Chapter 7
Economic Policy in
the Open Economy
Under Fixed
Exchange Rates
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Learning Objectives
 Explain general equilibrium in the
macroeconomy using the IS/LM/BP model.
 Describe the impact of changes in fiscal
policy on income, trade, and interest rates
under fixed exchange rates.
 Describe the impact of changes in monetary
policy on income, trade, and interest rates
under fixed exchange rates.
 Perceive how varying degrees of capital
mobility alter the effectiveness of fiscal and
monetary policy under fixed exchange rates.
Targets, Instruments, and
Policy: A Model
“External balance”
 Any decrease in the interest rate (e.g.,
because of expansionary monetary
policy) will cause a decrease in shortterm capital inflows or an increase in
short-term capital outflows and a BOP
deficit.
 Expansionary fiscal policy (by increasing
Y and M) also leads to a BOP deficit.
“Internal balance”
 Expansionary monetary policy lowers
interest rates and increases I; this will be
inflationary unless fiscal policy offsets it.
As we discussed in Chapter 24, there are
four situations when there are internal
and external imbalances:
Case I: BOP deficit; unacceptably rapid
inflation
Case II: BOP surplus; unacceptably high
unemployment
Case III: BOP deficit; unacceptably high
unemployment
Case IV: BOP surplus; unacceptably rapid
inflation
The Mundell-Fleming Diagram
i
IB
IV
EB
II
I
III
To achieve internal
and external balance,
fiscal and monetary
policy must both be
used.
G-T
General Equilibrium in the Open
Economy: the IS/LM/BP Model
 To understand the effects of
policies on the open economy, we
need to use a general equilibrium
model.
 The IS/LM/BP model is built around
three sorts of equilibria:
1.money market equilibrium (the LM
curve),
2.real sector equilibrium (the IS curve),
and
3.BOP equilibrium (the BP curve).
Money Market Equilibrium: the
LM Curve
The LM curve comprises all
combinations of the interest
rate (i) and income (Y) such
that money supply and
money demand are equal.
Money Market Equilibrium: the
LM Curve
 Money supply is assumed to equal
money demand.
 Money supply is fixed.
 Money demand depends inversely
on the interest rate (i) and
positively on income (Y).
• As interest rates rise, the opportunity
cost of holding money rises, and so the
quantity demanded of money
decreases.
• As income rises demand for money
increases.
Money Market Equilibrium: the
LM Curve
Ms
i
At i1, Ms>Md: people will buy
bonds, reducing i.
At i2, Ms<Md: people will sell
bonds, increasing i.
i1
ie
i2
L = f(i,Y)
money
Money Market Equilibrium: the
LM Curve
 If income rises, money demand
will exceed money supply, and
interest rates will rise.
 Therefore, the LM curve is the
positive relationship between
the interest rate and income (Y).
 Points to the left of the LM
curve mean there is an excess
supply of money; points to the
right imply an excess demand.
Money Market Equilibrium: the
LM Curve
i
LM
income
Money Market Equilibrium: the
LM Curve
Increases in Ms or decreases
in Md will shift LM to the right.
Decreases in Ms or increases
in Md will shift LM to the left.
Real Sector Equilibrium: the
IS Curve
The IS curve comprises all
combinations of the interest rate (i)
and income (Y) such that the real
sector of the economy is in equilibrium.
Real Sector Equilibrium: the
IS Curve
 Investment should depend
inversely on the interest rate (i).
• As interest rates rise, the cost of
borrowing rises, so I falls.
 As before, consumption (C)
depends positively on income
(Y).
 Also, exports (X) and
government spending (G) are
fixed.
Real Sector Equilibrium: the
IS Curve
 The IS curve is the relationship
between the interest rate and Y.
• As the interest rate falls,
investment increases, thereby
increasing Y.
• As the interest rate rises,
investment decreases, thereby
decreasing Y.
 Therefore, the IS curve is
downward- sloping.
Real Sector Equilibrium: the
IS Curve
i
IS
income
Real Sector Equilibrium:
the IS Curve
Increases in
Decreases in
autonomous I,
autonomous I,
X, G or
X, G or
decreases in T
increases in T
will shift IS to
will shift IS to
the right.
the left.
BOP Equilibrium: the BP Curve
The BP curve comprises all
combinations of the interest rate (i)
and income (Y) such that the balance
of payments is in equilibrium.
BOP Equilibrium: the BP Curve
 The BP curve is the relationship
between the interest rate and Y.
• If Y increases and i is unchanged,
M will increase and a BOP deficit
will open.
• To return to BOP balance, i must
rise. This would trigger net shortterm capital inflows.
 Therefore, the BP curve is
upward- sloping.
BOP Equilibrium: the BP Curve
i
BP
income
BOP Equilibrium: the BP Curve
Points to the
Points to the
left of the BP
right of the BP
curve imply a
curve imply a
BOP surplus.
BOP deficit.
BOP Equilibrium: the Slope of
the BP Curve
 The slope of the BP curve depends
on how responsive short-term
private capital flows are to changes
in the interest rate.
 Points to the right of the BP curve
represent BOP deficits, triggering an
increase in i, which would cause in
increase in capital inflows.
 If capital inflows are very responsive,
a small Δi will bring us back to BOP
equilibrium (that is, a relatively flat
BP curve).
BOP Equilibrium: the Slope of
the BP Curve
The upward-sloping BP represents
“imperfect capital mobility.”
The typical upward slope of the BP curve
results from impediments to capital flows
or when the country is large enough to
influence international interest rates.
BOP Equilibrium: the Slope
of the BP Curve
 Capital could be perfectly mobile.
 This would occur if any deviation of
the domestic i away from the
international rate immediately
triggered capital flows that brought
interest rates back in line.
 When capital is perfectly mobile,
the BP curve is a horizontal line.
BOP Equilibrium: the Slope
of the BP Curve
 Capital could be perfectly immobile.
 If a country fixes its exchange rate,
it typically maintains strict foreign
exchange controls.
 When capital is perfectly immobile,
the BP curve is a vertical line.
BOP Equilibrium: the BP
Curve
 A depreciation of the home
currency, an autonomous increase
in exports, or an autonomous
decrease in imports will shift BP to
the right.
 An appreciation of the home
currency, an autonomous decrease
in exports, or an autonomous
increase in imports will shift BP to
the left.
Equilibrium in the Open
Economy
LM
i
BP
E
iE
Only at point E is the
economy in full
equilibrium.
IS
YE
income
Equilibrium in the Open
Economy: Adjustments
 Suppose exchange rates are fixed.
 How does the system adjust to a “shock”
such as an increase in foreign income?
 This should increase exports, shifting BP
rightwards to BP′.
 The IS curve will shift rightwards to IS′.
 To maintain the fixed exchange rate, the
central bank must purchase the surplus
foreign currency; this shifts LM
rightwards to LM′.
 Eventually, a new equilibrium is reached
at E''.
Equilibrium in the Open
Economy
LM
i
LM'
BP
BP'
i*
E
E''
i''
IS
Y*
Y''
IS'
income
Fiscal Policy Under Fixed
Exchange Rates
 With perfect capital immobility, any
fiscal stimulus initially increases Y
and M (and also i), but because
capital is immobile, a BOP deficit
emerges, decreasing the money
supply and increasing i further.
 In the end, Y returns to its original
level – the fiscal stimulus
completely crowds out domestic
investment (I).
Fiscal Policy Under Fixed
Exchange Rates
i
LM'
BP
LM
Perfect capital
immobility
E'
i'
iE
E
IS
YE
IS'
income
Fiscal Policy Under Fixed
Exchange Rates
 With perfect capital mobility, any
fiscal stimulus increases Y and M,
but i does not rise due to capital
inflows.
 To maintain the fixed exchange rate,
the central bank must increase the
domestic money supply.
 In the end, Y rises, but i stays the
same.
Fiscal Policy Under Fixed
Exchange Rates
LM
i
LM'
Perfect capital
mobility
E'
iE
E
BP
IS
YE
Y'
IS'
income
Fiscal Policy Under Fixed
Exchange Rates
 The bottom line:
• When capital is relatively mobile,
fiscal policy is more effective at
increasing national income.
• When capital is relatively immobile,
fiscal policy is less effective at
increasing national income.
Monetary Policy Under Fixed
Exchange Rates
With perfect capital immobility, a monetary
stimulus initially increases Y and M (and
lowers i), but because capital is immobile, a
BOP deficit emerges.
The central bank must sell foreign exchange
(decreasing the money supply) to maintain
the fixed exchange rate.
In the end, the LM curve returns to its
original place – the monetary stimulus
doesn’t change Y.
Monetary Policy Under Fixed
Exchange Rates
i
LM LM'
BP
Perfect capital
immobility
iE
E
IS
YE
income
Monetary Policy Under Fixed
Exchange Rates
 With perfect capital mobility, any
monetary stimulus increases Y
and M, but i does not fall due to
capital inflows.
 Again, to maintain the fixed
exchange rate, the central bank
must decrease the domestic
money supply.
 In the end, the LM curve returns to
its original place – the monetary
stimulus doesn’t change Y.
Monetary Policy Under Fixed
Exchange Rates
LM
i
LM'
Perfect capital
mobility
iE
E
BP
IS
YE
income
Monetary Policy Under Fixed
Exchange Rates
 The bottom line:
• When capital is relatively mobile,
monetary policy is ineffective at
increasing national income.
• When capital is relatively immobile,
monetary policy is ineffective at
increasing national income.
 Maintaining a fixed exchange rate
system means losing monetary
policy as an effective tool.
Effects of Official Changes in the
Exchange Rate System
 Obviously, to maintain a
fixed exchange rate
system, a country would
not want to devalue or
revalue the currency
often.
 However, such policy
actions are occasionally
required: what will be
the effects?
Effects of Official Changes in the
Exchange Rate System
 If the home country’s exchange
rate is devalued, exports rise and
imports fall.
 This shifts both the IS and BP
curves rightward.
 The money supply must be
expanded – the central bank must
buy foreign exchange.
 This means the LM curve also
shifts rightward.
 The devaluation increases Y.
Effects of Official Changes in the
Exchange Rate System
The bottom line:
When capital is relatively
immobile, a devaluation
increases national income.
When capital is relatively
mobile, a devaluation
increases national income to
an even greater extent.
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