The IS–LM Model for an Open Economy
Having discussed the Keynesian approach to stabilization policy in the context
of the IS–LM model for a closed economy (sections 3.2–3.4), we next
consider the use of fiscal and monetary policy for stabilization purposes in an
open economy using a model first developed by Robert Mundell and Marcus
Fleming at the start of the 1960s (see Mundell, 1963; Fleming, 1962). As we
will discuss, the effects of a change in fiscal and monetary policy depend on
the degree of capital mobility and the type of exchange rate regime in existence.
We begin with a review of the main changes we need to incorporate in
extending the IS–LM model to an open economy.
The goods market and the IS curve
As in the case of a closed economy, equilibrium in the goods market occurs
where the aggregate demand for and aggregate supply of goods are equal. In
an open economy aggregate demand is composed of not only the sum of
consumption, investment and government expenditure, but also ‘net’ exports,
that is, exports minus imports (X – Im). Exports are assumed to be a function
of: (i) income in the rest of the world; (ii) the price of a country’s goods
relative to those produced by competitors abroad, which may be defined as
ePD/PF, where e is the exchange rate expressing domestic currency in terms
of foreign currency, PD is the price of domestic goods in terms of domestic
currency and PF is the price of foreign goods in terms of foreign currency;
and (iii) other factors such as tastes, quality of the goods, delivery dates and
so on. Imports are assumed to be determined by the same factors that influence
exports (since one country’s exports are another country’s imports) with
the exception that the income variable relevant to imports is domestic income.
As domestic income rises, ceteris paribus, aggregate demand will
increase and some portion of this increase in demand will be met by imported
goods; that is, the marginal propensity to import is greater than zero.
As discussed in section 3.3.1, the IS curve traces out a locus of combinations
of interest rates and income associated with equilibrium in the goods
market. The open economy IS curve is downward-sloping but is steeper than
in the case of a closed economy because of the additional leakage of imports
which increase as domestic income increases, thereby reducing the size of the
multiplier. In addition to the factors which affect the position of the IS curve
in a closed economy, a change in any of the variables which affect ‘net’
exports will cause the IS curve to shift. For example, an increase in exports
due to a rise in world income will be associated with a higher level of
domestic income, at any given level of the rate of interest, causing the IS
curve to shift outwards to the right. Similarly, ceteris paribus, net exports
will increase if: (i) the exchange rate falls (that is, depreciates or is devalued)
providing the Marshall–Lerner conditions are fulfilled, namely that starting
from an initial balanced trade position and also assuming infinite price
elasticities of supply for imports and exports, the sum of the price elasticities
of demand for imports and exports is greater than unity (see De Vanssay,
2002); (ii) the foreign price level rises; and (iii) the domestic price level falls.
In each of these cases the IS curve would shift outwards to the right, as
before, the magnitude of the shift being equal to the size of the shock times
the multiplier. Conversely a change in the opposite direction in any one of
these variables will shift the IS curve to the left.
The money market and the LM curve
The open economy LM curve is exactly the same as in the case of a closed
economy with one important extension. In an open economy operating a
fixed exchange rate the domestic money supply will be altered by balance of
payments deficits/surpluses (that is, the net balance on the combined current
and capital accounts) unless the authorities are able to sterilize or neutralize
the effects of the balance of payments deficits/surpluses on the domestic
money supply. Under a regime of fixed exchange rates the authorities are
committed to buy and sell foreign exchange for the home currency at a fixed
price. For example, in the case of a balance of payments surplus residents
will sell foreign currency to the authorities for domestic currency at a fixed
exchange rate. Ceteris paribus, a balance of payments surplus will result in
an increase in both the authorities’ foreign exchange reserves and the domestic
money supply, thereby shifting the LM curve downwards to the right.
Conversely, a balance of payments deficit will result in a fall in both the
authorities’ foreign exchange reserves and the domestic money supply, thereby
shifting the LM curve upwards to the left. In contrast, under a regime of
flexible exchange rates the exchange rate adjusts to clear the foreign exchange
market (that is, the central monetary authorities do not intervene in
the foreign exchange market) so that the sum of the current and capital
accounts is always zero. In consequence the LM curve is independent of
external factors and the determinants of the position of the LM curve are the
same as those discussed earlier in section 3.3.2.
To complete the IS–LM model for an open economy we next turn to
consider overall balance of payments equilibrium and the BP curve.
The overall balance of payments and the BP curve
Early Keynesian analysis of the balance of payments (see Dimand, 2002c)
focused on the determination of the current account and how government
policy could improve the balance of payments on it (in particular the conditions
under which devaluation would be successful in doing just this). The
late 1950s/early 1960s witnessed a period of increasingly liberalized trade
and capital movements and, as noted earlier, Mundell and Fleming extended
the Keynesian model of an open economy to include capital flows. At the
onset of this discussion it is important to note that we assume we are dealing
with a small open economy in the sense that changes within the domestic
economy of that country and its macroeconomic policies have an insignificant
effect on the rest of the world.
Overall balance of payments equilibrium requires that the sum of the
current and capital accounts of the balance of payments is zero. As noted
earlier, imports are a function of domestic income and relative prices (of
domestic and foreign goods), while exports are a function of world income
and relative prices. Ceteris paribus, as domestic income rises, imports increase
and the balance of payments on the current account worsens. With
static expectations about exchange rate changes, net capital flows are a function
of the differential between domestic and foreign interest rates. Ceteris
paribus, as the domestic interest rate rises, domestic assets become more
attractive and the capital account of the balance of payments improves due to
the resulting inward flow of funds.
The BP curve (see Figure 3.9) traces out a locus of combinations of
domestic interest rates and income levels that yield an overall zero balance of
payments position on the combined current and capital accounts. The BP
curve is positively sloped because if balance of payments equilibrium is to be
maintained (that is, a zero overall balance) then increases (decreases) in the
level of domestic income which worsen (improve) the current account have
to be accompanied by increases (decreases) in the domestic rate of interest
which improve (worsen) the capital account. Points above and to the left of
the BP curve are associated with an overall balance of payments surplus
since, given the level of income, the domestic rate of interest is higher than
that necessary to produce an overall zero balance of payments position.
Conversely, points below and to the right of the BP curve indicate an overall
balance of payments deficit since, given the level of income, the domestic
rate of interest is lower than that necessary to produce an overall zero balance
of payments position.
The slope of the BP curve depends on the marginal propensity to import and
the interest elasticity of international capital flows. Ceteris paribus, the BP
curve will be flatter (steeper) the smaller (larger) is the marginal propensity to
import and the more (less) interest-elastic are capital flows. For example, the
more sensitive capital flows are to changes in domestic interest rates, the
smaller will be the rise in the domestic interest rate required to maintain a zero
overall balance of payments equilibrium for a given increase in income, and
hence the flatter will be the BP curve. The BP curve shown in Figure 3.9
represents a situation of imperfect capital mobility since the domestic rate of
interest can depart from that ruling in the rest of the world. With respect to the
interest elasticity of international capital movements it is important to note that
in the two limiting cases of perfect capital mobility and complete capital
immobility the BP curve would become horizontal and vertical respectively.
For example, in the case of perfect capital mobility the BP curve will be
horizontal; that is, the domestic rate of interest will be tied to the rate ruling in
the rest of the world. If the domestic rate of interest were to rise above the given
world rate there would be an infinite capital inflow, and vice versa.
The BP curve is drawn for given levels of the world income, interest rate
and price level; the exchange rate; and the domestic price level. If any of
these variables should change, then the BP curve would shift. For example,
anything that results in an increase in exports and/or a decrease in imports
(such as a rise in world income; a fall in the exchange rate; a rise in the
foreign price level; or a fall in the domestic price level) will cause the BP
curve to shift downwards to the right, and vice versa. In other words, at any
given level of domestic income an improvement in the current account will
require a lower domestic rate of interest to maintain a zero overall balance of
payments position via capital account effects.
The complete model and the effects of a change in fiscal and
monetary policy
We are now in a position to consider the full IS–LM model for a small open
economy. Equilibrium in the goods and money markets, and in the balance of
payments, occurs at the triple intersection of the IS, LM and BP curves
indicated in Figure 3.9. In what follows we analyse the effects of a change in
fiscal and monetary policy on: (i) the level of income and the balance of
payments in a fixed exchange rate regime, and (ii) the level of income and the
exchange rate in a flexible exchange rate regime.
Under a regime of fixed exchange rates, while fiscal expansion will result
in an increase in income, it may lead to either an improvement or a deterioration
in the overall balance of payments position, and vice versa. The effects
of fiscal expansion on the level of income and the balance of payments are
illustrated in the two panels of Figure 3.10. In panel (a) the LM curve is
steeper than the BP curve, while in panel (b) the converse is true. In both
panels of Figure 3.10 the economy is initially operating at point A, the triple
intersection of the three curves IS0, LM and BP with equilibrium in the goods
and money markets, and in the balance of payments, at r0Y0. Expansionary
fiscal policy shifts the IS curve outwards to the right from IS0 to IS1 and
results in an increase in the domestic rate of interest from r0 to r1 (improving
the capital account) and an increase in income from Y0 to Y1 (worsening the
current account). As can be seen from both panels of Figure 3.10, the net
outcome on the overall balance of payments position depends on the relative
slopes of the LM and BP curves (that is, the structural parameters underlying
the model). In panel (a) the net outcome is an overall balance of payments
surplus at point B (that is, the curves IS1 and LM intersect at a point above the
BP curve), while in panel (b) it is one of an overall balance of payments
deficit (that is, the curves IS1 and LM intersect at point B below the BP
curve). Expansionary fiscal policy is more likely to lead to an improvement in
the overall balance of payments position: (i) the smaller is the marginal
propensity to import and the more interest-elastic are capital flows (that is,
the flatter the slope of the BP curve) and (ii) the greater is the income
elasticity and the smaller is the interest elasticity of the demand for money
(that is, the steeper the slope of the LM curve), and vice versa. In practice the
LM curve is likely to be steeper than the BP curve due to the interest elasticity
of the demand for money being less than that for capital flows. This view
tends to be backed up by available empirical evidence and will be adopted in
the discussion that follows on long-run equilibrium.
At this point it is important to stress that in analysing the consequences for
the balance of payments of a change in fiscal policy under fixed exchange
rates the Keynesian approach assumes that the authorities can, in the short
run, sterilize the effects of a balance of payments surplus or deficit on the
money stock. The results we have been analysing necessarily relate to the
short run because in the long run it becomes increasingly difficult to sterilize
the effects of a persistent surplus or deficit on the money stock. Long-run
equilibrium requires a zero balance on the balance of payments, otherwise
the domestic money supply changes in the manner discussed in section 3.5.2.
As such the balance of payments surplus at point B in panel (a) of Figure 3.10
will cause an expansion of the domestic money supply following intervention
by the authorities to maintain the fixed exchange rate. This causes the LM
curve to shift downwards to the right and long-run equilibrium will occur at
point C, where the balance of payments is zero and the goods and monetary
markets are in equilibrium.
In contrast to fiscal expansion under a regime of fixed exchange rates,
with imperfect capital mobility, monetary expansion will always lead to a
deterioration in the balance of payments, and vice versa, regardless of whether
or not the LM curve is steeper than the BP curve. This is illustrated in Figure
3.11, where the economy is initially operating at point A, the triple intersection
of the three curves IS, LM0 and BP, with equilibrium in the goods and
money markets, and in the balance of payments. Expansionary monetary
policy shifts the LM curve from LM0 to LM1 and results in a reduction in the
domestic rate of interest from r0 to r1 (worsening the capital account) and an
increase in the level of income from Y0 to Y1 (worsening the current account).
With adverse interest and income effects on the capital and current accounts
respectively, the overall balance of payments is unambiguously in deficit at
point B (that is, the curves IS and LM1 intersect at a point below the BP
curve).
In a similar manner to that discussed for expansionary fiscal policy, point B
cannot be a long-run equilibrium. The implied balance of payments deficit
causes a contraction in the money supply, shifting the LM curve backwards.
The long-run adjustment process will cease at point A where the LM curve
has returned to its original position. In other words, in the absence of sterilization,
monetary policy is completely ineffective as far as influencing the
level of income is concerned. This assumes that the domestic country is small
relative to the rest of the world so that expansion of its money supply has a
negligible effect on the world money supply.
Readers should verify for themselves that, for a small open economy
operating under a regime of fixed exchange rates, in the limiting case of
perfect capital mobility, the equilibrium level of domestic income is in the
long run established at the intersection of the IS and ‘horizontal’ BP curves.
In this situation fiscal policy becomes all-powerful (that is, fiscal expansion
results in the full multiplier effect of the simple Keynesian 45° or cross model
with no crowding out of private sector investment), while monetary policy
will be impotent, having no lasting effects on aggregate demand and income.
Before considering the effectiveness of fiscal and monetary policy under
flexible exchange rates it is interesting to note that Mundell (1962) also
considered the appropriate use of monetary and fiscal policy to successfully
secure the twin objectives of internal (output and employment at their full
employment levels) and external (a zero overall balance of payments position)
balance. Mundell’s solution to the so-called assignment problem follows
his principle of effective market classification (Mundell, 1960). This principle
requires that each policy instrument is paired with the objective on which
it has the most influence and involves the assignment of fiscal policy to
achieve internal balance and monetary policy to achieve external balance.
We now consider the effects of a change in fiscal and monetary policy on
income and the exchange rate under a regime of flexible exchange rates. The
effects of fiscal expansion on the level of income and the exchange rate again
depend on the relative slopes of the BP and LM curves. This is illustrated for
imperfect capital mobility in panels (a) and (b) of Figure 3.12, which are the
flexible counterparts of Figure 3.10 discussed above with respect to fixed
exchange rates.
In panel (a) of Figure 3.12 the BP curve is steeper than the LM curve. The
economy is initially in equilibrium at point A, the triple intersection of curves
IS0, LM0 and BP0. Expansionary fiscal policy shifts the IS curve from IS0 to
IS1. As we have discussed above, under fixed exchange rates fiscal expansion
would result in a balance of payments deficit (that is, IS1 and LM0 intersect at
point B below BP0). With flexible exchange rates the exchange rate adjusts to
correct potential balance of payments disequilibria. An excess supply of
domestic currency in the foreign exchange market causes the exchange rate
to depreciate, shifting the IS1 and BP0 curves to the right until a new equilibrium
is reached along the LM0 curve to the right of point B, for example at
point C, the triple intersection of the curves IS2, LM0 and BP1 with an income
level of Y1. In this particular case the exchange rate depreciation reinforces
the effects of domestic fiscal expansion on aggregate demand, leading to a
higher level of output and employment.
Panel (b) of Figure 3.12 depicts the case where the LM curve is steeper than
the BP curve. The economy is initially in equilibrium at point A, the triple
intersection of curves IS0, LM0 and BP0. Fiscal expansion shifts the IS curve
outwards from IS0 to IS1 with the intersection of curves IS1 and LM0 at point B
above BP0. This is equivalent to a balance of payments surplus under fixed
exchange rates and causes the exchange rate to adjust to eliminate the excess
demand for domestic currency. In contrast to the situation where the BP curve
is steeper than the LM curve, the exchange rate appreciates, causing both the
IS1 and BP0 curves to shift to the left. Equilibrium will be established along the
LM curve to the left of point B, for example at point C. In this situation fiscal
policy will be less effective in influencing output and employment as exchange
rate appreciation will partly offset the effects of fiscal expansion on aggregate
demand. As noted above, panel (b) is more likely to represent the true situation.
In the limiting case of perfect capital mobility illustrated in panel (c) of
Figure 3.12, fiscal policy becomes completely ineffective and is unable to
affect output and employment. In the case of perfect capital mobility the BP
curve is horizontal; that is, the domestic rate of interest is tied to the rate
ruling in the rest of the world at r*. If the domestic rate of interest were to rise
above the given world rate there would be an infinite capital inflow, and vice
versa. Fiscal expansion (that is, a shift in the IS curve to the right from IS0 to
IS1) puts upward pressure on the domestic interest rate. This incipient pressure
results in an inflow of capital and leads to an appreciation of the exchange
rate. As the exchange rate appreciates net exports decrease, causing the IS
curve to move back to the left. Equilibrium will be re-established at point A
only when the capital inflows are large enough to appreciate the exchange
rate sufficiently to shift the IS curve back to its original position. In other
words fiscal expansion completely crowds out net exports and there is no
change in output and employment. At the original income level of Y0 the
current account deficit will have increased by exactly the same amount as the
government budget deficit.
Finally we consider the effects of monetary expansion on the level of
income and the exchange rate under imperfect and perfect capital mobility.
The case of imperfect capital mobility is illustrated in panel (a) of Figure
3.13. The economy is initially in equilibrium at point A, the triple intersection
of curves IS0, LM0 and BP0. Monetary expansion shifts the LM curve
from LM0 to LM1. Under fixed exchange rates this would result in a balance
of payments deficit. With flexible exchange rates the exchange rate depreciates
to maintain balance of payments equilibrium and both the BP and IS
curves shift to the right until a new equilibrium is established along the
curve LM1 to the right of point B, such as point C, the triple intersection of
curves IS1, LM1 and BP1. The effect of monetary expansion is reinforced by
exchange rate depreciation, leading to a higher level of income. In the
limiting case of perfect capital mobility illustrated in panel (b) monetary
expansion (which shifts the LM curve from LM0 to LM1) will put downward
pressure on the domestic interest rate. This incipient pressure results in
capital outflows and a depreciation of the exchange rate, causing the IS
curve to shift to the right (from IS0 to IS1) until a new equilibrium is
established at point C, the triple intersection of curves LM1, IS1 and BP at
the given world interest rate r* and a new income level Y1. In this limiting
case monetary policy is completely effective and contrasts with the position
of fiscal policy discussed above.
In summary, under a regime of fixed exchange rates with imperfect capital
mobility, while fiscal expansion will result in an increase in income, its
effects on the overall balance of payments (assuming sterilization takes place)
are ambiguous (depending on the relative slopes of the LM and BP curves).
In contrast, there is no ambiguity following a change in monetary policy.
Monetary expansion will result in an increase in income and always lead to a
deterioration in the balance of payments. However, in the absence of sterilization,
monetary policy is completely ineffective in influencing the level of
income. Furthermore, in the limiting case of perfect capital mobility fiscal
policy becomes all-powerful, while monetary policy will be impotent, having
no lasting effects on aggregate demand and the level of income. Under a
regime of flexible exchange rates, with imperfect capital mobility, while
fiscal expansion will result in an increase in income, it could (depending on
the relative slopes of the LM and BP curves) cause the exchange rate to
depreciate or appreciate, thereby reinforcing or partly offsetting the effect of
fiscal expansion on aggregate demand and income. In contrast, monetary
expansion results in an increase in income, with the effects of monetary
expansion on aggregate demand and income being reinforced by exchange
rate depreciation. In the limiting case of perfect capital mobility fiscal policy
becomes impotent and is unable to affect output and employment, while
monetary policy becomes all-powerful.
In concluding our discussion it is important to note that there are a number
of limitations of the above IS–LM model for an open economy. These limita
tions include: restrictive assumptions (for example fixed wages and prices,
and static expectations about exchange rate changes); specification of the
capital account (where net capital flows between countries depend solely on
the differential between domestic and foreign interest rates) which is inconsistent
with portfolio theory where perpetual capital flows require continuous
interest changes; the implicit assumption that a country is able to match a
continuous deficit on the current account with a surplus on the capital account
whereas, in reality, the nature of the balance of payments objective is
likely to be much more precise than just overall balance of payments equilibrium;
and adopting comparative statics rather than considering the dynamics
of adjustment following a disturbance (see Ugur, 2002). For a discussion of
the origin and subsequent refinements of the Mundell–Fleming model the
reader is referred to Frenkel and Razin (1987); Mundell (2001); Obstfeld
(2001); Rogoff (2002); Broughton (2003).
Having analysed the effectiveness of fiscal and monetary policy in the
context of the fixed-price Keynesian models of both a closed and open
economy we next discuss the original Phillips curve analysis and comment
on the importance of the curve to orthodox Keynesian economics.
Having discussed the Keynesian approach to stabilization policy in the context
of the IS–LM model for a closed economy (sections 3.2–3.4), we next
consider the use of fiscal and monetary policy for stabilization purposes in an
open economy using a model first developed by Robert Mundell and Marcus
Fleming at the start of the 1960s (see Mundell, 1963; Fleming, 1962). As we
will discuss, the effects of a change in fiscal and monetary policy depend on
the degree of capital mobility and the type of exchange rate regime in existence.
We begin with a review of the main changes we need to incorporate in
extending the IS–LM model to an open economy.
The goods market and the IS curve
As in the case of a closed economy, equilibrium in the goods market occurs
where the aggregate demand for and aggregate supply of goods are equal. In
an open economy aggregate demand is composed of not only the sum of
consumption, investment and government expenditure, but also ‘net’ exports,
that is, exports minus imports (X – Im). Exports are assumed to be a function
of: (i) income in the rest of the world; (ii) the price of a country’s goods
relative to those produced by competitors abroad, which may be defined as
ePD/PF, where e is the exchange rate expressing domestic currency in terms
of foreign currency, PD is the price of domestic goods in terms of domestic
currency and PF is the price of foreign goods in terms of foreign currency;
and (iii) other factors such as tastes, quality of the goods, delivery dates and
so on. Imports are assumed to be determined by the same factors that influence
exports (since one country’s exports are another country’s imports) with
the exception that the income variable relevant to imports is domestic income.
As domestic income rises, ceteris paribus, aggregate demand will
increase and some portion of this increase in demand will be met by imported
goods; that is, the marginal propensity to import is greater than zero.
As discussed in section 3.3.1, the IS curve traces out a locus of combinations
of interest rates and income associated with equilibrium in the goods
market. The open economy IS curve is downward-sloping but is steeper than
in the case of a closed economy because of the additional leakage of imports
which increase as domestic income increases, thereby reducing the size of the
multiplier. In addition to the factors which affect the position of the IS curve
in a closed economy, a change in any of the variables which affect ‘net’
exports will cause the IS curve to shift. For example, an increase in exports
due to a rise in world income will be associated with a higher level of
domestic income, at any given level of the rate of interest, causing the IS
curve to shift outwards to the right. Similarly, ceteris paribus, net exports
will increase if: (i) the exchange rate falls (that is, depreciates or is devalued)
providing the Marshall–Lerner conditions are fulfilled, namely that starting
from an initial balanced trade position and also assuming infinite price
elasticities of supply for imports and exports, the sum of the price elasticities
of demand for imports and exports is greater than unity (see De Vanssay,
2002); (ii) the foreign price level rises; and (iii) the domestic price level falls.
In each of these cases the IS curve would shift outwards to the right, as
before, the magnitude of the shift being equal to the size of the shock times
the multiplier. Conversely a change in the opposite direction in any one of
these variables will shift the IS curve to the left.
The money market and the LM curve
The open economy LM curve is exactly the same as in the case of a closed
economy with one important extension. In an open economy operating a
fixed exchange rate the domestic money supply will be altered by balance of
payments deficits/surpluses (that is, the net balance on the combined current
and capital accounts) unless the authorities are able to sterilize or neutralize
the effects of the balance of payments deficits/surpluses on the domestic
money supply. Under a regime of fixed exchange rates the authorities are
committed to buy and sell foreign exchange for the home currency at a fixed
price. For example, in the case of a balance of payments surplus residents
will sell foreign currency to the authorities for domestic currency at a fixed
exchange rate. Ceteris paribus, a balance of payments surplus will result in
an increase in both the authorities’ foreign exchange reserves and the domestic
money supply, thereby shifting the LM curve downwards to the right.
Conversely, a balance of payments deficit will result in a fall in both the
authorities’ foreign exchange reserves and the domestic money supply, thereby
shifting the LM curve upwards to the left. In contrast, under a regime of
flexible exchange rates the exchange rate adjusts to clear the foreign exchange
market (that is, the central monetary authorities do not intervene in
the foreign exchange market) so that the sum of the current and capital
accounts is always zero. In consequence the LM curve is independent of
external factors and the determinants of the position of the LM curve are the
same as those discussed earlier in section 3.3.2.
To complete the IS–LM model for an open economy we next turn to
consider overall balance of payments equilibrium and the BP curve.
The overall balance of payments and the BP curve
Early Keynesian analysis of the balance of payments (see Dimand, 2002c)
focused on the determination of the current account and how government
policy could improve the balance of payments on it (in particular the conditions
under which devaluation would be successful in doing just this). The
late 1950s/early 1960s witnessed a period of increasingly liberalized trade
and capital movements and, as noted earlier, Mundell and Fleming extended
the Keynesian model of an open economy to include capital flows. At the
onset of this discussion it is important to note that we assume we are dealing
with a small open economy in the sense that changes within the domestic
economy of that country and its macroeconomic policies have an insignificant
effect on the rest of the world.
Overall balance of payments equilibrium requires that the sum of the
current and capital accounts of the balance of payments is zero. As noted
earlier, imports are a function of domestic income and relative prices (of
domestic and foreign goods), while exports are a function of world income
and relative prices. Ceteris paribus, as domestic income rises, imports increase
and the balance of payments on the current account worsens. With
static expectations about exchange rate changes, net capital flows are a function
of the differential between domestic and foreign interest rates. Ceteris
paribus, as the domestic interest rate rises, domestic assets become more
attractive and the capital account of the balance of payments improves due to
the resulting inward flow of funds.
The BP curve (see Figure 3.9) traces out a locus of combinations of
domestic interest rates and income levels that yield an overall zero balance of
payments position on the combined current and capital accounts. The BP
curve is positively sloped because if balance of payments equilibrium is to be
maintained (that is, a zero overall balance) then increases (decreases) in the
level of domestic income which worsen (improve) the current account have
to be accompanied by increases (decreases) in the domestic rate of interest
which improve (worsen) the capital account. Points above and to the left of
the BP curve are associated with an overall balance of payments surplus
since, given the level of income, the domestic rate of interest is higher than
that necessary to produce an overall zero balance of payments position.
Conversely, points below and to the right of the BP curve indicate an overall
balance of payments deficit since, given the level of income, the domestic
rate of interest is lower than that necessary to produce an overall zero balance
of payments position.
The slope of the BP curve depends on the marginal propensity to import and
the interest elasticity of international capital flows. Ceteris paribus, the BP
curve will be flatter (steeper) the smaller (larger) is the marginal propensity to
import and the more (less) interest-elastic are capital flows. For example, the
more sensitive capital flows are to changes in domestic interest rates, the
smaller will be the rise in the domestic interest rate required to maintain a zero
overall balance of payments equilibrium for a given increase in income, and
hence the flatter will be the BP curve. The BP curve shown in Figure 3.9
represents a situation of imperfect capital mobility since the domestic rate of
interest can depart from that ruling in the rest of the world. With respect to the
interest elasticity of international capital movements it is important to note that
in the two limiting cases of perfect capital mobility and complete capital
immobility the BP curve would become horizontal and vertical respectively.
For example, in the case of perfect capital mobility the BP curve will be
horizontal; that is, the domestic rate of interest will be tied to the rate ruling in
the rest of the world. If the domestic rate of interest were to rise above the given
world rate there would be an infinite capital inflow, and vice versa.
The BP curve is drawn for given levels of the world income, interest rate
and price level; the exchange rate; and the domestic price level. If any of
these variables should change, then the BP curve would shift. For example,
anything that results in an increase in exports and/or a decrease in imports
(such as a rise in world income; a fall in the exchange rate; a rise in the
foreign price level; or a fall in the domestic price level) will cause the BP
curve to shift downwards to the right, and vice versa. In other words, at any
given level of domestic income an improvement in the current account will
require a lower domestic rate of interest to maintain a zero overall balance of
payments position via capital account effects.
The complete model and the effects of a change in fiscal and
monetary policy
We are now in a position to consider the full IS–LM model for a small open
economy. Equilibrium in the goods and money markets, and in the balance of
payments, occurs at the triple intersection of the IS, LM and BP curves
indicated in Figure 3.9. In what follows we analyse the effects of a change in
fiscal and monetary policy on: (i) the level of income and the balance of
payments in a fixed exchange rate regime, and (ii) the level of income and the
exchange rate in a flexible exchange rate regime.
Under a regime of fixed exchange rates, while fiscal expansion will result
in an increase in income, it may lead to either an improvement or a deterioration
in the overall balance of payments position, and vice versa. The effects
of fiscal expansion on the level of income and the balance of payments are
illustrated in the two panels of Figure 3.10. In panel (a) the LM curve is
steeper than the BP curve, while in panel (b) the converse is true. In both
panels of Figure 3.10 the economy is initially operating at point A, the triple
intersection of the three curves IS0, LM and BP with equilibrium in the goods
and money markets, and in the balance of payments, at r0Y0. Expansionary
fiscal policy shifts the IS curve outwards to the right from IS0 to IS1 and
results in an increase in the domestic rate of interest from r0 to r1 (improving
the capital account) and an increase in income from Y0 to Y1 (worsening the
current account). As can be seen from both panels of Figure 3.10, the net
outcome on the overall balance of payments position depends on the relative
slopes of the LM and BP curves (that is, the structural parameters underlying
the model). In panel (a) the net outcome is an overall balance of payments
surplus at point B (that is, the curves IS1 and LM intersect at a point above the
BP curve), while in panel (b) it is one of an overall balance of payments
deficit (that is, the curves IS1 and LM intersect at point B below the BP
curve). Expansionary fiscal policy is more likely to lead to an improvement in
the overall balance of payments position: (i) the smaller is the marginal
propensity to import and the more interest-elastic are capital flows (that is,
the flatter the slope of the BP curve) and (ii) the greater is the income
elasticity and the smaller is the interest elasticity of the demand for money
(that is, the steeper the slope of the LM curve), and vice versa. In practice the
LM curve is likely to be steeper than the BP curve due to the interest elasticity
of the demand for money being less than that for capital flows. This view
tends to be backed up by available empirical evidence and will be adopted in
the discussion that follows on long-run equilibrium.
At this point it is important to stress that in analysing the consequences for
the balance of payments of a change in fiscal policy under fixed exchange
rates the Keynesian approach assumes that the authorities can, in the short
run, sterilize the effects of a balance of payments surplus or deficit on the
money stock. The results we have been analysing necessarily relate to the
short run because in the long run it becomes increasingly difficult to sterilize
the effects of a persistent surplus or deficit on the money stock. Long-run
equilibrium requires a zero balance on the balance of payments, otherwise
the domestic money supply changes in the manner discussed in section 3.5.2.
As such the balance of payments surplus at point B in panel (a) of Figure 3.10
will cause an expansion of the domestic money supply following intervention
by the authorities to maintain the fixed exchange rate. This causes the LM
curve to shift downwards to the right and long-run equilibrium will occur at
point C, where the balance of payments is zero and the goods and monetary
markets are in equilibrium.
In contrast to fiscal expansion under a regime of fixed exchange rates,
with imperfect capital mobility, monetary expansion will always lead to a
deterioration in the balance of payments, and vice versa, regardless of whether
or not the LM curve is steeper than the BP curve. This is illustrated in Figure
3.11, where the economy is initially operating at point A, the triple intersection
of the three curves IS, LM0 and BP, with equilibrium in the goods and
money markets, and in the balance of payments. Expansionary monetary
policy shifts the LM curve from LM0 to LM1 and results in a reduction in the
domestic rate of interest from r0 to r1 (worsening the capital account) and an
increase in the level of income from Y0 to Y1 (worsening the current account).
With adverse interest and income effects on the capital and current accounts
respectively, the overall balance of payments is unambiguously in deficit at
point B (that is, the curves IS and LM1 intersect at a point below the BP
curve).
In a similar manner to that discussed for expansionary fiscal policy, point B
cannot be a long-run equilibrium. The implied balance of payments deficit
causes a contraction in the money supply, shifting the LM curve backwards.
The long-run adjustment process will cease at point A where the LM curve
has returned to its original position. In other words, in the absence of sterilization,
monetary policy is completely ineffective as far as influencing the
level of income is concerned. This assumes that the domestic country is small
relative to the rest of the world so that expansion of its money supply has a
negligible effect on the world money supply.
Readers should verify for themselves that, for a small open economy
operating under a regime of fixed exchange rates, in the limiting case of
perfect capital mobility, the equilibrium level of domestic income is in the
long run established at the intersection of the IS and ‘horizontal’ BP curves.
In this situation fiscal policy becomes all-powerful (that is, fiscal expansion
results in the full multiplier effect of the simple Keynesian 45° or cross model
with no crowding out of private sector investment), while monetary policy
will be impotent, having no lasting effects on aggregate demand and income.
Before considering the effectiveness of fiscal and monetary policy under
flexible exchange rates it is interesting to note that Mundell (1962) also
considered the appropriate use of monetary and fiscal policy to successfully
secure the twin objectives of internal (output and employment at their full
employment levels) and external (a zero overall balance of payments position)
balance. Mundell’s solution to the so-called assignment problem follows
his principle of effective market classification (Mundell, 1960). This principle
requires that each policy instrument is paired with the objective on which
it has the most influence and involves the assignment of fiscal policy to
achieve internal balance and monetary policy to achieve external balance.
We now consider the effects of a change in fiscal and monetary policy on
income and the exchange rate under a regime of flexible exchange rates. The
effects of fiscal expansion on the level of income and the exchange rate again
depend on the relative slopes of the BP and LM curves. This is illustrated for
imperfect capital mobility in panels (a) and (b) of Figure 3.12, which are the
flexible counterparts of Figure 3.10 discussed above with respect to fixed
exchange rates.
In panel (a) of Figure 3.12 the BP curve is steeper than the LM curve. The
economy is initially in equilibrium at point A, the triple intersection of curves
IS0, LM0 and BP0. Expansionary fiscal policy shifts the IS curve from IS0 to
IS1. As we have discussed above, under fixed exchange rates fiscal expansion
would result in a balance of payments deficit (that is, IS1 and LM0 intersect at
point B below BP0). With flexible exchange rates the exchange rate adjusts to
correct potential balance of payments disequilibria. An excess supply of
domestic currency in the foreign exchange market causes the exchange rate
to depreciate, shifting the IS1 and BP0 curves to the right until a new equilibrium
is reached along the LM0 curve to the right of point B, for example at
point C, the triple intersection of the curves IS2, LM0 and BP1 with an income
level of Y1. In this particular case the exchange rate depreciation reinforces
the effects of domestic fiscal expansion on aggregate demand, leading to a
higher level of output and employment.
Panel (b) of Figure 3.12 depicts the case where the LM curve is steeper than
the BP curve. The economy is initially in equilibrium at point A, the triple
intersection of curves IS0, LM0 and BP0. Fiscal expansion shifts the IS curve
outwards from IS0 to IS1 with the intersection of curves IS1 and LM0 at point B
above BP0. This is equivalent to a balance of payments surplus under fixed
exchange rates and causes the exchange rate to adjust to eliminate the excess
demand for domestic currency. In contrast to the situation where the BP curve
is steeper than the LM curve, the exchange rate appreciates, causing both the
IS1 and BP0 curves to shift to the left. Equilibrium will be established along the
LM curve to the left of point B, for example at point C. In this situation fiscal
policy will be less effective in influencing output and employment as exchange
rate appreciation will partly offset the effects of fiscal expansion on aggregate
demand. As noted above, panel (b) is more likely to represent the true situation.
In the limiting case of perfect capital mobility illustrated in panel (c) of
Figure 3.12, fiscal policy becomes completely ineffective and is unable to
affect output and employment. In the case of perfect capital mobility the BP
curve is horizontal; that is, the domestic rate of interest is tied to the rate
ruling in the rest of the world at r*. If the domestic rate of interest were to rise
above the given world rate there would be an infinite capital inflow, and vice
versa. Fiscal expansion (that is, a shift in the IS curve to the right from IS0 to
IS1) puts upward pressure on the domestic interest rate. This incipient pressure
results in an inflow of capital and leads to an appreciation of the exchange
rate. As the exchange rate appreciates net exports decrease, causing the IS
curve to move back to the left. Equilibrium will be re-established at point A
only when the capital inflows are large enough to appreciate the exchange
rate sufficiently to shift the IS curve back to its original position. In other
words fiscal expansion completely crowds out net exports and there is no
change in output and employment. At the original income level of Y0 the
current account deficit will have increased by exactly the same amount as the
government budget deficit.
Finally we consider the effects of monetary expansion on the level of
income and the exchange rate under imperfect and perfect capital mobility.
The case of imperfect capital mobility is illustrated in panel (a) of Figure
3.13. The economy is initially in equilibrium at point A, the triple intersection
of curves IS0, LM0 and BP0. Monetary expansion shifts the LM curve
from LM0 to LM1. Under fixed exchange rates this would result in a balance
of payments deficit. With flexible exchange rates the exchange rate depreciates
to maintain balance of payments equilibrium and both the BP and IS
curves shift to the right until a new equilibrium is established along the
curve LM1 to the right of point B, such as point C, the triple intersection of
curves IS1, LM1 and BP1. The effect of monetary expansion is reinforced by
exchange rate depreciation, leading to a higher level of income. In the
limiting case of perfect capital mobility illustrated in panel (b) monetary
expansion (which shifts the LM curve from LM0 to LM1) will put downward
pressure on the domestic interest rate. This incipient pressure results in
capital outflows and a depreciation of the exchange rate, causing the IS
curve to shift to the right (from IS0 to IS1) until a new equilibrium is
established at point C, the triple intersection of curves LM1, IS1 and BP at
the given world interest rate r* and a new income level Y1. In this limiting
case monetary policy is completely effective and contrasts with the position
of fiscal policy discussed above.
In summary, under a regime of fixed exchange rates with imperfect capital
mobility, while fiscal expansion will result in an increase in income, its
effects on the overall balance of payments (assuming sterilization takes place)
are ambiguous (depending on the relative slopes of the LM and BP curves).
In contrast, there is no ambiguity following a change in monetary policy.
Monetary expansion will result in an increase in income and always lead to a
deterioration in the balance of payments. However, in the absence of sterilization,
monetary policy is completely ineffective in influencing the level of
income. Furthermore, in the limiting case of perfect capital mobility fiscal
policy becomes all-powerful, while monetary policy will be impotent, having
no lasting effects on aggregate demand and the level of income. Under a
regime of flexible exchange rates, with imperfect capital mobility, while
fiscal expansion will result in an increase in income, it could (depending on
the relative slopes of the LM and BP curves) cause the exchange rate to
depreciate or appreciate, thereby reinforcing or partly offsetting the effect of
fiscal expansion on aggregate demand and income. In contrast, monetary
expansion results in an increase in income, with the effects of monetary
expansion on aggregate demand and income being reinforced by exchange
rate depreciation. In the limiting case of perfect capital mobility fiscal policy
becomes impotent and is unable to affect output and employment, while
monetary policy becomes all-powerful.
In concluding our discussion it is important to note that there are a number
of limitations of the above IS–LM model for an open economy. These limita
tions include: restrictive assumptions (for example fixed wages and prices,
and static expectations about exchange rate changes); specification of the
capital account (where net capital flows between countries depend solely on
the differential between domestic and foreign interest rates) which is inconsistent
with portfolio theory where perpetual capital flows require continuous
interest changes; the implicit assumption that a country is able to match a
continuous deficit on the current account with a surplus on the capital account
whereas, in reality, the nature of the balance of payments objective is
likely to be much more precise than just overall balance of payments equilibrium;
and adopting comparative statics rather than considering the dynamics
of adjustment following a disturbance (see Ugur, 2002). For a discussion of
the origin and subsequent refinements of the Mundell–Fleming model the
reader is referred to Frenkel and Razin (1987); Mundell (2001); Obstfeld
(2001); Rogoff (2002); Broughton (2003).
Having analysed the effectiveness of fiscal and monetary policy in the
context of the fixed-price Keynesian models of both a closed and open
economy we next discuss the original Phillips curve analysis and comment
on the importance of the curve to orthodox Keynesian economics.
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