1

PGP 2018-19
IIM Ahmedabad

Macroeconomics and Policy

Open Economy IS-LM

 2

Balance of payments (BoP)

• Economies are linked through two broad channels

1. Trade in goods and services

➢ Some of a country’s production is exported to foreign

countries. This increases demand for domestically produced
goods

➢ Some goods that are consumed or invested at home are

produced abroad and imported

➢ Constitutes a leakage from (or addition to) the “circular flow

of income” that we studied earlier
 3

Balance of payments (BoP)

2. International capital flows

• Residents can hold own country assets OR assets in

foreign countries (or both)

➢ Portfolio managers shop around the world for the most

attractive yields

➢ As international investors shift their assets around the

world, they link financial assets markets at home and
abroad.

➢ This affect income, exchange rates, and the ability of

monetary policy to affect interest rates
 7

The link between trade & capital flows

NX = Y – (C + I + G )

=> NX = (Y – C – G ) – I
=> NX = S – I
=> Trade balance = Net capital outflows

Thus,
a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
 8

Net Exports
• Net exports NX = (X-M), is the excess of exports over
imports
– NX depends on:
➢domestic income Y
➢foreign income, Yf
➢Real exchange rate ε = ePf/P
where
e=Rupees/ForeignCurrency

Fall in ε  real appreciation (goods abroad become

cheaper than at home)
Increase in ε  real depreciation (goods abroad become
more expensive than at home)
 9

Example: McDonald burger

• one good: Big Mac (Indian equivalent Maharaja Mac)
• price in U.S in July 2018:
Pf = $5.51
• price in India of Big Mac equivalent (Maharaja Mac) in July 2018:
P = Rs. 173
• nominal exchange rate (July 2018)
e = 68.825 Rs/$
To buy the Maharaj Mac in India, cost in USD
= 173/68.825=2.51 USD => ε = $5.51/$2.51 = 2.2

ε = ePf/P To buy the same burger in the

United States, someone from
= 68.825*5.51/173 India would have to pay an
amount that could buy
= 379.23/173 = 2.2 2.2 Majaraja Macs.
 10

Example: McDonald burger

Extent of undervaluation/overvaluation of INR according to Big
Mac Index
(where a Big Mac costs $2.51 in India and $5.51 in USA)

= (2.51-5.51)*100/5.51

= -54.4%

According to Big Mac Index, INR was 54.4% undervalued

 -80
-70
-60
-50
-40
-30
-20
-10
0
10
20
Switzerland
Sweden
United States
Norway
Canada
Euro area

-14.1
Denmark
Israel
Australia
Uruguay
Brazil
Lebanon
Singapore
New Zealand
Britain
Colombia
Chile
South Korea
Costa Rica
UAE
Sri Lanka
Thailand
Honduras
Japan
-36.4

Kuwait
Czech Rep.
Guatemala
Croatia
Qatar
Nicaragua
Peru
Saudi Arabia
Bahrain
China
-43.8

Pakistan
Hungary
Vietnam
Jordan
Poland
Oman
Argentina
Philippines
Moldova
Mexico
Economist Big Mac Index: July 2018

Hong Kong
India
-54.4

South Africa
-57.9

Azerbaijan
Romania
Overvaluation/undervaluation according to Big Mac Index (July 2018)

Turkey
Taiwan
Indonesia
Malaysia
-62

Russia
Ukraine
Egypt
11
 12
Real exchange rates encompass a wide range of
goods and services across multiple trade partners

Big Mac index is a nice illustration with one common good

In reality real exchange rates span

- Large number of goods and services
- Large number of trade partners
- Adjust for inflation between India and trade partner countries

RBI calculates a 36-country REER (real effective exchange rate) index,

based on 36 trade partner countries

NEER - nominal effective exchange rate (no adjustment for inflation)

REER - real effective exchange rate (adjustment for inflation)
 13

Brief digression on PPP

Two currencies are at purchasing power parity (PPP) when a
unit of domestic currency can buy the same basket of goods at
home or abroad

If ε =1, currencies are at PPP

If ε > 1, goods abroad are more expensive than those at

home (more incentive for exports and disincentive for imports)

If ε < 1, goods abroad are cheaper than at home

 14

Net exports NX

ε = (ePf/P)

where e=Local currency/ForeignCurrency

NX = X (Y f ,  ) − M (Y ,  ) = NX (Y , Y f ,  )
 15

The NX curve for China

When ε is ε NX(ε)
relatively high ε1 so China’s net
(depreciated exports will
currency), be high
Chinese goods
are relatively
inexpensive

0 NX
NX(ε1)
 16

The NX curve for India

ε NX(ε)

At lower enough
values of ε (real
appreciation),
Indian goods
become so
expensive that
ε2 we export less
than we import

0 NX
NX(ε2)
 17

The Balance of Payments

• Balance of payments: the record of the transactions of

the residents of a country with the rest of the world
• Two main accounts:
➢ Current account: records trade in goods and services,
as well as transfer payments

➢ Capital account: records purchases and sales of

assets, such as stocks, bonds, and land

Any transaction that gives rise to a

payment by a country’s residents is
a deficit item in that country’s
balance of payments.
 18

External Accounts Must Balance

• The central point of international payments is very simple:
Individuals and firms have to pay for what they buy
abroad

– If a person spends more than her income, her deficit

needs to be financed by selling assets or by borrowing

– Similarly, if a country runs a deficit in its current

account the deficit needs to be financed by selling
assets or by borrowing abroad

Selling assets or borrowing from abroad implies the

country is running a capital account surplus . A current
account deficit is financed by an offsetting capital inflow
 19

Fixed and flexible exchange rates

• Fixed exchange rates (e.g., Bahrain Dinar, Saudi Riyal,
Qatari Riyal, UAE Dirham, West African CFA Franc, Nepal
rupee)

• Flexible exchange rates (e.g., USD, euro, yen, ruble, peso,

INR)

• Intermediate exchange rate regimes (e.g., China)

 3.2
3.4
3.8
4.2

3.6

3
4
Jan-75
Sep-76
May-78
Jan-80
Sep-81
Local currency/USD

Note: Increase indicates depreciation

May-83
Jan-85
Sep-86
May-88
Jan-90
Sep-91
UAE Dirham

May-93
Jan-95
Sep-96
May-98
Jan-00
Sep-01
Saudi Riyal

May-03
Jan-05
Sep-06
May-08
Fixed exchange rates – some examples

Jan-10
Sep-11
Qatar Riyal

May-13
Jan-15
20
 21

Fixed Exchange Rates

• In a fixed exchange rate system, central banks stand ready to buy
and sell their currencies at a fixed price in terms of dollars
– Ensures that market prices equal to the fixed rates
➢No one will buy dollars for more than fixed rate since know
that they can get them for the fixed rate
➢No one will sell dollars for less than fixed rate since know
can sell them for the fixed rate

• Central banks hold FX reserves to sell when have to intervene in

the foreign exchange market
– Intervention in FX markets: the buying or selling of foreign
exchange by the central bank
 22

Fixed Exchange Rates

What determines the level of intervention of a central bank in a
fixed exchange rate system?
• The balance of payments measures the amount of foreign
exchange intervention needed from the central banks
➢ Ex. Suppose India were running a current account deficit
vis-à-vis USA, the demand for dollars in exchange for
Rupees exceeds the supply of dollars in exchange for
Rupees. Then RBI would buy the excess Rupees, paying for
them with dollars
→Under a fixed exchange rate, the price fixer (i.e. the RBI)
must make up the excess demand or take up the excess
supply
→Makes it necessary to hold an inventory for foreign
currencies that can be provided in exchange for the
domestic currency.
 23

Fixed Exchange Rates

What determines the level of intervention of a central bank in a fixed
exchange rate system?
• As long as the central bank has the necessary reserves, it can
continue to intervene in the foreign exchange markets to keep the
exchange rate constant
• If a country persistently runs deficits in the balance of payments:
– The central bank eventually will run out of reserves on of
foreign exchange
– Will be unable to continue its intervention
– Before this occurs, the central bank will likely devalue the
currency
 24

Flexible Exchange Rates

In a flexible (floating) exchange rate system, central banks allow the
exchange rate to adjust to equate the supply and demand for foreign
currency
– For example (Increase in capital flows)
➢ Exchange rate of the Rupee against the dollar is 65 rupees per
dollar
➢ Suppose U.S capital flows to the India decrease
➢ Supply of USD in Indian market decreases, more demand for
dollars relative to supply
➢ RBI stands aside and allows the exchange rate to adjust
➢ Exchange rate could increase to 70 rupees per dollar
➢ US goods become more expensive in terms of rupees
➢ Demand for US goods by Indians declines
 0.5
1.5
2.5
3.5

0
1
2
3
Jan-75
Sep-76
May-78
Jan-80
Local currency/USD

Sep-81
May-83

Note: Increase indicates depreciation

Euro
Jan-85
Sep-86
May-88
Jan-90
Sep-91
May-93
Jan-95

British Pounds
Sep-96
May-98
Jan-00
Sep-01
May-03
Jan-05
Sep-06
Deutsche Mark

May-08
Jan-10
Sep-11
May-13
Jan-15
Flexible exchange rates – some examples
25
 50
100
150
200
250
300
350

0
Jan-75
Nov-76
Sep-78
Local currency/USD

Jul-80

Note: Increase indicates depreciation

May-82
Mar-84
Jan-86
Nov-87
Sep-89
Jul-91
May-93

Yen
Mar-95
Jan-97
Nov-98
Sep-00
Jul-02
May-04
Mar-06
Jan-08
Nov-09
Sep-11
Jul-13
May-15
Flexible exchange rates – some examples
26
 10
20
30
40
50
60
70

0
Jan-75
Jul-76
Jan-78
Local currency/USD

Jul-79
Jan-81

Note: Increase indicates depreciation

Jul-82
Jan-84
Jul-85
Jan-87
Jul-88
Jan-90
Jul-91
Jan-93
Jul-94
Jan-96

INR
Jul-97
Jan-99
Jul-00
Jan-02
Jul-03
Jan-05
Jul-06
Jan-08
Jul-09
Jan-11
Jul-12
Jan-14
Jul-15
Flexible exchange rates – some examples
27
 28

Intermediate regimes: managed exchange rates –

some examples (Malaysia until 2006)
Local currency/USD
10
9
8
7
6
5
4
3
2
1
0
Jan-91

Jan-01

Jan-11
Jan-75
Jan-77
Jan-79
Jan-81
Jan-83
Jan-85
Jan-87
Jan-89

Jan-93
Jan-95
Jan-97
Jan-99

Jan-03
Jan-05
Jan-07
Jan-09

Jan-13
Jan-15
China Renmimbi Malaysia Ringitt
Note: Increase indicates depreciation
 29

Goods market equilibrium in an Open economy

• Earlier NX was considered exogenous (part of autonomous

demand)

• Now, incorporate real exchange rate and net exports (NX)

into the standard IS-LM model
 30

Goods market equilibrium in an Open economy

IS curve in an open economy

Y = DS (Y , i ) + NX (Y , Y f ,  )
where Domestic Spending DS =C+I+G
IS curve now includes NX as a component of
Aggregate Demand

Note: We use nominal interest rate (i) instead of (r) without any loss of
generality when discussing open economy IS-LM model, assuming
prices (P) fixed
 31

Goods market equilibrium in an Open economy

• IS curve now includes NX as a component of AD

Y = DS (Y , i ) + NX (Y , Y f ,  )
• Level of competitiveness or real exchange rate (ε)
affects the IS curve. A real depreciation (rise in ε)
increases the demand for domestic goods → shifts
IS to the right

• An increase in Yf results in an increase in foreign

spending on domestic goods. This shifts IS to the right
 32

Goods market equilibrium in an Open economy

• Marginal propensity to import = fraction of an extra unit of

income spent on imports

• Note that IS curve will be steeper in an open economy

compared to a closed economy
– For a given reduction in interest rates, it takes a smaller
increase in output and income to restore equilibrium in
the goods market

(since imports M also increase with increase in Y, thereby

reducing NX)
 33

Mundell-Fleming Model:
Perfect Capital Mobility Under Fixed Exchange Rates

• The Mundell-Fleming model incorporates foreign

exchange markets under perfect capital mobility into the
standard IS-LM framework

– Under perfect capital mobility, the slightest interest rate

differential provokes large capital inflows

=> central bank cannot conduct an independent

monetary policy under fixed exchange rates

We will see why

 34

The Balance of Payments and Capital Flows

Balance of payments surplus

BP = NX (Y , Y f ,  ) + CF (i − (i f +  ))
– The trade balance (NX) is a function of domestic and
foreign income and real exchange rate
• An increase in domestic income Y worsens the trade
balance (NX), i.e. larger trade deficit or smaller trade
surplus;

• An increase in foreign income Yf improves the trade

balance (NX), i.e. smaller trade deficit or larger trade
surplus
 35

The Balance of Payments and Capital Flows

Balance of payments surplus

BP = NX (Y , Y f ,  ) + CF (i − (i f +  ))
– The trade balance (NX) is a function of domestic and
foreign income and real exchange rate

• A real depreciation (rise in ε) increases the demand for

domestic goods, reduces the demand for foreign goods,
and improves the trade balance (NX), i.e. smaller trade
deficit or larger trade surplus
 36

The Balance of Payments and Capital Flows

Balance of payments surplus

BP = NX (Y , Y f ,  ) + CF (i − (i f +  ))
– The trade balance is a function of domestic and foreign income
and real exchange rate

– The capital account (capital flows CF) depends on the

interest rate differential (i – (if + θ))

➢An increase in the domestic interest rate (i) above the

sum of world level (if) and country risk premium (θ) pulls
in capital from abroad, improving the capital account (CF)
 37
Mundell-Fleming Model: Perfect Capital
Mobility Under Fixed Exchange Rates
 38
Monetary tightening under fixed exchange rates,
perfect capital mobility
• Adjustment Process: Suppose a country tightens
(reduces) money supply to increase interest rates
– Portfolio holders worldwide shift assets into country
– Due to huge capital inflows, balance of payments shows a
larger surplus
– The exchange rate appreciates (leading to decrease in ε)
– The central bank must intervene to hold the exchange rate
fixed
– The central bank buys foreign currency in exchange for
domestic currency
– Intervention causes domestic money stock to increase, and
interest rates drop
– Interest rates continue to drop until return to level prior initial
intervention (No effect of monetary policy!)
With perfect capital mobility, central bank cannot conduct
an independent monetary policy under fixed exchange rates
 39

Monetary tightening under fixed exchange rates,

perfect capital mobility
IS-LM curves in addition to the BP=0 (Note: BP schedule is
horizontal under perfect capital mobility (i = if + θ)

i1=if+θ
 40

Monetary expansion under fixed exchange rates,

perfect capital mobility
• Consider a monetary expansion (loosening) → shifts
LM down and to the right
– There is a large payments (BOP) deficit, and pressure for the
exchange rate to depreciate (rise in ε)
– Central bank must intervene, selling foreign money, and
receiving domestic money in exchange
• Supply of money falls, pushing up interest rates as LM
moves back to original position
 41

Fiscal Expansion under fixed exchange rates,

perfect capital mobility
• Monetary policy is infeasible, but fiscal expansion under fixed
exchange rates and perfect capital mobility is highly effective
– A fiscal expansion shifts the IS curve to the right. This
increases interest rates and output
– The higher interest rates creates a capital inflow and BOP
surplus
– Tendency to appreciate the exchange rate (fall in ε)
– To keep exchange rate at original level, the central bank
buys foreign currency in exchange for local currency
– This expands the money supply
– Shifting the LM curve to the right
– Pushes interest rates back to their initial level, but output
increases yet again
Note: Original fiscal policy multiplier in AD model with no crowding out.
 42
Fiscal expansion under fixed exchange rates,
perfect capital mobility
IS-LM curves in addition to the BP=0 (BP schedule is horizontal under
perfect capital mobility (i = if + θ)

i1=if+θ
 43

Perfect Capital Mobility and Flexible Exchange

Rates
• Use the Mundell-Fleming model to explore how monetary
and fiscal policy work in an economy with a flexible
exchange rate and perfect capital mobility

– Assume domestic prices are fixed in short-run as

earlier
 44

Perfect Capital Mobility and Flexible Exchange

Rates
• Under a flexible exchange rate system, the central bank
does not intervene in the market for foreign exchange
to target a specific level of the exchange rate

– The exchange rate must adjust to clear the market so

that the demand for and supply of foreign exchange
balance

– Without central bank intervention, the balance of

payments (BP) must always equal zero (no reserve
accumulation or depletion)

– The central bank can set the money supply at will since
there is no obligation to intervene → no automatic link
between BP and money supply!
 45
Perfect Capital Mobility and Flexible Exchange
Rates
• Perfect capital mobility implies that the balance of
payments balances when i = if + θ

– A real appreciation (fall in ε) means home goods are

relatively more expensive, and IS shifts to the left

– A depreciation (rise in ε) makes home goods relatively

cheaper, and IS shifts to the right
 46
Perfect Capital Mobility and Flexible Exchange Rates
• The arrows make the link between the interest rate and AD
– When i > if + θ the currency appreciates, NX falls, AD falls, IS
shifts left
– When i < if + θ the currency depreciates, NX rises, AD rises, IS
shifts right
i

Appreciation
i1=if+θ

Depreciation

IS
Y
 47
Perfect Capital Mobility and Flexible Exchange
Rates
Show how various changes affect the output level, interest rate,
and exchange rate

Case A: Fiscal expansion:

➢ At a given output level, interest rate, and exchange

rate, there is an excess demand for goods

➢ IS shifts to the right

➢ The new equilibrium, E’, corresponds to a higher

income level and interest rate

➢ But don’t reach E’ since BP in disequilibrium → exchange

rate appreciation (fall in ε) will push economy back to E
 48
Perfect Capital Mobility and Flexible Exchange
Rates: Adjustment to real disturbance
Case A: Fiscal expansion
i
LM

i=if+θ

IS’
IS
Y
 49
Perfect Capital Mobility and Flexible Exchange
Rate: Adjustment to a Real Disturbance

• Case B: Increase in demand for exports:

➢Same result as with fiscal expansion
➢Tendency for demand to increase is halted by
exchange appreciation (see next slide)
 50
Perfect Capital Mobility and Flexible Exchange
Rates: Adjustment to real disturbance
Case B: Increase in demand for exports
i
LM

i=if+θ

IS’
IS
Y

Real disturbances to demand do not affect equilibrium output

under flexible exchange rates with capital mobility.
 51
Perfect Capital Mobility and Flexible Exchange
Rates: Monetary expansion
Case C: Increase in the nominal money supply (monetary
expansion)
➢ The real stock of money, M/P, increases since P is fixed
➢ There will be an excess supply of real money balances
➢ To restore equilibrium, interest rates will have to fall → LM
shifts to the right
➢ Goods market is in equilibrium, but interest rate i is below
the world level and risk premium (i+θ) at E’
➢ Capital outflows depreciate the exchange rate (rise in ε)
➢ Import prices increase, domestic goods more
competitive, and demand for home goods expands
➢ IS shifts right to E”, where i = if + θ
 52
Perfect Capital Mobility and Flexible Exchange
Rates: Monetary expansion

i
IS
IS’

i=if+θ

LM’
LM
Y
 53
Perfect Capital Mobility and Flexible Exchange
Rates: Monetary expansion
Case C: Increase in money supply
➢ Result: A monetary expansion leads to an increase in
output and a depreciation of the exchange rate under
flexible rates

Under flexible rates, the central bank

can control the nominal money
stock. That is a key aspect of flexible
exchange rate system.

Recall: Under fixed exchange rates, the central

bank cannot control the nominal money stock.
 54

Disturbances and Stabilization tools with capital

mobility
• Economy initially at full employment (Y*) & balanced trade.
Prices fixed in short-run

• Capital fully mobile

• Decline in export demand under:

– Case D: Fixed exchange rate

– Case E Flexible exchange rate

 55

Case D: Decline in export demand, fixed exchange

rate, full capital mobility
• A decline in demand for exports implies that domestic
production has to be reduced (assuming flat aggregate
supply curve)

=> decrease in output

=> trade deficit develops
=> Balance of payment deficit
 56

Case D: Decline in export demand, fixed exchange

rate, full capital mobility
• Fall in net exports (NX) and balance of payment deficit

• Fall in aggregate demand (AD) => IS shifts left. Domestic

interest rate falls below foreign interest rate plus sovereign
risk premium (i < if + θ)

• => Capital outflows

• => Depreciation pressure (pressure for ε to rise)

• Central bank intervenes in foreign exchange market to

stabilize exchange rate - sells FX, buys domestic currency
=>Money supply falls

• Monetary tightening reduces output Y further

 57

Case D: Decline in export demand, fixed exchange

rate, full capital mobility

i=if+θ

End up initially at E2 in Deficit/Unemployment zone

 58
Case D: Decline in export demand, fixed exchange
rate, full capital mobility

i=if+θ

Capital flows and Central bank’s “automatic response” to

keep exchange rate fixed results in E3 (even lower output!)
Demand-side stabilization policy – increase in govt. spending can
take economy back to E1
 59

Decline in export demand, flexible exchange rate,

full capital mobility
• Decline in net exports (NX) and balance of payment deficit
• Fall in aggregate demand (AD) => IS shifts left. Domestic
interest rate falls below foreign interest rate plus sovereign
risk premium (i < if + θ)
• => Capital outflows => depreciation pressure (pressure
for ε to rise)
• Central bank doesn’t intervene and exchange rate
depreciates (ε rises)
• Foreign goods become more expensive to residents and
domestic goods become cheaper to foreigners
• Trade balance (NX) improves
• IS curve shifts back to the right. Process continues until
i = if + θ
• Flexible exchange rate acts as an adjustment mechanism
 60

Decline in export demand, flexible exchange rate,

full capital mobility

i=if+θ

Capital flows and flexible exchange rates allow output to go back to

original level Y* (flexible exchange rate acts as automatic stabilizer)