CHAPTER FOUR

OPEN ECONOMY MACROECONOMICS

Any economy is linked to the rest of the world through two broad channels; trade (in goods and
services) and finance. The trade linkage means some of a county’s production is exported to
foreign countries, while some goods that are consumed or invested at home are produced abroad
and imported.

4.1 EXCHANGE RATES AND EXCHANGE RATE

We will start our discussion with exchange rate, exchange rate regimes and alternative exchange
rates.

A. Exchange Rate Definitions

The exchange rate is simply the price of one currency in terms of another, and there are two
methods of expressing it:
 domestic currency units per unit of foreign currency- for example Birr /USD
 Foreign currency units per unit of domestic currency- for example USD / Birr.

The spot and forward exchange rates: Foreign exchange dealers not only deal with a wide
variety of currencies but they also have a set of dealing rates for each currency, which are known
as spot and forward rates.
The spot exchange rate is the quotation between two currencies for immediate delivery. In
other words, the spot exchange rate is the current exchange rates of two currencies vis-à-vis each
other. In practice, there is normally a two-day lag between a spot purchase or sale and the actual
exchange of currencies to allow for verification, paper work and clearing of payments.
The forward exchange rate- In addition to the spot exchange rate, it is possible for economic
agents to agree today to exchange currencies at some specified time in the future, most
commonly for 1 month, 3months, 6 months, 9 months and 1 year. The rate of exchange at which
such a purchase or sale can be made is known as the forward exchange rate.

Nominal, Real and Effective Exchange Rates

Nominal exchange rate: the exchange rate that prevails at a given date is known as the nominal
exchange rate, and the amount of USD that will be obtained for one Birr in the foreign exchange
market. The nominal exchange rate is merely the price of one currency in terms of another with
no reference made to what this means in terms of purchasing power of goods/services.
Real exchange rate: the real exchange rate is the nominal exchange rate adjusted for relative
prices between the countries under consideration. The real exchange rate is normally expressed
in index form algebraically as;

1
 P
Sr =S
P∗¿ ¿
Where Sr , is the index of the real exchange rate, S is the nominal exchange rate in index form, P
the index of the domestic price level and P* is the index of the foreign price level.

Effective exchange rate: since most countries of the world do not conduct all their trade with a
single foreign country, policy makers are not so much concerned with what is happening to their
exchange rate against a single foreign currency but rather what is happening to it against a basket
of foreign currencies with which the country trade. The effective exchange rate as a measure pf
whether price of the currency is appreciating or depreciating against a weighted basket of foreign
currencies. In order to illustrate how an effective exchange rate is compiled consider a
hypothetical case of Ethiopia conducting 20% of trade with the China and 80% of its trade with
Europe. This means a weight 0.2 will be attached to the bilateral exchange rate index with the
dollar and 0.8 to the euro.

Alternative Exchange Rate Regimes

Floating Exchange Rate Regime: Under floating exchange rate regime, the authorities do not
intervene to buy or sell their currency in the foreign exchange market. Rather, they allow the
value of their currency to change due to fluctuations in the supply and demand of the currency.
In the figure below the exchange rate is initially determined by the interaction of the demand
(D1) and supply (S1) of Birr at the exchange rate of $.08/Birr1. There is an increase in the
demand for Ethiopian exports, which shifts the demand curve from D1 to D2, and the increase in
the demand for Birr leads to an appreciation of the Birr from $0.08/ birr1 to $1/birr1. Figure b
examines the impact of an increase in the supply of Birr due to an increased demand for US
exports and therefore dollars. The increased supply of birr shift the S1 schedule top the right to
S2 resulting in a depreciation of the Birr to $0.06/birr1. The essence of a floating exchange rate
is that the exchange rate adjusts in response to changes in the supply and demand for a currency.

2
Fixed exchange rate regime: In figure 5.2 (a) the exchange rate is assumed to be fixed by the
authorities at the point where the demand schedule (D1) intersects the supply schedule (S1) at
$0.08/ birr1. If there is an increase in the demand for birr, which shifts the schedule from D1 to
D2, there is a resulting pressure for the birr to be revalued. To avert an appreciation it is
necessary for the central bank to sell Q1Q2 of birr to purchase dollars in the foreign exchange
market, these purchases shift the supply of birr from S1 to S2. Such intervention eliminates the
excess demand for birr so that the exchange rate remains fixed at $0.08/ birr1. The intervention
increases the central bank’s reserves of USD while increasing the amount of birr in circulation.
Figure 5.2 (b) depicts an initial situation where the exchange rate is pegged by the authorities at
the point where the demand schedule (D1) intersects the supply schedule (S1) at $0.08/ birr1. An
increase in the supply of birr (increased demand of USD) shifts the supply schedule from S1 to
S2. The result is an excess supply of birr at the prevailing exchange rate. This means that there
will be pressure for the birr to be devalued. To avoid this, the national Bank of Ethiopia has to
intervene in the foreign exchange market to purchase Q1Q2 birr to peg the exchange rate. The
intervention is represented by a rightward shift of the demand schedule from D1 to D2. Such
intervention removes the excess supply of birr so that the exchange rate remains pegged at $0.08/
birr1.

4.2 THE BALANCE OF PAYMENTS

Definition

The balance of payments is a statistical record of all the economic transactions between residents
of the reporting country and residents of the rest of the world during a given time period. It
reveals how many goods and services the country has been exporting and importing and whether

3
the country has been borrowing money from or lending money to the rest of the world. In
addition, whether or not the central monetary authority has been added to or reduced its reserves
of foreign currency is reported in the statistics.

An important point a country’s balance of payments statistics is that in an accounting sense it

always balances. This is because it is based upon the principle of double entry bookkeeping.
Each transaction between a domestic and foreign resident has two sides to it, a receipt and a
payment, and both of these are recorded in the balance of payments statistics. Each recipient or
currency from residents of the rest of the world is recorded as a credit item (a plus on the
accounts), while each payment to residents of the rest of the world is recorded as a debt (a minus
in the account).

Traditionally, the statistics are divided into two main sections- the current account and the capital
account. The current account items refer to income flows, while the capital account records
changes in assets and liabilities.

The trade balance: The trade balance is the sum of the visible trade balance because it
represents the difference between receipts for exports of goods and expenditure on imports of
goods, which can be visibly seen crossing frontier. The receipts for exports are recorded as a
credit in the balance of payments, while the payment for imports is recorded as a debit. The trade
balance is in surplus if the country has earned more from its exports of goods than it has paid for
its imports of goods.

The Currents Account Balance: The current account balance is the sum of the visible trade
balance and the invisible balance. The invisible balance shows the difference between revenue
received for exports of services and payments made for imports of services such as shipping,
tourism, insurance, and banking. In addition, receipts and payments of interest, dividends and
profits are recorded in the invisible balance because they represent the rewards for investment in
overseas companies, bonds, and equity, while payments reflect the rewards to foreign residents
for their investment in the domestic economy. As such, they are receipts and payments for the
services of capital that earn and cost the country income just as do exports and imports.

The Capital Account Balance: The capital account records transactions concerning the
movement of financial capital into and out of the country. Capital comes into the country by
borrowing, sales of overseas assets and investment in the country by foreigners. These items are
referred to as capital inflows and are recorded as credit items in the balance of payments. Capital
inflows are, in effect, a decrease in the country’s holding of foreign assets or an increase in
liabilities to foreigners. The fact that capital inflows are recorded as credits in the balance
payments often presents students with difficulty.

4
Items in the capital account are normally distinguished according to whether they originate from
the private or public sector and whether they are of a shot-term or long-term nature. The
summation of the capital inflows and outflows as recorded in the capital account gives the capital
account balance.

Official Settlements Balance: Given the huge statistical problems involved in compiling the
balance of payments statistics, there will usually be a discrepancy between the sum all the items
recorded in the current account, capital account and the balance of official financing which in
theory should sum to zero.

The summation of the current account balance, capital account balance and the statistical
discrepancy gives the official settlements balance. The balance on this account is important
because it shows the money available for adding to the country’s official reserves or paying off
the country’s official borrowing. A central bank normally holds a stock of reserves made up of
foreign currency assets. Such reserves are held primarily to enable the central bank to purchase
its currency should it wish to prevent it depreciating. Any official settlements deficit has to be
covered by the authorities drawing on the reserves, or borrowing money from foreign central
banks or IMF. If, on the other hand, there is an official settlements surplus this can be reflected
by the government increasing official reserves or repaying debts to the IMF or other sources
overseas (a minus since money leaves the country).

Trade balance
+exports of goods
-imports of goods
= trade balance
Current account balance
Trade balance
+exports of services
+ Interest, dividends and profits received
+ Unilateral receipts
-Import of services
- Interest, dividends and profits paid
- Unilateral payments abroad
= current account balance
Basic balance
Current account balance
+balance on long term capital account
+ Statistical error
= official settlements balance

5
4.3 The Basic Model

A. Open Economy National Income Identity

The key macroeconomic difference between open and closed economies is that, in an open
economy, a country’s spending in any given year need not equal its output of goods and services.
A country can spend more than it produces by borrowing from abroad, or it can spend less than it
produces and lend the difference to foreigners.

In an open economy gross domestic product (GDP) differs from that of a closed economy
because there is an additional injection- export expenditure which represents foreign expenditure
on domestically produced goods. There is also an additional leakage, expenditure on imports
which represents domestic expenditure on foreign goods and which raises foreign national
income. The identity for an open economy is given by:

[4.1] Y = C + I + G + X – M

where Y is national income, C is domestic consumption, I is domestic investment, G is

government expenditure, X is export expenditure and M is import expenditure.

If we deduct taxation T from both hand sides of equation (4.1), we have:

Y-T = C + I + G + X – M –T

[4.2] Yd = C + I + G + X – M –T

If we denote private savings as S=Yd-C we can rearrange equation (4.2) to obtain;

[4.3] X-M = (S-I) + (T-G)

Where, (X-M) is Current account balance, S I Net savings/ dis-savings of the private sector
and (T G Government deficit/surplus
This is an important identity that says a current account deficit has a counterpart in either private
dissaving, that is private investment exceeding private saving and/or in a government deficit

The equation is merely an identity and says nothing about causation. Nonetheless, it is often
stated that the current account deficit is due to lack of private savings and/or the government
budget deficit. However, it is possible that the causation runs the other way, with the current
account deficit being responsible for the lack of private savings or budget deficit.

Income determination in an open economy

In an open economy, the equilibrium level of national income is determined where the domestic
balance is equals to the external balance. The starting point would be equation [4.1]

Y = C + I + G + X – M; and we would make certain additions to this equation.

6
Domestic consumption is partly autonomous and partly determined by the level of national
income. This is denoted algebraically by:

C =Ca + cY

Import expenditure is also assumed to be partly autonomous and partly a positive function of the
level of domestic income:

M = Ma + mY

where Ma is autonomous import expenditure and m is the marginal propensity to import, that is
the fraction of any increase in income that is spent on imports. In this simple formulation import
expenditure is assumed to be a positive linear function of income. There are several justifications
for this; on the one hand increased income leads to increased expenditure on imports, and also
more domestic production normally requires more imports of intermediate goods.

Government expenditure and exports are assumed to be exogenous; government expenditure

being determined independently by political decisions, and exports by foreign expenditure
decisions and foreign income.

Substituting consumption and import equations into equation [4.1] we obtain:

Y = Ca + cY + I + G + X - Ma + mY

Rearranging this equation, we have

[4.4] Y - Ca + cY + I + G = X - Ma + mY

Y – AD(Y) = NX(Y)

where AD is aggregate demand which is equals to Ca + cY + I + G and NX is net export defined

as X - Ma + mY.

Equation 4.4 tells us that the economy would be in equilibrium where the domestic balance –i.e.
Y – AD is equals to the external balance – i.e. NX. Income (Y) and net export balance associated
with this condition are the equilibrium levels of output and trade balance. The equilibrium
condition stated in equation [4.4] is depicted on the figure below.

7
The above figure shows the equilibrium condition in an open economy. The (Y – AD) curve is
upward sloping since its slope is given by 1- c which is equals to marginal propensity to save and
hence positive; the NX curve is downward sloping with the slope of –m.

At the intersection of the two curves the economy would be in equilibrium as the internal balance
is bridged up by the external balance or vice versa. Y* and NX* are the equilibrium level of
national income and trade balance or net export.

Open-Economy Multipliers

Before we drive the open economy multiplier we assume:

i. both domestic prices and the exchange rate are fixed,

ii. the economy is operating at less than full employment so that increases in demand
result in an expansion of output, and
iii. the authorities adjust the money supply to changes in money demand by pegging the
domestic interest rate

The implication of the last assumption is that increases in output that lead to a rise in money
demand would, with a fixed money supply, lead to a rise in the domestic interest rate. But it is
assumed that the authorities passively expand the money stock to meet any increase in money
demand so that interest rates do not have to change. There is no inflation resulting from the
money supply expansion because it is merely a response to the increase in money demand.

8
Rearranging equation [4.4]

Y = Ca + cY + I + G + X - Ma + mY

(1- c + m)Y = Ca + I + G + X - Ma

Given that (1- c) is equal to the marginal propensity to save s, that is, the fraction of any increase
in income that is saved, then we obtain:

1
[4.5] Y = ( Ca+ I +G+ X −Ma )
s+m

Transformed this equation into difference we obtain:

1
[4.6] dY = ( dCa+dI +dG+dX −dMa )
s+ m

The Government Expenditure Multiplier

The first multiplier of interest is the government expenditure multiplier, which shows the
increase in national income resulting from a given increase in government expenditure. This is
given by:

dY 1
= >0
dG s+ m

This equation states that an increase in government expenditure will have an expansionary effect
on national income, the size of which depends upon the marginal propensity to save and the
marginal propensity to import. Since the sum of these is less than unity, an increase in
government expenditure will result in an even greater increase in national income. Furthermore,
the value of the open-economy multiplier is less than the closed-economy multiplier which is
given by 1/s. The reason for this is that increased expenditure is spent on both domestic and
foreign goods rather than domestic goods alone, and the expenditure on foreign goods raises
foreign rather than domestic income.

Export Multiplier

In this simple model, the multiplier effect of an increase in exports is identical to that of an
increase in government expenditure and is given by:

dY 1
= >0
dX s +m

In practice it is often the case that government expenditure tends to be somewhat more biased to
domestic output than private consumption expenditure, implying that the value of m is smaller in

9
the case of the government expenditure multiplier than in the case of the export multiplier. If this
is the case, an increase in government expenditure will have a more expansionary effect on
domestic output than an equivalent increase in exports.

The Current Account Multiplier

The other relationships of interest are the effects of an increase in government expenditure and of
exports on the current account balance. The current account (CA) is given by

[4.7] CA = X – Ma – mY

Totally differentiating [4.7]

d(CA) = dX – dMa – mdY

Substituting equation [4.6] for dY

m
[4.8] dCA =dX −dMa− ( dCa+dI +dG+ dX−dMa )
s +m

From equation [4.8] we can derive the effects of an increase in government expenditure on the
current account balance which is given by

dCA −m
=
dG s +m

That is, an increase in government spending leads to a deterioration of the current account
balance which is some fraction of the initial increase in government expenditure. This is because
economic agents spend part of the increase in income on imports.

The other multiplier of interest is the effect of an increase in exports on the current account
balance. This is given by the expression.

dCA m s
=1− = >0
dX s+m s +m

Since s/s + m is less than unity, an increase in exports leads to an improvement in the current
account balance that is less than the original increase in exports. The explanation for this is that
part of the increase in income resulting from the additional exports is offset to some extent by
increased expenditure on imports.

4.4 The Problem of Internal and External Balance

During the period 1948–1973, the international monetary system was one of fixed exchange
rates, with the major currencies being pegged to the US dollar. Only in cases of fundamental
disequilibrium were authorities allowed to devalue or revalue their currency. This meant that

10
there was considerable interest in the relative effectiveness of fiscal and monetary policies as a
means of influencing the economy. Although economic policy-makers generally have many
macroeconomic objectives, the discussion in the 1950s and 1960s was primarily concerned with
two objectives. The principal goal was one of achieving full employment for the labour force
along with a stable level of prices which may be termed internal balance. Although governments
were generally committed to achieving full employment, it is widely recognized that expanding
output in an open economy will have implications for the current account. For instance,
expanding output and employment through expansionary fiscal policy will result in greater
expenditure on imports and consequently will lead to a deterioration of the current account. As
authorities had agreed to maintain fixed exchange rates, they were interested in running
equilibrium in the balance of payments. This later objective can be termed as external balance.

This Figure shows the above problem of maintaining both internal and external balance
simultaneously. As a result of expansionary fiscal policy the [Y – AD(Y)] curve shifts from [Y–
AD(Y)]1 to [Y – AD(Y)]2 and the new equilibrium point is achieved with a higher level of output
(Y**) but the current account balance has deteriorated simultaneously. The multipliers also tell
us the same thing-i.e.

dY 1 dCA −m
= >0 while = <0
dG s+ m dG s+m

A major lesson of this simple model is that the use of one instrument to achieve two targets –
internal and external balance- is most unlikely to be successful. The idea that a country generally
requires as many instruments as it has target was elaborated by the Nobel Prize-winning
economist Jan Tinbergen (1952), and is popularly known as Tinbergen's instruments-targets rule.

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To maintain the external balance, devaluation would be a good candidate. By making imports
expensive in the domestic market and by making exports cheaper in the foreign market,
devaluation can improve the current account balance and hence the country can maintain its
external balance. As the figure below shows, devaluation shifts the NX curve upward from NX1
to NX2 and equilibrium can be maintained at a higher level of output and better level of current
account balance.

However, the effectiveness of devaluation in yielding the above solution depends on the
Marshall-Lerner condition (MLC). The MLC can be derived as follows.

The current account balance (CA) when expressed in terms of the domestic currency is given by:

[4.9] 𝐶𝐴=𝑋−eM; where e is the nominal exchange rate.

Totally differentiating [4.9]

𝑑(𝐶𝐴)=𝑑𝑋−𝑒(𝑑𝑀)−𝑀(𝑑𝑒)

Dividing by de throughout

dCA dX dM
= −e −M
de de de

At this point we introduce two definitions; the price elasticity of demand for exports ηx is
defined as the percentage change in exports over the percentage change in price as represented
by the percentage change in the exchange rate; this gives:

12
 dX e
ηx= .
de X

dX X
Sot that, =ηx
de e

And the price elasticity of demand for imports ηm is defined as the percentage change in imports
over the percentage change in their price as represented by the percentage change in the
exchange rate:

−dM e
ηm= .
de M

dM M
So that, =−ηm.
de e

Hence,

dCA X
=ηx + ηm. M −M
de e

Divide both sides M,

dCA X
=ηx + ηm−1
Mde eM

Assuming that we initially have balanced trade X = eM and hence X/eM = 1, and rearranging
yields:

dCA
[4.10] =M (ηx +ηm−1)
de

Equation [4.10] is known as the Marshall-Lerner condition and says that starting from a
position of equilibrium in the current account, a devaluation will improve the current account;
dCA
that is, >0, only if the sum of the foreign elasticity of demand for exports ( ηx ¿ and the home
de
country elasticity of demand for imports (ηm ¿ is greater than unity, that is ηx +ηm >0 . If the sum
of these two elasticities is less than unity then devaluation will lead to a deterioration of the
current account.

Empirical Evidence on import and export demand elastisities

The possibility that devaluation may lead to a worsening rather than improvement in the balance
of payment led to much research into empirical estimates of the elasticity of demand for exports
and imports. Economists divided up into two camps popularly known as 'elasticity optimists'
who believed that the sum of these two elasticities tended to exceed unity, and 'elasticity

13
pessimists' who believed that these elasticities tended to be less than unity. It was argued that
devaluation may work better for industrialized countries than for developing countries. Many
developing countries are heavily dependent upon imports so that their price elasticity of demand
for imports is likely to be very low. While for industrialized countries that have to face
competitive export markets, the price elasticity of demand for their export may be quite elastic.
The implication of the Marshall-Lerner condition is that devaluation may be a cure for some
countries balance of payment deficits but not for others.

Even for countries that devaluation is a solution for the BOP deficit, the initial J-curve effect (see
the below figure) may not be precluded. The J-curve shows that the deficit may initially rise but
after a lag of sometime the trend would be reversed so that the BOP would be in surplus. The J-
curve effect arises mainly as elasticities are lower in the short run than in the long run, in which
case the Marshall-Lerner condition may only hold in the medium to long run.

The J-curve

The possibility that in the short run the Marshall-Lerner condition may not be fulfilled although
it generally holds over the longer run leads to the phenomenon of what is popularly known as the
J-curve effect. The idea underlying the J-curve effect is that in the short run export volumes and
import volumes do not change much, so that devaluation leads to deterioration in the current
account. However, after a time lag export volumes start to increase and import volumes start to
decline; consequently the current deficit starts to improve and eventually moves into surplus. The
issue then is whether the initial deterioration in the current account is greater than the future
improvement so that overall devaluation can be said to work.

14
There have been numerous reasons advanced to explain the slow responsiveness of export and
import volumes in the short run and why the response is far greater in the longer run; two of the
most important are:

A time lag in consumer responses- It takes time for consumers in both the devaluing country
and the rest of the world to respond to the changed competitive situation. Switching away from
foreign imported goods to domestically produced goods inevitably takes some time because
consumers will be worried about issues other than the price change, such as the reliability and
reputation of domestic produced goods as compared to the foreign imports.

A time lag in producer response- Even though devaluation improves the competitive position
of exports it will take time for domestic producers to expand production of exportable. In
addition, the orders for imports are normally made well in advance and such contracts are not
readily cancelled in the short run. Factories will be reluctant to cancel the orders for vital inputs
and raw materials. For example, the waiting list for a Boeing aeroplane can be over five years; it
is most unlikely that the Ethiopian airline will cancel the order just because the Birr has been
devalued.

Imperfect competition; building up a share of foreign markets can be a time consuming and
costly business. This being the case, foreign exporters may be very reluctant to lose their market
share in the devaluing country and might respond to the loss in their competitiveness by reducing
their exports prices. To the extent that they do this, the rise in the cost of imports caused by the
devaluation will be partly offset. Similarly, foreign import competing industries may react to the
threat of increased exports by the devaluing country by reducing prices in their home markets,
limiting the amount of additional exports by the devaluing country.

4.4 The Mundell-Fleming Model: Macroeconomic Policy in an Open Economy

This model owes its origins to papers published by James Flemming (1962) and Robert Mundell
(1962, 1963). Their major contribution was to incorporate international capital movements into
formal macroeconomic models based on the Keynesian ISLM framework. Their papers led to
some dramatic implications concerning the effectiveness of fiscal and monetary policy for the
attainment of internal and external balance.

Derivation of the IS, LM and BP curves

Both the IS and LM curves have their usual shape. At this point our emphasis would be in
deriving the BP curve.

Derivation Of the IS Schedule for an Open Economy: The IS curve for an open economy
shows various combinations of the level of output (Y) and the rate of interest that makes the
leakages, that is savings and import expenditure (S+M), equal to injections, that is investment,
government expenditure and exports (I+G+X). In an open economy, we have the identity:

15
[4.11] Y=C+I+G+X-M

Where Y is the national income, C is domestic consumption, I is domestic investment, G is

government expenditure, X is export expenditure and M is import expenditure.

Recall, Y-C=S, where S is savings, we can rewrite equation (4.11) as:

[4.12] S+M=I+G+X

Assume S= Sa+ sY, where Sa is autonomous savings and s is the marginal propensity to save.

M= Ma+ mY, where Ma is autonomous savings and m is the marginal propensity to import.

I=I(r), which says investment (I) is a function of interest rate (r).

Moreover, we assumed G and X are exogenous.

Hence, equation can be written as:

[4.13] Sa+ Ma+ (s+m) Y= I(r) +G+X

The derivation of the IS curve is illustrated in the below figure.

We know that the income level Y1 generates leakages L1 that will be equal to injections In1 if
the interest rate is r1. This means that in quadrant (4) we can depict point on the IS curve for an
open economy because at interest rate r1 and income level Y1 we know that leakages are equal
to injections. We can repeat the same process for the income level Y2 to obtain the rate of

16
interest r2 for which leakages are equal to injections. By repeating the process, we can obtain a
large number of income and interest rate levels for which leakages are equal to injections. By
joining up these points we obtain the IS curve for an open economy. As can be seen in the fourth
quadrant the IS curve is downward sloping from left to right in the interest rate/ income space.
This is because higher levels of income generate higher levels of leakages requiring a fall in the
interest rate to generate increased investment and maintain equality of injections and leakages.

Derivation of the LM Schedule for an Open Economy: The LM schedule shows various
combinations of the level of income and rate of interest for which the money market is in
equilibrium; that is, for which money demand equals money supply.

In the simplified model, we assume that money is demanded for only two reasons; transaction
purpose and speculative purposes.

The transactions demand for money is assumed positive function of income. This is expressed
algebraically as: Mt= Mt (Y), Where Mt is the transaction demand for money.

It is assumed that any money balances held in excess of those required for transactions purposes
are speculative balances. The demand for speculative balances is a negative function of the rate
of interest and is expressed algebraically as:

Msp= Msp (r), where Msp is speculative demand for money.

In equilibrium, the money demand (Md) made up of transactions and speculative balances equal
to the money supply (Ms). This is expressed algebraically as:

Md=Mt +Msp =Ms

The derivation of the LM curve is illustrated in the below figure.

17
Quadrant 1 depicts the transaction demand for money as a positive function of income. As
income rises from Y1 to Y2, the demand for transaction balances rises from Mt1 to Mt2. The
transactions balance figure is transferred to quadrant 2, which shows the distribution of the fixed
money supply between transaction and speculative balances. The distance Oa represents the total
money supply, so that if Mt1 is held for transaction purpose, then Oa minus Mt1 which is equal
to Msp1 is held as a speculative balance. Quadrant 3 shows the speculative demand for money
schedule, which is downward sloping from left to right because the demand for speculative
balances is inversely related to the rate of interest. The schedule reveals that speculative balances
Msp1 are only willingly held at the interest rate r1. We now have enough information to plot a
point on the LM schedule; this is done in quadrant 4 which shows that at interest rate r1 and
income level Y1 the demand for speculative and transaction balances is equal to the money
supply.

By taking another income level Y2, we can by a similar process find a rate of interest r2, which
is compatible with money-market equilibrium. Other such derivatives can be done and by joining
them together, we obtain the LM schedule. The LM schedule is upward sloping from left to
right. This is because high income levels require relatively large transaction balances which for a
given money supply can only be drawn out of speculative balances by a relatively high interest
rate.

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Derivation of the BP Schedule: The balance of payments schedule shows different
combinations of rates of interest and income that are compatible with equilibrium in the balance
of payments.

The overall balance of payment is made up of three major components: the current account
balance (CA), the capital account (K) and the change in the authorities' reserve (dR). By
maintaining balance in supply and demand for the currency- that is external balance- we mean
that there is no need for the authorities to have to change their holdings of foreign exchange
reserves. This implies that if there is a current account deficit there needs to be an offsetting
surplus in the capital account so that the authorities do not have to change their reserve.
Conversely, if there is a current account surplus there needs to be an offsetting deficit in the
capital account to have equilibrium in the balance of payment.

Since exports are determined exogenously and imports are a positive function of income, the
higher the level of national income the smaller will be any current account surplus/ the larger any
current account deficit. The net capital flow (K) is a positive function of the domestic interest
rate. Assuming that the rate of interest in the rest of the world (rf) is fixed, the higher the
domestic interest rate (r) the greater the capital inflow into the country or the smaller any capital
outflow. This relationship is expressed as:

K = K(r – rf)

Since the balance of payment schedule shows various combinations of levels of income and the
rate of interest for which the balance of payments is in equilibrium, then

X–M+K=0

A positive K indicates a net inflow of funds, whereas a negative K indicates a net outflow of
funds. The derivation of the BP schedule is depicted in the below figure.

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Quadrant [1] shows the relationship between the current account and level of national income.
The current balance schedule slopes downwards from left to right because increases in income
lead to a deterioration of the current account. At income level Y1 there is a current account
surplus of CA1, whereas at income level Y2 there is a CA deficit of CA2. The current account
surplus or deficit is transferred to quadrant [2] where the 450 line converts the CA position to an
equal capital flow of the opposite sign. With a CA surplus CA1 there is a required capital
outflow K1 to ensure balance of payment equilibrium; while a CA deficit CA2 requires a capital
inflow K2. Quadrant [3] shows the rate of interest that is required for a given capital flow. The
capital flow schedule is downward sloping from left to right; this is because high interest rates
encourage a net capital inflow whereas low interest rates encourage a net capital outflow. To get
a capital outflow of K1 requires the interest rate to be r1, while a capital inflow of K2 requires a
higher interest rate r2.

Since income level Y1 is associated with a balance of payment surplus, there has to be an
offsetting capital outflow K1 which requires an interest rate r1; these coordinates give a point on
the BP schedule that is depicted in quadrant [4]. The BP schedule is upward sloping because
higher levels of income cause deterioration in the current account; this necessitates a reduced
capital outflow/ higher capital inflow requiring a higher interest rate. Every point on the BP
schedule shows a combination of domestic income and rate of interest for which the overall
balance of payments is in equilibrium.

The slope of the BP schedule is determined by the degree of capital mobility internationally. The
higher the degree of capital mobility then the flatter the BP schedule would be. This is because
for a given increase in income which leads to a deterioration of the current account, the higher
the degree of capital mobility, the smaller the required rise in the domestic interest rate to attract

20
sufficient capital inflows to ensure overall equilibrium. When capital is perfectly mobile, the
slightest rise in the domestic interest above the world interest rate leads to a massive capital
inflow making the BP schedule horizontal at the world interest rate. At the other extreme, if
capital is perfectly immobile internationally then a rise in the domestic interest rate will fail to
attract capital inflows making the BP schedule vertical at the income level that ensures current
account balance. Between these two extremes, that is, when we have an upward sloping BP
schedule, we say that capital is imperfectly mobile.

Equilibrium of the model: the economy is at equilibrium at the intersection of the IS, LM and
BP curves.

The Basic Mundell-Fleming Model

IS: Y = c(Y) + I(r) + G + X(e) – e.M(Y, e)

LM: L(Y, r) = DC + R

BP: R= X(e) – e. M(Y, e) + K(r – rf) .

DC and R are domestic credit and reserve parts of the money supply; and is change in reserve. .R

4.4.1 The Mundell -Fleming Model with Perfect Capital Mobility

The model assumes a small country facing perfect capital mobility. Any attempt to raise the
domestic interest rate leads to a massive capital inflow until the interest rate return to the world
interest rate. Conversely, any attempt to lower the domestic interest rate leads to a massive
capital outflow as international investors seek higher world interest rates. The implication of

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perfect capital mobility is that the BP schedule for a small open economy becomes horizontal
straight line at a domestic interest rate that is the same as the world interest rate.

Fixed Exchange Rate and Perfect Capital Mobility

Monetary Policy

Assuming an increase in money supply

The above figure depicts a small open economy with a fixed exchange rate. The initial level of
income is where the ISLMBP curves intersect at the income level Y1. If the authorities attempt
to raise output by a monetary expansion, the LM curve shifts right from LMo to LM1; there is
downward pressure on the domestic interest rate and this results in a massive capital outflow.
This capital outflow means that there is pressure for a devaluation of the currency (as shown in
the above figure), and the authorities have to intervene in the foreign exchange market to
purchase the home currency with reserves. Such purchases result in a reduction of the money
supply in the hands of private agents, and the purchases have to continue until the LM curve
shifts back to its original position at LM0 where the domestic interest rate is restored to the
world interest rate.

 Hence, with perfect capital mobility and fixed exchange rates, monetary policy is
ineffective at influencing output.

Fiscal Policy

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Fiscal expansion shifts the IS schedule to the right from ISo to IS1. This puts upward pressure on
the domestic interest rate and leads to a capital inflow. To prevent an appreciation the authorities
have to purchase the foreign currency with domestic currency. This means that the amount of
domestic currency held by private agents’ increases and the LM0 schedule shifts to the right. The
increase in the money stock continues until the LM curve passes through the IS1 curve at the
initial interest rate. Hence, under fixed exchange rates and perfect capital mobility an active
fiscal policy alone has the ability to achieve both internal and external balance. This is an
exception to the instruments-targets rule, although monetary policy does have to passively adjust
to maintain the fixed exchange rate.

Small open economy with perfect capital mobility and floating exchange rate

Monetary policy

The initial equilibrium is at the income level Y1 where the ISo intersects the LMo. A monetary
expansion shifts the LM curve from LMo to LM1 leading to downward pressure on the interest
rate, a capital outflow, and a depreciation of the exchange rate. The depreciation leads to an
increase in exports and reduction in imports so shifting the IS curve to the right and the LM
curve to the left, so that the final equilibrium is obtained at a higher level of income. Clearly with
an appropriate initial monetary expansion the authorities could obtain both internal and external
balance by monetary policy alone.

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Fiscal policy

The increase in government expenditure shits the IS schedule to the right from ISo to IS1 leading
to upward pressure on the domestic interest rate resulting in a massive capital inflow and an
appreciation of the exchange rate. The appreciation of the exchange rate results in a reduction of
exports and an increase in imports, and this forces the IS schedule back to its original position.
Hence, with perfect capital mobility and a floating exchange rate, fiscal policy is ineffective in
influencing output.

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Conclusion

Under perfect capital mobility:

 Fiscal policy is very effective at influencing output under fixed exchange rates and
 monetary policy is very effective at influencing output under floating exchange rates
 Under fixed rates policy makers will pay more attention to fiscal policy than under
floating rates when more emphasis will be placed on monetary policy.
 The degree of capital mobility and the exchange rate regime both demonstrate that
appropriate economic policy design in an open economy is very different from that in a
closed economy context.

4.4.2 A Small Open Economy with Imperfect Capital Mobility

a. Internal and external balance under fixed exchange rate

A situation of fixed exchange rates and unemployment is depicted in the below figure. The
economy is assumed to be at point A with interest rate r1 and income level Y1, which means that
while the economy is in external balance the income level is below the full employment level of
income Yf.

The government attempts to eradicate the unemployment via a bond financed fiscal expansion,
which shifts the IS schedule to the right from IS1 to IS2. Domestic output expands from Y1 to
Y2 and the economy would be at point B with interest rate r2. In raising the level of output
beyond the full employment level, we find that the induced increase in imports moves the current
account into deficit, and although the rise in the interest rate attracts some capital inflow the
balance of payments is in overall deficit since the economy is to the right of the BP schedule.
The authorities are forced to purchase the home currency in the foreign exchange market, but
because they pursue a sterilization policy the LM schedule remains at LM1. Hence, using only a
single policy instrument, in this case fiscal policy, the government can temporarily achieve its
internal objective at the expense of a sacrifice in the objective of external balance.

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Ideally, however, the authorities would like to achieve both internal and external balance. This is
possible if they combine the expansionary fiscal policy-IS1 to IS2-with a contractionary
monetary policy which shifts the LM schedule from LM1 to LM2 where it passes through point
C on the BP schedule. The restrictive monetary policy raises interest rates further than in the case
of a solely fiscal expansion to r3, and in so doing attracts additional capital inflows so as to
restore the balance of payments back to equilibrium. Hence, by combining an expansionary
fiscal policy with a contractionary monetary policy the authorities can achieve both internal and
external balance. An important lesson from this example is that the authorities can achieve both
internal and external balance without the need to change the exchange rate; this is because they
have two independent instruments, monetary and fiscal policy, and two targets.

b. Internal and external balance under floating exchange rates

Monetary expansion: as shown in the below figure initial equilibrium is at point A with interest
rate r1 and output level Y1. The authorities adopt an expansionary monetary policy and this
shifts the LM schedule from LM1 t o LM2. The combination of a fall in the interest rate and
increase in income leads to a balance of payments deficit at point B. However, the exchange rate
is allowed to depreciate and this leads to a rightward shift of the IS schedule from IS1 to IS2, and
a rightward shift of BP schedule from BP1 to BP2. However, it also leads to a leftward shift of
the LM schedule until all three schedules intersect at a common point such as point C, with new
income level Y2 and interest rate r2. Hence, by using monetary policy in conjunction with
exchange rate changes, it is possible to raise real output to the full employment level and
achieves external balance simultaneously.

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In sum up, the money supply expansion results in exchange rate depreciation, a fall in the
domestic interest rate and an increase in income. The lower the interest rate implies a lower
capital inflow/higher capital outflow than before the money supply expansion, while the increase
in income worsens the current account. This implies that the depreciation improves the current
account to exactly offset the preceding effect.

Fiscal expansion: The effects of a fiscal expansion on the exchange rate under floating rates
depend crucially upon the slope of the BP schedule relative to the LM schedule.

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In the above figure, the BP schedule is steeper than the LM schedule, which means that capital
outflows are relatively insensitive to interest rate changes, while money demand is fairly elastic
with respect to the interest rate. An expansionary fiscal policy shifts the IS schedule from IS1 to
IS2. The induced rise of the domestic interest rate and domestic income has opposing effects on
the balance of payments, the expansion in real output leads to a deterioration of the current
account but the rise in interest rate improves the capital account. However, because capital flows
are relatively immobile, the former effect outweighs the latter so the balance of payments moves
into deficit. In turn, the deficit leads to a depreciation of the exchange rate, this has the effect of
shifting the BP schedule to the right from BP1 to BP2 and the LM schedule to the left from LM1
to LM2 and the IS schedule even further to the right from IS2 to IS3. Final equilibrium is
obtained at point C, with interest rate r2 and income level Y2. Hence, the deterioration in the
balance of payments resulting from the rise in real income is offset by a combination of a higher
interest rate and exchange rate depreciation.

Limitations of the Mundell-Fleming Model

1. The Marshall Lerner condition: the model assumes that the Marshall Lerner condition holds
even though it is essentially of a short term model which is the time scale under which the
Marshall-Lerner conditions are least likely to be met.

2. Interaction of stocks and flows: the model ignores the problem of the interaction of stocks
and flows. According to it a current account deficit can be financed by a capital inflow. While
such a policy is feasible in the short run, a capital inflow over time increases the stock of foreign
liabilities owed by the country to the rest of the world, and this factor means a worsening of the
future current account as interest is paid abroad. Clearly, a country cannot go on financing a
current account deficit indefinitely as the country becomes an ever-increasing debtor to the rest
of the world.

3. Neglect of the long run budget constraints: the model fails to take account of long run
constraints that govern both the private and public sector. In the long run private sector spending
has to equal its disposable income, while in the absence of money creation government
expenditure has to equal its revenue from taxation. This means that in the long run the current
account has to be in balance. One implication of these budget constraints is that a forward
looking private sector would realize that increased government expenditure will imply higher
taxation for them in the future, and this will induce increased private sector savings today that
will undermine the effectiveness of fiscal policy.

4. Wealth Effect: the model does not allow for wealth effects that may help in the process of
restoring long run equilibrium. A decrease in wealth resulting from a fall in foreign assets
associated with a current account deficit will ordinarily lead t a reduction in import expenditure
which should help to reduce the current account deficit. While such an omission of wealth effects

28
on the import expenditure function may be justified as being small significance in the short run,
the omission nevertheless again emphasizes the essentially short-term nature of the model.

5. Neglect of supply side factors: one of the obvious limitations of the model is that it
concentrates on the demand side of the economy and neglects the supply side. There is an
implicit assumption that supply adjust in accordance with changes in demand. In addition,
because the aggregate supply curve is horizontal up to full employment, increases in aggregate
demand do not lead to changes in the domestic price level, rather they are reflected solely by
increases in real output.

6. Treatment of capital flows: one of the biggest problems of the model concerns the modelling
of capital flows. It is assumed that a rise in the domestic interest rate leads to a continuous capital
inflow from abroad. However, to expect such flows to continue indefinitely is unrealistic because
after a point international investors will have rearranged the stocks of their international
portfolios to their desired content and once this happens the net capital inflows into the country
will cease. The only way that the country could then continue to attract capital inflows would be
a further rise in its interest rate until once again international portfolios are restored to their
desired content. Hence a country that needs a continuous capital inflow to finance its current
account deficit has to continuously raise its interest rate. In other words, capital inflows are a
function of the change in the interest differential rather than the differential itself.

7. Exchange rate expectations: A major problem with the model is the treatment of exchange
rate expectations. The model does not explicitly model these and implicitly presumes that the
expected change is zero, which is known as static exchange rate expectation. While this might
not seem to be an unreasonable assumption under fixed

a monetary expansion leads to a depreciation of the currency under floating exchange rates- in
such circumstances it seems unreasonable to assume that economic agents do not expect
depreciation as well. If agents expect depreciation this may require a rise in the domestic interest
rate to encourage them to continue to hold the currency which will have an adverse effect on
domestic investment- implying a weaker expansionary effect of monetary policy than is
suggested by the model. Indeed, the need to maintain market confidence in exchange rates can
severely restrict the ability of government to pursue expansionary fiscal and monetary policies.

8. Ignores the domestic price level effect of devaluation:

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