, a right combination of external economic policies, such as foreign exchange rate policy, and a domestic economic policy is important.

The bottom line is as follows:


When there is no capital mobility, such as in a closed economy or autarky economy, fiscal and monetary policies work in the way that we have studies so far as long as the external economic policy as regards foreign exchange rates is the flexible foreign exchange rate system. In fact it does not have to be the case of no capital mobility. It may be the case where international capital flows are not significant compared to the domestic capital flows. For example, this has been the case of the U.S. until the early 1980s: the U.S. Thus, most of macroeconomics textbooks, which were written in the U.S. up until this time, regarded the IS-LM as a complete model.
If capital is immobile, the results of the combination of domestic and foreign economic policies are given in the table below.






Fiscal Policy

Monetary Policy

Fixed Foreign Exchange Rate System

X


X


Flexible Foreign Exchange Rate System

O

O

“X” means the domestic and foreign policies will contradict each other; and “O” means that the two policies will reinforce each other.


If capital is mobile across the two countries, the results of combination of domestic and external economic policies are given in the table below.





Fiscal Policy

Monetary Policy

Fixed Foreign Exchange Rate System

O


X


Flexible Foreign Exchange Rate System

X

O

Today the fluidity of international capital has increased dramatically since the start of globalization, which has led to international financial liberalization. Under the current circumstances as given above, a government cannot control the foreign exchange rate, and the money supply at the same time. If it tries to intervene in the foreign currency market and to control foreign exchange rates, it will lose the control of money supply and thus monetary policy will be compromised.


The U.S. and the IMF have been trying to have the world where all the foreign exchange rates are to be determined by the free market forces and thus to have all countries adopt the flexible foreign exchange rate system. If this happens, the monetary policy, not the fiscal policy, will be the effective domestic economic policy.

I. Introduction



1) Assumption: Price level (domestic: P; foreign P*) is fixed.
2) Definition:
S denotes exchange rate. It is defined as the price of foreign currency in terms of domestic currency.


  • If the Canadian dollar price of U.S. $1 is 1.50, we take this as an exchange rate. Note that the news paper uses different exchange rate, that is, how much of foreign currencies a unit of domestic dollar can fetch. For instance, if Cdn $1 can fetch U.S. $0.67, the exchange rate is 0.65. All throughout this course, we will use the first definition, which is convenient and consistent: Just like any other goods such as a hamburger, the price of a unit of foreign currency is the exchange rate.

An increase in exchange rate or S due to market forces under the flexible exchange rate system is called an appreciation of foreign currency and a depreciation of domestic currency.


When government raises exchange rates or S under the fixed exchange rate system, it is called a ‘devaluation’ of domestic currency. The opposite is called an ‘evaluation’.

2. IS Curve
1) Modification of the IS curve in the Open Macroeconomics setting
The IS is derived by equating Y with AE = C + I + G + X-M. Whenever there is a change in AE or its components, the IS curve shifts around. Now the X-M has to be specified.
X-M is the Net exports (NX), which is approximate equal to the Current Account balance: X-M = NX = CA.
So we can rewrite into AE = C + I + G + CA. Whatever affects the components of the AE shifts the IS curve: Now an improving current account will shift the IS to the right, and a deteriorating current account to the left.

2) What determines the Net Exports or Current Account Balance?


X = M*(Y*, SP*/P)
Our exports are the imports by the foreign country. How much the foreign country imports from us depends on their income (foreign country's national income), and the relative price level of the foreign country to our country (SP*/P).

P* is the price level of the foreign country in terms of the foreign currency. S is `our' price of `their' dollar. So the product of S P* is the relative price level of the foreign country to our (the domestic country) in our currency terms. For instance, suppose that a hamburger in the U.S. is $1.00 in U.S. dollar terms (P*), a Canadian hamburger is $1.30 in Canadian dollar terms (P), and the Canadian dollar price of U.S. $1 is $1.40 (S). The U.S. hamburger costs Canadian $1.40 as S times P* = 1.4 X 1. The Canadian hamburger costs Canadian $1.30. So the relative price level of the foreign to the domestic country is 1.4 to 1.3, that is, 1.076. The foreign price level is 1.076 times as high as the domestic price level. In our model we assume that the price level, domestic and foreign, is fixed. An increase in the exchange rate or S makes the foreign good dearer and more expensive, and raises the foreign price level compared to the domestic price level. This will in turn make consumers, domestic and foreign, switch from foreign to domestic goods: our exports of domestic goods rise and our imports of foreign goods fall. Our current account and the balance of payment will improve: S SP* SP*/P Foreign price level Demand for domestic goods and Demand for foreign goods X and M Net Exports(X-M) (doubly improving) CA.




M = M(Y, SP*/P)

Our imports are an increasing function of our national income, and a decreasing function of the relative price level of the foreign to the domestic country: The more money we have, the more of foreign goods we can afford to import. The higher the foreign price level, the less we would like to import.


Combining the above two as CA = NX = X-M, we get
CA = X(Y*, SP*/P) - M(Y, SP*/P)

Ultimately, the current account is a function of Y, Y*, SP*/P;


CA = f(Y, Y*, SP*/P)
Let's review the impact of each variable on the net exports or current account:
i) Y  M  NX = CA
ii) Y*  X  NX = CA 
iii) S  SP*/P   M and X  NX = CA
This suggests that the IS curve becomes endogenous under the flexible exchange rate system. A changing exchange rate leads to a change in the AE curve, which in turn shifts the IS curve around.
In short, the IS curve has shift parameters of C, I. G and CA(=X-M), and CA becomes endogenous under the flexbile foreign exchange rate system.

3. LM Curve
LM curve has shift parameters the real money supply (=MS/P) and the random term in the money demand u. The price level is fixed. The only shift parameters are the nominal money supply MS and the random money demand term u.
As the nominal money supply MS changes (increases/decreases), LM shifts around (to the right/left).
As will be seen in details later, under the Fixed Exchange Rate System, government intervention into the foreign exchange market has a side-effect of a changing money supply and thus the nominal money supply becomes endogenous and the LM curve moves around beyond the control of government.
Money supply becomes endogenous, and the LM curve shifts around under the fixed foreign exchange rate system.

4. BP Curve
1) Definition
There are two concepts of the Balance of Payment. The broad sense of the Balance of Payment includes all the external transactions in the private as well as public sectors. The narrow sense of the BP with which we are mainly concerned in economics is the account of the private sector's transactions with other countries. This is called `the Above-the-Line' Balance of Payment, where the line of demarcation divides the transactions of the private sector from those of the public sector or the government:
I. Current Account (CA)

Trade Exports Imports Remittances

Transfers
II. Capital Account of the Private Sector (KA)

Capital Flows Inflows Outflows

_________________________________________
III. Capital Account of the Public Sector

Official Financing Inflows Outflows

The double entry bookkeeping makes the broad sense of the BP, which is the sum of I, II and III, equals zero all the time. So it is rather uninteresting.
Our BP, the narrow sense of BP, or the Above-the-Line BP is the sum of I + II:
BP = X – M

=CI - CO

=CA + KA.
It can take on any value. When it happens to be equal to zero, it is said, the BP is in equilibrium: BP = 0. Otherwise, the BP is in disequilibrium. We also say that the economy is in the external equilibrium. When BP<0, the BP is in deficits. When BP>0, the BP is in surplus.
The BP curve is the locus of the combinations of the national income and interest rate (y, i) which bring about the BP equilibrium: BP = 0 along this BP curve.

2) Determinants of BP = CA + KA
i) CA

We have already examined the determinants of the current account. Recall that CA = NX (Y, Y*, SP*/P);

-when domestic national income rises, CA falls.

-when foreign national income rises, CA rises.

-when foreign exchange rate rises, foreign currency becomes more expensive in terms of domestic currency, and thus the domestic prices of foreign goods goes up. Therefore, less imports and more exports, and CA rises.
ii) KA = Net Private Capital Inflows = CI - CO
KA = NCI ( i , i*, Se) where i stands for the domestic country’s interest rate, i* for the foreign country’s interest rate, and is the interest differential between domestic and foreign countries or how higher domestic interest rate is than foreign one. This signifies the relative attractiveness of investment in the domestic country to investment in the foreign country. The larger the interest differential becomes, the larger get the capital inflows into the domestic country.
When i-i*, international investors bring foreign currencies to convert into domestic currency: KA, and BP
The above will happen either when domestic interest rate r rises, or when foreign interest rate i* falls.
Se has the same effect as the foreign interest rate. If people revise their expectations about the future value of S, the investors will anticipate a higher return from investment in the foreign country, and thus they will move capital from the domestic country to the foreign country. Capital outflows rise, and thus the balance of payment falls.

iii) Now BP is the sum of the current and the capital accounts


BP = CA(Y, Y*, SP*/P) + KA(i-i*)
Therefore, BP = BP(Y, Y*, SP*/P, i-i*,Se )

*Notational Issues: For now we ignore the expected inflation rate. Then nominal interest rate i is equal to real interest rate r. For now we will use r and i interchangeably.



3) Derivation of BP curve
The BP curve shows different combinations of interest rates and income which all bring about external equilibrium or BP=0. In general the BP curve is upward sloping, meaning that along the external equilibrium BP=0 the interest rate and income are changing in the same direction.


Step 1: Start with a point where BP = 0 (@ a)
Step 2: Now suppose that national income rises. The current account and thus BP will deteriorate:

Y rises  M   CA   BP < 0 (@ b)


Step 3: How to restore the external equilibrium BP=0?

There should be an improvement of KA by the same amount of the decrease in CA, and then they will cancel each other. In order to have KA improve, the domestic interest rate should be raised:

KA by r (@ c). Then BP = CA + KA = 0 again.
Step 4: Link a and c to get `BP = 0 Curve.
Note that the region above or to the left of the BP curve the BP is in surplus and the region below or to the right of the BP curve the BP is in deficits:
Let's suppose that the BP = 0 at point a in the following graph. Point b means less national income and thus less demand for foreign goods: the better current account and thus now the BP is in surplus: BP= CA () + KA >0. Note that as this point lies at the same height of point a, the interest rate remains unchanged and thus there is no change in the capital account. Point c means more income and thus less CA and BP<0.

Point d lies straight above point a of BP=0, meaning the same national income but a higher domestic interest rate. The better capital account and thus now the BP is in surplus: BP= CA + KA () >0. Point e lies straight below point a, meaning the same national income but a lower domestic interest rate. The capital account at point e is smaller than that at point a, and thus now the BP is in deficits at point e: BP= CA + KA () <0.



4) Different Slopes of BP curve
The slopes of BP curve depend on the Degree of Capital Mobility across countries or the sensitivity of capital flow with respect to interest rate differentials. The principle is that the more mobile the capital (the freer capital flows), the flatter the BP curve.
Illustration



In the above two graphs, the same increase in Y causes the same decrease in CA at b. As BP = CA + KA, in order to get back to BP = 0, the same amount of increase in KA through capital inflows is required.
However, to induce the same increase in KA, Case I requires a more raise of interest rate than Case II: When capital is not so mobile like Case I, a relatively large increase in interest rate is needed to induce the same increase in KA. On the contrary, when capital is very mobile, only a small rise in the interest rate will bring about the same amount of capital inflows and thus the needed KA improvement.
There are four different slopes of the BP curves depending on the degree of mobility of capital:


5) Shift of BP Curve
All determinants of BP = BP(Y, Y*, SP*/P, r-r*) other than r and Y shift the BP curve: Y*, S, and r* are shift parameters. The first two variables which affect the Current Account shift the BP curve horizontally (to the right/left). The last variable r* or the foreign interest rate which primarily affects the Capital Account shifts the BP curve vertically (up/down).
Case I: S  BP shifts to the right


Recall that to the left of the BP curve, BP > 0 (surplus); to the right of BP curve, BP < 0 (deficit).
i)Suppose that initially BP =0 at point a
ii) S  SP*/P (relative foreign price level)  X and M  CA 

So now point a should have BP>0 at the same interest rate (no change in KA). Point a should lie to the left of the new BP curve BP', which is the BP surplus region in the graph. To restore the external equilibrium BP = 0, the national income should rise to have a deterioration of the current account which offsets the initial improvement in CA. Point a moves to point b. From the viewpoint of the BP curve, we can say that the BP curve shifts to the right.


Case II: Y*  BP shifts to the right

Case III: r* or i* rises BP shifts up

i) Initially BP = 0 at point a


ii) r*  Capital Outflows   KA ; So now point a should have BP <0 at the same Y (which means no change in CA as there is no change in income). Point a should lie below the new BP.


We note that Cases I and II affect the CA favourably, and shift the BP curve to the right, and Case III affects the KA adversely and shifts the BP curve up. The emerging principle is that whatever affects the CA favourably shifts the BP curve to the right, and whatever affects the KA favourably shifts the BP curve down.


In general cases of an upward sloping BP curve, the rightward shift is virtually the same as the downward shift: all expands the BP surplus region in the graph. However, they are quite different in the following extreme cases:

In the case of perfect capital mobility, an increase in exchange rate or S would not affect the BP curve at all. The horizontal BP curve shifts to the right without any substantive change.

r = i r = i

Y Y


In the case of perfect capital immobility, an increase in foreign interest rate would not affect the BP curve at all. The vertical BP curve shifts up without any substantive change.

r = i r = i



Y Y


Case IV: Se rises  BP shifts up
An increase in Se will have the same effect as an increase in r*.

5. Exchange Rate
Depending on what exchange rate system the government adopts, either IS-BP or LM may become endogenous.

1) Imbalance of Payment and Pressures on Exchange Rates


BP > 0

(surplus)



Excess Supply of Foreign Currency

Downward Pressure on Foreign Exchange Rate

BP < 0

(deficit)



Excess Demand for Foreign Currency

Upward Pressure on Foreign Exchange Rate

BP > 0 means that the Balance of Payment is in surplus. This implies that BP = CA + KA > 0 and that the total receipt of foreign currency (exchange) through exports(X) and capital inflows(CI) exceeds the total payment of foreign currency through imports(M) and capital outflows(CO).


X + CI > M + CO; X-M + CI -CO > 0 ;

NX + NCI > 0, where NCI denotes Net Capital Inflows.

CA + KA > 0; BP > 0
So the Supply of foreign currency exceeds the Demand for foreign currency. When S>D, there is Excess Supply and there occurs downward pressures on the price of foreign currency, that is, foreign exchange rate. Left alone, foreign exchange rate will fall.

2) Fixed Exchange Rate System:


  • " Money Supply becomes Endogenous"

  • “LM Curve moves around to restore the balance of payment equilibrium”

The Fixed Exchange Rate System means the government's standing commitment to maintain foreign exchange rate at a fixed level through unlimited sales/purchases of foreign currency.


Under the fixed exchange rate system, government should buy/sell foreign currency whenever there occurs BP surplus/deficit.
In the above example, to diffuse the downward pressure on exchange rate and to fix the exchange rate, government should eliminate the Excess Supply of foreign currency by moping it up. Government should buy excess supply of foreign currency.
Under the fixed exchange rate system, there is a very important side effect to this operation. You may remember whenever government buys anything from the general public, it should make payment in domestic currency from them. As Money flows from the government to the general public, Money Supply increases. The LM curve shifts to the right. Under the fixed exchange rate system, money supply becomes endogenous (meaning that government loses control over MS).


BP

Gov't action to fix S

Side Effect (LM)

surplus

buys foreign currency

MS increases()

deficit

sells foreign currency

MS decreases()


Sterilization Policy


Actually there is a way of regaining the control of MS: at least in the short-run;
The government may take a counteraction in the open market operation in order to offset any change in MS due to its purchase of foreign currency.
For instance, in the case of BP surplus under the fixed exchange rate system, the government has to buy foreign exchanges. This will increase the money supply in the private sector. This in turn may put upward pressures on the price level and inflationary trends. If the government would like to reign in the money supply, then it should do something .The government may sell bonds. These sales of bonds or securities are in exchange for domestic money as their payment. Thus all in all, the money supply comes back to the initial level. There will not be any net change in money supply.
This counteraction designed to offset the impact of government intervention in the foreign exchange market is called `Sterilization' policy.


The short-term nature of sterilization is more obvious with the case of BP deficits.

The BP deficits will exert an upward pressure on foreign exchange rates. To diffuse the upward pressures on exchange rates, the government will have to sell foreign currencies. This government action has a side-effect of decreasing the money supply as the private sector’s buyers of the foreign exchanges will make payments with domestic currency. Thus the money supply falls, exerting a contractionary impact on the economy. The sterilization policy in the case dictates that the government may buy bonds or securities. As the government makes payments in domestic currency, money flows from government to private sector. The money supply of the private sector rises. This offsets the initial decrease in money supply which has resulted from the government sales of foreign exchanges. Overall, there will be no net change in the money supply.
Graphically, the BP deficits shift the LM curve to the left in its gravitation to restore the new equilibrium. However, the sterilization policy puts the LM back to the state where the BP takes place. In this way, the sterilization policy perpetuates the BP balance of payment disequilibrium, or BP deficits in this particular case. This forces the government to intervene in the foreign exchange market and the sales of foreign exchanges. The government will continue to do so until it runs out of foreign exchanges. Thus the sterilization is only a short-term measure of gaining the control of money supply.

Without Sterilization



With Sterilization





i LM’ LM i LM




BP BP


IS

IS
Y Y




3) Flexible Exchange Rate System:


  • “Exchange rates change”.

  • "IS and BP curves becomes endogenous to restore the balance of payment equilibrium."




BP

Exchange Rate

Current Account

BP Curve

IS Curve

surplus

S 

CA 

to left

to left

deficit

S 

CA 

to right

to right

When BP > 0 and government does not do anything to diffuse the downward pressure on exchange rate, the exchange rate will fall (S). The falling exchange rate means a lower relative foreign price level (SP*/P). Exports decrease and imports increases, and thus the net export NX = X-M or current account CA falls. AE = C + I + G + X-M falls and the IS curve shifts to the left.



6. Applications
Let us familiarize ourselves with the terminologies such as the internal (domestic) and external equilibrium: The intersection of the IS and LM curves is called the `Internal Equilibrium'. The External Equilibrium is achieved along the BP curve where BP=0. At the `Grand Equilibrium' both the internal and external equilibria are achieved at the same time. Graphically the intersection of the IS and LM curves should be on the BP curve.
Shocks can create a discrepancy between the internal equilibrium (intersection of IS and LM) and the external equilibrium (BP curve): the intersection of IS-LM is no longer on BP curve. BP is in disequilibrium: BP>0 or BP<0. There occurs an adjustment process of internal and external equilibrium converging to each other. Alternative exchange rate systems do have different adjustment processes. After the process is over, the economy restores external and internal equilibrium: BP=0. Under the Fixed Exchange Rate System, the MS changes endogenously, and thus the LM curve shifts to restore the external equilibrium. Under the Flexible Exchange Rate System: S (goes up/down) changes endogenously and thus IS and BP curves shift (to the right/left).
1) Inevitability of Competitive Devaluation in the 1930s
If an economy has unemployment and BP deficits at the same time under the fixed exchange rate system and no capital mobility, it is impossible to resolve any problems, of the domestic and international sector, through fiscal or monetary polices. The two policies will be completely incapable of any solution. The only possible way out is devaluation.

In the above graph, let's suppose that the initial condition of an economy is at point E0 with unemployment (y < yf) and BP deficits (to the right of the BP curve is the BP negative region).
If government raises its expenditures in the hopes of eliminating unemployment, the balance of payment will deteriorate further. The BP deficits require the government sell foreign currencies under the fixed exchange rate system. The side-effect will be a decrease in the money supply and the LM curve will shift to the left. An expansionary monetary policy or the government's attempt to increase money supply and thus to shift the LM to the right will be also futile under the fixed exchange rate system: the BP deficits require the government to sell foreign currencies and thus to reduce money supply. As a result the LM curve continues to shift to the left.
The only solution is to shift the BP curve and the IS curve at the same time so that the intersection of the new IS and LM curves are on the new vertical BP curve. This can be done only when the exchange rate is raised by the government. We may recall that this administered raise in the exchange rate is called `devaluation'.
In the 1920s and 1930s, the prevailing exchange rate system was the fixed one, and the international capital mobility was very limited at least outside economic blocs. Many countries suffered from recession and balance of payment deficits. They tried all kinds of economic policies with no success and finally entered competitive devaluations, which resulted into a total collapse of the international fixed exchange rate system.
2) Impacts of Fiscal and Monetary Policies on BP

The expansionary monetary policy increases the national income Y and decreases interest rate i.


The first leads to a deterioration of the current account balance as an increased national income leads to more imports. The second leads to the deterioration of the capital account as the lower interest rate means capital outflows. The combined impact is clearly negative on the BP.




BP LM

LM




BP


BP<0



BP<0

IS



  • As shown in the graph below, an expansionary fiscal policy has an ambiguous impact on the balance of payment;

An expansionary fiscal policy leads to a larger Y and a higher interest rate or i. The first leads to a deterioration of the current account of BP, and the second to the improvement of the capital account of BP. The first negative and the second positive impacts work against each other. The overall impact depends on the relative magnitude of the two effects.


When capital is mobile, the improvement of the capital account may be substantial, and be large enough to more than offset the first negative impact. The net BP will improve.

i

IS


BP>0



BP


LM

Mobile Y
When capital is immobile, the improvement of the capital account may be small, and thus be not large enough to offset the BP deterioration resulting from an increasing national income and imports. All in all, the BP will deteriorate on the net basis.



i BP

LM


BP<0



IS

Immobile Y



3) Modified Effectiveness of Fiscal and Monetary Policies
We have just seen that, in certain cases with added international dimensions, the IS-LM model developed for a closed economy should be greatly modified.
Effectiveness of fiscal and monetary policies in the open macroeconomics (IS-LM-BP model) will be significantly different from the prediction for the closed economy (IS-LM model).
(1) Effectiveness of Fiscal Policies
Case I. Capital is relatively immobile: The BP curve is steeper than the LM curve.
Expansionary fiscal policy leads to the BP deficit: a rightward shift of the IS curve in the IS-LM setting means a higher equilibrium national income and a higher interest rate. A higher national income means a fall in CA. A higher interest rate means a rise in KA. The assumed capital immobility means that the second is smaller than the first, and thus the net impact on the BP is negative. The BP deficit means the excess demand for foreign currencies (exchanges). There occurs upward pressure on exchange rates.
Under the Fixed exchange rate system, as government diffuses the foreign currency shortage by selling foreign currencies, the payment for them in domestic currency flows into the government and thus the money supply in the private sector decreases. The LM curve shifts to the left, exerting recessionary impacts on the economy and thus partially offsetting the initial expansionary fiscal policy. Here the fiscal policy is being hampered.

(Note: Fixed Forex, Immobile Capital)

Under the Flexible exchange rate system, the exchange rate will rise. As a result the price level of the foreign country expressed in terms of domestic currency rises, which leads to international demand switch from foreign to domestic goods. CA improves. The IS curve will shift further to the right, and the BP curve will shift to the right, too. The resultant equilibrium income is still larger. Here the fiscal policy is reinforced by the international factor.


(Note: Flexible Forex. Capital Relatively Immobile)
Under a relative capital immobility, the fiscal policy and the flexible exchange rate system are a good combination.

Case II. Capital is relatively mobile: The BP curve is flatter than the LM curve.


Expansionary fiscal policies lead to the BP surplus. Why? When the IS curve shifts to the right as a result of the expansionary fiscal policy, two things will happen to affect the BP: an increase in Y* at the new internal equilibrium or the new intersection of the IS-LM leads to more imports and thus a decrease in CA. On the other hand, the interest rate goes up as a result of crowing-out and this rise in the interest rate attracts more international funds into the country, which leads to an increase in KA. The net change in the BP is the difference between the decrease in CA and an increase in KA. The assumption of the highly mobile capital implies that the increase in KA is larger than the decrease in CA: a higher interest rate will attract an avalanche of massive capital inflows which will more than dominate the deteriorating current account due to a higher income.
The BP surplus means an excess supply (`too much of foreign currencies').
Under the Fixed exchange rate system, as government mops up the foreign currency surplus by buying foreign currencies, the payment for them in domestic currency flows from the government to the private sector and thus the money supply in the private sector increases. The LM curve shifts to the right, exerting expansionary impacts on the economy and thus reinforcing the initial expansionary fiscal policy. Here the fiscal policy is being reinforced.



Under the Flexible exchange rate system, the exchange rate will fall. As a result the price level of the foreign country expressed in terms of domestic currency falls, which leads to international demand switch from domestic to foreign goods. CA falls. The IS curve will shift to the left, partially offsetting its initial rightward shift, and the BP curve will shift up too. The resultant equilibrium income is not as large as that in the simple IS-LM setting. Here the fiscal policy is partially offset by the international factor.


Under a relative capital mobility, the fiscal policy and the fixed exchange rate system are a good combination. When international capital flows are quite brisk in and out of a country, and government is now being engaged in fiscal policy, it should not allow the exchange rate to fluctuate. The fluctuation exchange rate will offset the current fiscal policy.
For instance, the capital mobility between Canada and U.S. is very high. Let's suppose that the Canadian government wants to get out of recession by increasing government expenditures. The resultant higher interest rate will attract international funds into Canada (KA) and thus the BP will improve. There occurs a downward pressure on foreign exchange rate (upward pressure on the external value of the Canadian dollar). The point is that if the government wants to boost the economy, it cannot afford to let the exchange rate fall. Because the falling exchange rate will hamper exports and encourage imports. The CA will fall and thus the AE (=C + I + G + CA) will fall. There will be a recessionary impact on the export industry, which nullifies the initial expansionary fiscal policy. If government instead engages itself in fixing the exchange rate (keeping the Canadian dollar artificially low), government ends up selling the Canadian dollars and buying the U.S. dollars. The money supply (Canadian dollars) in the private sector rises. It will exert expansionary impacts on the economy, furthering the initial fiscal policy. The fiscal policy and the fixed exchange rate system is a good combination.
You may think of the opposite case where the Canadian government wants to fight against inflationary pressure by cutting government expenditures. Still the fixed exchange rate system or some attempt to fix the exchange rate at the current level is a better choice than the flexible exchange rate system.
(2) Effectiveness of Monetary Policies
Regardless of the degrees of capital mobility, an expansionary monetary policy invariably leads to a deterioration of the BP: When the LM curve shifts to the right, the equilibrium income rises and equilibrium interest rate falls. a rising income leads to more imports and thus a fall in CA. A falling interest rate leads to a fall in KA. If we start with an initial equilibrium of BP=0, an expansionary monetary policy will lead to the BP deficit or BP <0.
Under the fixed exchange rate system, the BP<0 requires the government sell foreign currencies (simultaneously taking in domestic money as their payments). The money supply in the private sector decreases and thus the LM curve will shift to the left. The initial expansionary monetary policy is now hampered.
Under the flexible exchange rate system, the BP<0 will lead to a rise in the exchange rate. The rising exchange rate will bring about an increase in exports and a decrease in imports: CA The IS as well as the BP curves will shift to the right and meet the already-shifted LM curve.
Regardless of the capital mobility, the monetary policy and the flexible exchange rate system are a good combination.
For instance, when the first priority of the Canadian government is a tight monetary policy, it cannot afford to intervene into the foreign exchange market. It should take its hands off from it, and had better let the exchange rate go freely. If the government makes a wrong choice of the fixed exchange rate system, the BP surplus as a result of the tight monetary policy will require the government to buy foreign currencies, which leads to a self-defeating rise in the money supply.
Let’s illustrate the above points.

An expansionary monetary policy is intended to increase the national income. Depending on the capital mobility of the economy, the initial impact of the expansionary monetary policy is as follows:



Both lead to a balance of payment deficit. This deficit will have a contractionary impact under the fixed exchange rate system. And thus the LM will shift back to the left.

Under Flexible Exchange Rate System:



Under the flexible exchange rate system, the BP deficit leads to an increase in exchange rates, which in turn leads to a CA increase. A rising CA shifts the IS and BP curves to the right. The new equilibrium is now on the BP curve. We can say that the flexible exchange rate system magnifies the initial changes in the national income, and thus reinforces the expansionary monetary policy.



Fixed Exchange Rate System


The balance of payment deficit will lead to a contractionary impact under the fixed exchange rate system. And thus the LM curve will shift back to the left.


You can see that the secondary endogenous movement of the LM curve shifts the equilibrium national income back against the direction to which the initial monetary policy has changed Y. Thus, we can say that the fixed foreign exchange rate system offsets the monetary policy regardless of degrees of capital mobility.

4) Exchange Rate System as an Insulator against Shocks
Exchange rate system could be a built-in stabilizer or an amplifier of economic shocks or disturbances. Under what conditions which exchange rate system becomes a magnifier or a pacifier of troubles? As will see below, it all depends on the degree of capital mobility and the nature of shocks. One thing which clearly emerges from discussion will be that there is no insulator from foreign monetary shocks at all: no exchange rate system will serve as a buffer from the foreign monetary shocks.
For instance, if the U.S. government raises interest rate, which is a foreign monetary shock, its impact will be inevitable felt on the Canadian economy no matter which exchange rate system Canada adopts. What still matter is that such an impact could be expansionary or contractionary on the Canadian economy depending on the exchange rate system. A higher interest rate will lead to capital outflows from Canada, a KA deterioration and thus a BP deficit in Canada. If the fixed exchange rate system is adopted (the Canadian government tries to depend the external value of the Canadian dollars which are loosing values against the U.S. dollars), the very government's attempt to fix the exchange rate by selling the U.S. dollars in exchange for the Canadian dollars will lead to a decrease in the money supply in Canada. The LM curve shifts to the left, exerting a contractionary impact on the Canadian economy. Alternatively, if the Canadian government simply lets the exchange rate go, the falling exchange rate will lead to the improvement of the CA (recall S and CA move in the same direction all the time). The IS and BP curve will shift to the left, exerting a contractionary impact. One more thing we should keep in mind is that the expansionary impact is not necessarily a better one than the contractionary impact. Which is the better depends on what government wants for now. If government targets at boosting an economy amid recession, yes, the expansionary impact helps. However, if the government's first priority is to restrain the overheated economy, the expansionary impact will hurt.
In order to figure out the correct impact, we have to specify three important things very clearly before plunging into analysis:
(a) The Nature of Initial Shocks; "Do the initial troubles or shocks shift which curve(s)? IS, LM, and/or BP?"
(b) The Degree of Capital Mobility; "Is capital perfectly immobile, relatively immobile, relatively mobile or perfectly mobile?" Alternatively, "Is the BP curve in question vertical, steeper than the LM, flatter than the LM, or horizontal?" In the modern world, the vertical BP is hard to find except for a very few exceptional cases (for instance, between North Korea and any other country), which accordingly are uninteresting. The perfect capital mobility is not general either, yet it shares basic features with the case of a relatively mobile capital with a few minor modifications. The example of perfect capital mobility is between Canada and U.S. in the age of free trades, and the current situation is quite close to it. So we should examine at least the last two possible cases: a relatively mobile capital, and a relatively immobile capital.
(c) The Exchange Rate System; "What exchange rate system the government is adopting?" Alternatively, in the age of dirty floating where government mixes elements of fixed and flexible exchange rate systems as expediency dictates, "Is the government trying to intervene in the foreign exchange market and to influence the exchange rate or to let exchange rates go?"

(1) Internal Goods Market Shocks:
These are ΔC or ΔI which shifts the IS curve around.
Case I. Relatively Immobile Capital
In both graphs, the initial goods market shocks shift the IS to the right as the single-line arrow indicates. The internal equilibrium, which is the intersection of the new IS and LM curve, is now at E1. E1 lies to the right of the steep BP curve, belonging to a BP deficit region:
Under the fixed exchange rate system, the BP deficit leads automatically to a contractionary decrease in the money supply and the leftward shift of the LM curve, which is indicated by the double-line arrow. The new equilibrium E2 is now on the BP curve. Comparing E1 with the initial troubles only and E2 with the working fixed exchange rate system, we can say that the fixed exchange rate system partially offset the initial changes in income. Here clearly the fixed exchange rate system works as a moderator to fluctuations in income, and thus serves as a built-in stabilizer or insulator.
Under the flexible exchange rate system, the BP deficit leads to an increase in exchange rates which in turn leads to a CA increase. A rising CA shifts the IS and BP curves to the right, which are indicated by the double-line arrow. The new equilibrium E2 is now on the BP curve. Comparing E1 with the initial troubles only and E2 with the working fixed exchange rate system, we can say that the flexible exchange rate system magnifies the initial changes in income. Here clearly the flexible exchange rate system works as an amplifier of fluctuations in income.

Case II. Relatively Mobile Capital

Suppose that consumption or investment rises: Initially, only IS curve shifts to the right.



(2) Domestic Money Market Shocks:
Δu which shifts the LM curve around
First of all, we should note that the domestic monetary shocks do have unambiguous impact on the BP regardless of capital mobility. This contrasts with the domestic goods market shocks which can lead to either a BP surplus or deficit depending on capital mobility. You may recall because of this difference, in the previous section as to the effective of policies, the analysis of the fiscal policy was a lot more complicated than that of the monetary policy.
We know that a decrease in the money demand due to a random factor (u) shifts the LM curve to the right: md = K y - h i + u.
Fixed Forex


Both lead to a balance of payment deficit. This deficit will have a contractionary impact under the fixed exchange rate system. And thus the LM will shift back to the left.

Flexible Exchange Rate System



Under the flexible exchange rate system, the BP deficit leads to an increase in exchange rates, which in turn leads to a CA increase. A rising CA shifts the IS and BP curves to the right. The new equilibrium is now on the BP curve. We can say that the flexible exchange rate system magnifies the initial changes in income.




Fixed Exchange Rate System


The balance of payment deficit will lead to a contractionary impact under the fixed exchange rate system. And thus the LM curve will shift back to the left.


You can see that the secondary endogenous movement of the LM curve shifts the equilibrium national income back against the direction to which the initial monetary shock has changed Y. Thus, we can say that the fixed foreign exchange rate system offsets the monetary shock regardless of degrees of capital mobility.

(3) External Goods Market Shocks
Good market shocks: ΔCA (resulting from ΔY* and thus ΔX), which shifts the IS and BP curves around.
Suppose X rises, or Exchange rates rises: Initially, not only IS but also BP shift to the right.

We can think of the external goods market shock in the setting of perfect capital mobility. This is simpler to think of as the BP curve is horizontal.

I

LM LM


BP>0
BP

BP


IS IS

Fixed Exchange Rate


Flexible Exchange Rate




















(4) External Monetary Shocks:
Δr* (resulting from MS*) which affects KA only, so that only the BP curve moves around, particularly up or down..

Here again the rise in the foreign interest has unambiguous impact on the BP: A higher interest rate of the foreign country will lead to capital outflows from the domestic country and thus KA and BP deteriorates no matter what the exchange rate system might be. Recall that graphically the rise in foreign interest rate shifts the BP curve up: r*  BP. The BP deficit region expands: the area above the BP curve is now smaller after the shift than before. The intersection of IS-LM curves lies below the BP curve, which means that the economy is now with BP deficits.


We will discuss this case in a specific setting of a perfect capital mobility:

Cast this issue in the case of Perfect Capital Mobility, or horizontal BP


LM LM


BP’

BP BP


IS IS

Flexible Exchange Rate

Fixed Exchange Rate












b) Shifting LM curve: MS u r


FIX FLEX
For instance, if the U.S. government raises interest rate, which is a foreign monetary shock, its impact will be inevitably felt on the Canadian economy no matter which exchange rate system Canada adopts.
What still matter is that such an impact could be expansionary or contractionary on the Canadian economy depending on the exchange rate system. A higher interest rate will lead to capital outflows from Canada, a KA deterioration and thus a BP deficit in Canada.
If the Canadian government simply lets the exchange rate go, The BP deficits put upward pressure on foreign exchange rates.
The rising exchange rate will lead to the improvement of the CA (recall S and CA move in the same direction all the time). The IS and BP curve will shift to the right, exerting an expansionary impact. The national income rises.

Alternatively, if the fixed exchange rate system is adopted (the Canadian government tries to depend the external value of the Canadian dollars which are losing values against the U.S. dollars), the very government's attempt to fix the exchange rate by selling the U.S. dollars in exchange for the Canadian dollars will lead to a decrease in the money supply in Canada. The LM curve shifts to the left, exerting a contractionary impact on the Canadian economy.


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