IS - LM Model : Balance of Payment

or

IS-LM-BP model?

The IS-LM-BP model (also known as IS-LM-BoP or Mundell-Fleming model) is an extension of the IS-LM , which was formulated by the economists Robert Mundell  and Marcus Fleming, who made almost simultaneously an analysis of open economies in the 60s. Basically we could say that the Mundell-Fleming model is a version of the IS-LM model for an open economy. In addition to the balance in goods and financial markets, the model incorporates an analysis of the balance of payments. 

Even though both economists researched about the same topic, at about the same time, both have different analyses. Mundell’s paper “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates”, 1963, analyses the case of perfect mobility of capital, while Fleming´s model, depicted in his article “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, 1962, was more realistic as it assumed imperfect capital mobility, and thus made this one a more rigorous and comprehensive model. However, nowadays, his model has lost cogency, as the actual world situation has more resemblance with total capital mobility, which corresponds better to Mundell’s view.

In order to understand how this model works, we’ll first see how the IS curve, which represents the equilibrium in the goods market, is defined. Secondly, the LM curve, which represents the equilibrium in the money market. Thirdly, the BP curve, which represents the equilibrium of the balance of payments. Finally, we’ll analyse how the equilibrium is reached. 

IS curve: the market for goods and services

In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment,public spending, and net exports.  This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by:

Y = C(Y-T) + I + G + NX

We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS-LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net exports. Let’s say e is the domestic price of foreign currency or, in other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G + NX(e)

If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate. An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

As stated before, we also need to analyse changes in exchange rates (here, e). If e decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency. The opposite works in the same way: if e increases (also called a depreciation under flexible exchange rates or a devaluation under fixed exchange rates), domestic residents will pay more for the same goods. To sum up, an increase in e causes net exports to increase (IS curve shifts to the right) and a decrease in e causes net export to decrease (IS curve shifts to the left).

 

LM curve: the market for money

The LM curve represents the relationship between liquidity and money. In an open economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L(i,Y) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y. Also, the exchange rate must be analysed since it affects money demand (investors may decide buy or sell bonds in a country depending on the exchange rate).

The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates.

The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

BP curve: the balance of payments

The BP curve shows at which points the balance of payments is at equilibrium. In other words, it shows combinations of production and interest rates that guarantee that the balance of payments is viably financed, which means that the volume of net exports that affect total production must be consistent with the volume of net capital outflows. It will usually slope up since the higher the production, the higher the imports, which will disturb the equilibrium of the balance of payments, unless interest rates rise (which would cause capital inflows to maintain the equilibrium). However, depending in how great the mobility of capital is, it will have a greater or smaller slope: the higher the mobility, the flatter the curve.

Once the BP curve is derived, there is an important thing to know about how to use it. Any point above the BP curve will mean a balance of payments surplus. Any points below the BP curve will mean a balance of payments deficit. This is important since depending where we are, different things may affect the interest rates.

 

The IS-LM-BP model

In the model we distinguish between perfect and imperfect capital mobility, but also between fixed and flexible exchange rates. For each of these cases, we’ll see what happens when both an expansionary monetary and fiscal policy are applied to the economy. We’ll first review Mundell’s model, which deals with perfect mobility. Then, we’ll analyse Fleming’s imperfect mobility model.

1. Perfect capital mobility

1.1 Fixed exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, government intervention is required: the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has therefore no effect under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point E₂ to point E₁. Since the economy has now a balance of payments surplus, and because the exchange rate is fixed, government will intervene in the exact opposite way: they’ll purchase foreign currency and sell domestic currency. This will increase the money supply, shifting the LM curve to the right. The final equilibrium is reached at point E₂ where, at the same interest rate, production has increased greatly: fiscal policy works perfectly under these circumstances.

1.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E0 to E1. However, since now exchange rates are flexible, we have a different situation: the balance of payments deficit will depreciate the domestic currency. This will increase net exports (since foreigners can now buy more of our products with the same amount of money), which will shift the IS curve to the right (to IS’). The final equilibrium is reached at point E2 where, at the same interest rate, production has increased greatly: monetary policy works perfectly under these circumstances.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E0 to point E1. The economy will therefore have a balance of payments surplus, which in this case of flexible exchange rate will appreciate the domestic currency. This will decrease net exports, since we are able to import more goods and services with less money, while foreigners will import less of our products because of our appreciated domestic currency. This drop in net exports will shift the IS’ curve back to its original position. Since now the final equilibrium E2 corresponds to the initial equilibrium, we know fiscal policy is no good in this case.

It is easy to see why Mundell devised what is known as the impossible trinity. In a few words, no economy can have the following three: perfect capital mobility, fixed exchange rates and an independent and efficient monetary policy. Under the perfect capital mobility assumption, and in order to have an efficient monetary policy, exchange rates must be flexible. Or have fixed exchange rates but assume that monetary policy won’t be efficient.

2. Imperfect capital mobility

2.1 Fixed exchange rate

Here we have the exact same situation as before: an expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E₀ to E₁. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E₂). Monetary policy has again no effect, no matter how great or small capital mobility is.

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E0 to point E1. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). Since exchange rates are fixed, government will need to intervene: its acquisitions and disposals of both domestic and foreign currency will shift the LM curve to either LM’ or to LM* (you can review what happens above: a balance of payments surplus is the same scenario as in a fiscal policy with perfect capital mobility and fixed exchange rates, while the balance of payments deficit corresponds to the monetary policy scenario). Under these circumstances, fiscal policy is completely efficient. It’s actually the more efficient the higher capital mobility is.

2.2 Flexible exchange rate

An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E0 to E1. However, since now exchange rates are flexible, the balance of payments deficit will depreciate the domestic currency. This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore, with high capital mobility, final equilibrium will be at point E2. Monetary policy works well under these assumptions. It’s actually the more efficient the higher capital mobility is.

 

 

An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E0 to point E1. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, since domestic assets are more expensive, the BP+ curve will shift to the left. The final equilibrium will therefore be at point E2. If there is a balance of payments deficit (the case for the BP- curve), the result will be the same one as in the monetary policy case (being E2* the final equilibrium). In this scenario, fiscal policy will be more efficient the smaller capital mobility is.

The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies. A great deal of textbooks and papers argue for or against each of these models. However, there’s no denying the world is moving towards liberalizing international trade  and capital movements (mostly through WTO’s agreements), which would make us lean towards Mundell’s view. To sum up, under perfect capital mobility, monetary policy will only work with flexible exchange rates, while fiscal policy will only work with fixed exchange rates.

When we open the economy to international transactions we have to take into account the effects of trade in goods and services (i.e. items in the current account) as well as trade in assets (i.e. items in the capital account). Opening the economy to international trade in goods and services means that we have to take into account the increased demand for our goods by foreigners (our exports), as well as the decreased demand for our goods that occurs because we purchase foreign goods (i.e. our imports). 

Total expenditures in an open economy are C + I + G + NX, where NX -- net exports -- is equal to the level of exports (X) less the level of imports (V). Thus, our exports (X) represent spending by foreigners on domestic goods so they increase the level of domestic output. Imports (V), on the other hand, represent spending by domestic residents on foreign goods, so they decrease the level of (domestic) production. To analyze the effect of exports and imports on the equilibrium level of output, it is important to understand the various factors which determine the levels of exports and imports. 

Exports represent foreign demand for our goods and services. Foreign purchases of goods and services depend, among other things, on foreign income levels (just as our purchases of goods and services depend on our income levels). We assume that foreign income levels are constant, thus, foreigners demand a constant amount of our goods. Whether foreigners buy our goods, or some other country's goods, or their own goods, depends on the relative prices of those goods. The lower our relative price, the more of our goods they will purchase. The exchange rate is an indicator of the relative price of our goods to foreigners. We will use "e" as the domestic price of foreign currency (i.e. how many dollars must be given up to receive 1 unit of foreign currency). Let's say that e is initially 1. 5. If e ↓ , then a domestic resident will have to give up fewer dollars to get an additional unit of foreign currency (e1 < e0 ); foreigners, on the other hand, will need to give more of their currency to receive $1. A decrease in e, also called a revaluation under fixed exchange rates or an appreciation under flexible exchange rates, allows domestic residents to buy the same amount of foreign goods using less domestic currency. If e↑ , domestic residents will need to give more currency to receive one unit of foreign currency. An increase in e, also called a devaluation under fixed exchange rates or a depreciation under flexible exchange rates, means domestic residents must give up more currency to buy the same amount of foreign goods. If e increases (i.e. our currency devalues -- it is worth less), foreigners don't have to give up as much of their currency to purchase the same quantity of our goods, therefore, the relative price of our goods to foreigners has fallen: they purchase more of our goods. Thus, an increase in e causes exports to increase. An increase in e causes imports to fall (because foreign goods are relatively more expensive). 

To sum up, exports are determined by foreign income levels (which we assume to be constant) and the exchange rate. An increase in e causes X to increase. A decrease in e causes X to fall. If e is unchanged, X is constant. Imports (V) are domestic purchases of foreign goods. Imports represent expenditures on foreign goods instead of domestic goods. Thus, the level of domestic production does not have to be as high when-we import goods and services. The domestic demand for goods and services is determined by the domestic level of income: a higher level of income means a higher level of consumption -- consumption of both domestic and foreign goods. Thus, an increase in (domestic) income increases the level of imports. Similar to the case of exports, whether we purchase domestic goods or foreign goods depends on the relative prices of the goods. The exchange rate is an indicator of those relative prices. An increase in e (a depreciation in the value of the domestic currency) means that domestic residents have to give up more domestic currency to receive the same quantity of a foreign good. Thus, the relative price of that foreign good has risen and therefore, less of it will be purchased by domestic residents. So, an increase in e will cause a decrease in imports: a higher e raises the relative cost of foreign goods and therefore reduces V. Conversely, a decrease in e lowers the relative price of foreign goods and therefore increases V. Thus, imports are determined by domestic income levels and the exchange rate. An increase in Y or a decrease in e causes V to increase. A decrease in Y or an increase in e causes V to decrease. 

The effect of opening the economy to trade in goods and services, is that the IS curve needs to be specified for a given exchange rate. The IS curve still depicts the combinations of i and Y for which the level of total expenditures equals the level of production, but now, in addition to being determined by the interest rate, total expenditures are also determined by the exchange rate (since the exchange rate affects the level of NX). Under a fixed exchange rate regime, the IS curve is fixed (unless there is a change in government spending or tax rates, or the government devalues or revalues the currency). Under a flexible exchange rate regime, the price of foreign exchange fluctuates to equate the demand and supply of foreign exchange. Thus, e changes on a frequent basis. 

Whenever e changes, the IS curve shifts. If e increases (the domestic currency depreciates), X increases, V falls, thus, NX increases, which means total expenditures have risen, therefore the IS curve shifts to the right. If e falls (the domestic currency appreciates), X falls, V rises, thus NX falls and the IS curve shifts to the left. When discussing the effects of various policies (fiscal and monetary), you must be certain of the exchange rate regime: you get different answers with a flexible regime than with a fixed regime. 

To examine the effect of trade in financial assets (i.e. capital flows) we need to construct a BP curve. The BP curve shows the various combinations of interest rates and income levels for which the Current Account (CA) and the Capital Account (KA) offset each other (i.e. the Balance of Payments is in equilibrium). The Current Account (for our purposes, the CA is equivalent to the level of net exports) is determined by the domestic level of income (which affects V), the (constant) foreign level of income (which affects X), and the exchange rate (which affects both V and X). As the domestic level of income rises, imports rise while exports stay constant. Thus, as income rises (with e remaining unchanged), NX falls, therefore the CA falls. The Capital Account is determined by the factors that affect capital flows between countries: the rate of return on comparable assets. By assuming that foreign interest rates (i*) are constant and that there are no expectations that the exchange rate will change, a rise in domestic interest rates will attract capital here (K inflow) while a fall in domestic interest rates will attract capital to foreign countries (K outflow).

The derivation of the BP curve is undertaken in figure 1: 

The BP curve is drawn for a given exchange rate and a given foreign interest rate. To derive the BP curve, start with a specific level of income, Y0. At that income level, imports are Vo. The CA (X - V) is, therefore, X - VO. Assume this is negative (i.e. Vo > X), which means there’s a deficit in the CA. To offset the deficit in the CA, there has to be a KA surplus-(i.e. K inflows). Assume that a domestic interest rate i0 attracts sufficient capital inflows K0 to exactly offset the Current Account deficit. Thus, at the interest rate i0 and the income level Y0 the Current and the Capital Accounts offset each other, and these represent, therefore, one point on the BP curve. Consider a higher income level, Y1. At Y1, since income is higher, consumption is higher: consumption of our goods and consumption of foreign goods. Thus, at Y1 there are imports of V1 > V0. Since X is fixed (foreign income is constant and e is fixed), the CA is in even greater deficit than it was at income Y0. To offset this greater deficit in the CA, there need to be greater capital inflows than what occurred at i0. To induce more capital inflows, we need a higher domestic interest rate (remember i* is constant). Assume that the interest rate i1 induces capital inflows of K1 which are just sufficient to completely offset the CA deficit. Thus, i1 and Y1 are another combination of i and Y for which the BoP is in equilibrium, and therefore they represent another point on the BP curve.

The slope of the BP curve has 3 ranges, characterizing the degree of capital mobility in the economy. The BP is perfectly horizontal when capital is perfectly mobile. This situation occurs when financial assets are perfect substitute across countries. Any small deviation in the domestic interest rate from the foreign interest rate results in an infinite amount of capital flows. If the domestic interest rate is lower than the foreign interest rate, there are an infinite amount of capital outflows. If the domestic interest rate is higher than the foreign interest rate, there are an infinite amount of capital inflows. Obviously, whenever there are an infinite amount of capital flows, there is very strong pressure on the exchange rate to change. Under a fixed exchange rate regime, the Central Bank will have to buy or sell sufficient quantities of domestic currency to counteract this pressure on the exchange rate. Under a flexible exchange rate regime, the price of foreign exchange will adjust. 

 

When capital is mobile (but not perfectly mobile) the BP curve is not perfectly horizontal, but is flatter than the LM curve (note that capital mobility in this and the following instance is relative to the LM curve). Assets are not perfect substitutes across countries. Immobile capital occurs when the BP curve is steeper than the LM curve. As you will see below, the degree of capital mobility has a bearing on the outcome of various fiscal and monetary policies. 

One final point regarding the BP curve has to do with what happens when the economy is above (or to the left) of the curve, and what happens when the economy is below (or to the right) of the curve. If the internal equilibrium (the intersection of the IS-LM curves) is above the BP curve, then the domestic interest rate is inducing greater capital inflows than are necessary at that level of income to maintain the Balance of Payments in equilibrium. The greater than necessary capital inflows represent an additional credit, which means the BoP is in surplus (under a fixed exchange rate regime, or in incipient surplus -- a surplus about to happen -- under a flexible exchange rate regime) when the internal equilibrium is above the BP curve. Conversely, if the internal equilibrium is below the BP curve, there are insufficient capital inflows at that level of income to maintain a BoP equilibrium. In both of these cases there will have to be an adjustment made so that there is simultaneous equilibrium in the internal and the external sectors. 

The adjustment to an overall equilibrium (i.e., an equilibrium in the internal and external sectors) depends on the exchange rate regime. Under fixed exchange rates, the Central Bank stands ready to buy and sell sufficient quantities of the domestic currency to keep the exchange rate fixed at an agreed upon level. Thus, the BP curve never moves under fixed exchange rates: the adjustment is done through monetary policy (i.e. movements in the LM curve). Under flexible exchange rates, the price of foreign exchange is allowed to adjust to get the economy simultaneously to internal and external equilibrium. 

When the exchange rate changes, this affects the level of net exports: as e increases (i.e. the domestic currency depreciates), NX rises. The change in e, and its effect on NX, affects both the IS and the BP curves (subject to the qualification below). As NX rises, the level of total expenditures increases, therefore the IS curve shifts to the right. Simultaneously, as NX rises, the Current Account improves (i.e., the Current Account equals the level of net exports: as NX rises, the CA rises -- becomes less negative). As the CA improves, the economy does not need as high a level of capital inflows at each income level as it did before, therefore, the BP curve simultaneously shifts to the right. 

The one qualification about the BP curve shifting to the right when the exchange rate depreciates (i.e., e increases) has to do with the case of perfect capital mobility. When capital is perfectly mobile, if the internal equilibrium is below the BP curve, there is pressure on the exchange rate to depreciate (i.e., there is an infinite amount of capital outflows as investors seek to earn the higher rate of return they can earn on foreign assets). As e increases (depreciates), the level of NX rises, therefore, the CA-improves. The improvement in the CA is a finite number, whereas the capital outflows are an infinitely large number. Thus, under the case of perfect capital mobility, the BP does not shift when the exchange rate changes. 

 Fixed Exchange Rates, Perfect Capital Mobility, Increase in Money Supply

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there are infinite capital outflows as domestic investors seek to purchase higher returning foreign assets. These investors are exchanging their unwanted dollars for foreign exchange. The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted dollars and sells foreign exchange. As the Fed buys the dollars, the money supply is decreased: the LM curve moves to the left, coming to rest at its initial position. The economy moves back to A. There is no change in Y or i from this monetary policy. In abbreviated notation (acceptable on tests) this would be: ↑Ms → LM right: A to B. At B: deficit in the BoP - infinite K outflows. To relieve the pressure on the exchange rate, the Fed buys $ and sells foreign exchange : ↓ MS → LM left, back to A. No change in Y and i.  

Monetary policy is ineffective in altering the level of domestic output under fixed exchange rates and perfect capital mobility. 

 

 

Fixed Exchange Rates, Perfect Capital Mobility, Increase in G

The increase in G means an increase in Total Expenditures, therefore the IS curve shifts to the right and the economy goes from point A to point B. At B, there are infinite capital inflows as foreign investors seek to purchase higher returning domestic assets. These investors are exchanging their foreign currency for dollars. The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted foreign exchange and sells dollars. As the Fed sells the dollars, the Money supply is increased: the LM curve moves to the right and the economy goes from point B to point C. There is a large change in Y from this fiscal expansion. In abbreviated notation (acceptable on tests) this would be: ↑G → ↑ TE → IS right: A to B at B: BoP surplus due to infinite K inflows. To maintain the fixed e, Fed sells $ and buys For. Ex. → ↑MS → LM right: B to C. ↑Y from Y0, to Y1. 

 Fiscal policy is extremely effective in altering the level of domestic output under fixed exchange rates and perfect capital mobility.

 Flexible Exchange Rates, Perfect Capital Mobility, Increase in Money Supply

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there are infinite capital outflows as domestic investors seek to purchase higher returning foreign assets. These investors are exchanging their unwanted dollars for foreign exchange. This decreased demand for dollars causes the value of the dollar to fall on foreign exchange markets (i.e. the dollar depreciates, e increases). As e increases, Net Exports increase as domestic goods become relatively cheaper on international markets. As NX increases, Total Expenditures rise and the IS curve shifts to the right. The exchange rate will continue to depreciate, and the IS curve will continue to shift to the right until the capital outflow is halted (i.e. until the domestic interest rate equals the foreign interest rate). The new equilibrium is at C, where domestic output has increased. In abbreviated notation (acceptable on tests) this would be: ↑MS → LM right: A to B at B: infinite K outflows: ↑e (depreciates) as e ↑ → ↑NX → ↑TE → IS right: B to C. ↑Y from Y0 to Y1. 

 Monetary policy is extremely effective in altering the level of domestic output under flexible exchange rates and perfect capital mobility.

 Flexible Exchange Rates, Perfect Capital Mobility, Increase in G

The increase in Government spending means there's an increase in Total Expenditures, therefore the IS curve shifts to the right and the economy goes from point A to point B. At B, there are infinite capital inflows as foreign investors seek to purchase higher returning domestic assets. These investors are exchanging their currency for the more desirable dollar. This increased demand for dollars causes the value of the dollar to rise on foreign exchange markets (i.e. the dollar appreciates, e decreases). As e decreases, Net Exports decrease as domestic goods become relatively more expensive on international markets. As NX decreases, Total Expenditures fall and the IS curve shifts to the left. The exchange rate will continue to appreciate, and the IS curve will continue to shift to the left until the capital inflow is halted (i.e., until the domestic interest rate equals the foreign interest rate). The new equilibrium is at the same level of output as the initial level: the economy moves back to A. In abbreviated notation (acceptable on tests) this would be: ↑G → ↑ TE → IS right: A to B. At B : infinite K inflows → ↓ e (appreciates) as e↓ → ↓ NX → ↓ TE → IS left: back to A. No change in Y.

 Fiscal policy is ineffective in altering the level of domestic output under flexible exchange rates and perfect capital mobility.

 

Fixed Exchange Rates, Mobile Capital (BP flatter than LM), Increase in Money Supply

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there is a deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The deficit in the BoP means there is pressure on the exchange rate to depreciate (there are unwanted dollars on the foreign exchange market). The Federal Reserve has agreed to maintain the exchange rate at eo, and therefore buys up the unwanted dollars and sells foreign exchange. As the Fed buys the dollars, the Money supply is decreased: the LM curve moves to the left, coming to rest at its initial position. The economy moves back to A. There is no change in Y or i from this monetary policy. In abbreviated notation (acceptable on tests) this would be: ↑Ms → LM right: A to B - at B: BoP deficit (below the BP curve). To maintain the fixed e, Fed buys $ and sells For Ex. → ↓ Ms → LM left : back to A No change in Y and i

 Monetary policy is ineffective in altering the level of domestic output under fixed exchange rates with mobile capital. 

Fixed Exchange Rates, Immobile Capital (BP steeper than LM), Increase in Money Supply

The description for this case is the same as for Case 5. The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there is a deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The deficit in the BoP means there is pressure on the exchange rate to depreciate (there are unwanted dollars on the foreign exchange market). The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted dollars and sells foreign exchange. As the Fed buys the dollars, the Money supply is decreased: the LM curve moves to the left, coming to rest at its initial position. The economy moves back to A. There is no change in Y or i from this monetary policy. In abbreviated notation (acceptable on tests) this would be: ↑ Ms → LM right: A to B; at B: BoP deficit (below the BP curve). To maintain the fixed e, Fed buys $ and sells For. Ex. ↓ Ms → LM left: back to A. No change in Y and i 

Monetary policy is ineffective in altering the level of domestic output under fixed exchange rates with immobile capital. 

Fixed Exchange Rates, Mobile Capital (BP flatter than LM), Increase in G 

The increase in Government spending means there's an increase in Total Expenditures: the IS curve shifts to the right and the economy moves from A to B. At B, there is a surplus in the Balance of Payments because the level of capital inflows is more than sufficient to offset the deficit in the CA that prevails at B. The surplus in the BoP means there is pressure on the exchange rate to appreciate (there's an increased demand for dollars on the foreign exchange market). The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore satisfies this demand for dollars by selling dollars and buying foreign exchange. As the Fed sells the dollars, the Money supply is increased: the LM curve moves to the right, the economy moves from B to C. There has been an increase in the domestic level of output from the expansionary fiscal policy. In abbreviated notation (acceptable on tests) this would be: ↑G → ↑TE → IS right: A to B; at B: BoP surplus (above the BP curve). To maintain the fixed e, Fed sells $ and buys For. Ex. → ↑ Ms → LM right: B to C. ↑Y from Y0 to Y1. 

 Fiscal policy is effective in altering the level of domestic output under fixed exchange rates with mobile capital, but not as effective as if capital had been perfectly mobile. 

Fixed Exchange Rates, Immobile Capital (BP steeper than LM), Increase in G

The increase in Government spending means there's an increase in Total Expenditures: the IS curve shifts to the right and the economy moves from A to B. At B, there is a deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The deficit in the BoP means there is pressure on the exchange rate to depreciate (there are unwanted dollars on the foreign exchange market). The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted dollars and sells foreign exchange. As the Fed buys the dollars, the money supply is decreased: the LM curve moves to the left, the economy moves from B to C. There has been an increase in the domestic level of output from the expansionary fiscal policy. In abbreviated notation (acceptable on tests) this would be: 

↑G → ↑TE → IS right: A to B; at B: BoP deficit (below the BP curve). To maintain the fixed e, Fed buys $ and sells For. Ex. → ↓ Ms → LM left: B to C. ↑Y from Y0 to Y1.

 Fiscal policy is effective in altering the level of domestic output under fixed exchange rates with immobile capital, but not as effective as if capital had been mobile or perfectly mobile. 

 Flexible Exchange Rates, Mobile Capital (BP flatter than LM), Increase in Money Supply

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there is an incipient (incipient means about to happen—in reality, it never quite happens) deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The incipient deficit in the BoP means the exchange rate is depreciating (there are unwanted dollars on the foreign exchange market). As the exchange rate depreciates (e increases), Net Exports increase because the relative price of domestic goods on international markets has fallen. As NX rises, it has two effects that occur simultaneously: 1) Total Expenditures increase therefore the IS curve moves right, and, 2) the Current Account improves therefore the BP curve moves right. These shifts are labeled 2a and 2b, respectively, in the above diagram. Note that the cases with flexible exchange rates and non-perfectly mobile capital differ from the perfect capital mobility case. In the latter, the BP curve does not shift because the capital in/out flows are infinite, and therefore they overwhelm the effect that the change in NX has on the CA. The new equilibrium occurs at C, where the economy has had an increase in Y. In abbreviated notation (acceptable on tests) this would be: ↑Ms → LM right: A to B; at B: incipient BoP deficit (below the BP curve) → ↑e (depreciates) As e↑ → ↑NX 

→ (2a): ↑TE → IS right;

→ (2b): ↑CA → BP right. Together, these cause the economy to move from B to C: ↑Y from Y0 to Y1.

 Monetary policy is effective in altering the level of domestic output under flexible exchange rates with mobile capital.

 

 Flexible Exchange Rates, Immobile Capital (BP steeper than LM), Increase in Money Supply

This case is descriptively the same as case 9. The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there is an incipient deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The incipient deficit in the BoP means the exchange rate is depreciating (there are unwanted dollars on the foreign exchange market). As the exchange rate depreciates (e increases), Net Exports increase because the relative price of domestic goods on international markets has fallen. As NX rises, it has two effects that occur simultaneously: 1) Total Expenditures increase therefore the IS curve moves right, and, 2) the Current Account improves therefore the BP curve moves right. These shifts are labeled 2a and 2b, respectively, in the above diagram. Note that the cases with flexible exchange rates and non-perfectly mobile capital differ from the perfect capital mobility case. In the latter, the BP curve does not shift because the capital in/out flows are infinite, and therefore they overwhelm the effect that the change in NX has on the CA. The new equilibrium occurs at C, where the economy has had an increase in Y. In abbreviated notation (acceptable on tests) this would be: Ms → LM right: A to B; at B: incipient BoP deficit (below the BP curve) ↑e (depreciates).As e↑ → ↑NX   

→ (2a): ↑ TE → IS right;

→ (2b): ↑CA → BP right. Together, these cause the economy to move from B to C: ↑Y from Y0 to Y1.  

 Monetary policy is effective in altering the level of domestic output under flexible exchange rates with immobile capital. 

Flexible Exchange Rates, Mobile Capital (BP flatter than LM), Increase in G

The increase in Government spending means there's an increase in Total Expenditures: the IS curve shifts to the right and the economy moves from A to B. At B, there is an incipient surplus in the Balance of Payments because the level of capital inflows is more than sufficient to offset the deficit in the CA that prevails at B. The incipient surplus in the BoP means the exchange rate is appreciating (there is an increase in demand for dollars on the foreign exchange market). As the exchange rate appreciates (e decreases), Net Exports decrease because the relative price of domestic goods on international markets has risen. As NX falls, it has two effects that occur simultaneously: 1) Total Expenditures decrease therefore the IS curve moves left, and, 2) the Current Account worsens therefore the BP curve moves left. These shifts are labeled 2a and 2b, respectively, in the above diagram. Note that the cases with flexible exchange rates and non-perfectly mobile capital differ from the perfect capital mobility case. In the latter, the BP curve does not shift because the capital in/out flows are infinite, and therefore they overwhelm the effect that the change in NX has on the CA. The new equilibrium occurs at C, where the economy has had an increase in Y. In abbreviated notation (acceptable on tests) this would be: ↑G → ↑TE → IS right: A to B; at B: incipient BoP surplus (above the BP curve): ↓ e (appreciates) As e↓ → ↓ NX 

→ (2a): ↓ TE → IS left;

→ (2 b): ↓ CA → BP left. Together, these cause the economy to move from B to C: Y from Y0 to Y1. 

 Fiscal policy is more effective in altering the level of domestic output under flexible exchange rates with mobile capital than with perfect capital mobility.

 

Flexible Exchange Rates, Immobile Capital (BP steeper than LM), Increase in G

The increase in Government spending means there's an increase in Total Expenditures: the IS curve shifts to the right and the economy moves from A to B. At B, there is an incipient deficit in the Balance of Payments because the level of capital inflows is insufficient to offset the deficit in the CA that prevails at B. The incipient deficit in the BoP means the exchange rate is depreciating (there are unwanted dollars on the foreign exchange market). As the exchange rate depreciates (e increases), Net Exports increase because the relative price of domestic goods on international markets has fallen. As NX rises, it has two effects that occur simultaneously: 1) Total Expenditures increase therefore the IS curve moves right, and, 2) the Current Account improves therefore the BP curve moves right. These shifts are labeled 2a and 2b, respectively, in the above diagram. Note that the cases with flexible exchange rates and non-perfectly mobile capital differ from the perfect capital mobility case. In the later, the BP curve does not shift because the capital in/out flows are infinite, and therefore they overwhelm the effect that the change in NX has on the CA. The new equilibrium occurs at C, where the economy has had an increase in Y. In abbreviated notation (acceptable on tests) this would be: ↑G → ↑ TE → IS right: A to B; at B: incipient BoP deficit (below the BP curve): ↑e (depreciates) As e↑→ ↑ NX

→ (2a): ↑TE → IS right;

→ (2b): ↑CA → BP right. Together, these cause the economy to move from B to C: Y from Y0 to Y1

Fiscal policy is more effective in altering the level of domestic output under flexible exchange rates with immobile capital than with mobile capital or perfect capital mobility.