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OPEN MACROECONOMY

The Balance of Payments (BOP)

The balance of payments (BOP) is a systematic record of all economic transactions between the
residents of a country and the rest of the world over a specific period of time, typically one year.
The BOP includes all transactions involving goods, services, capital, and financial assets, as well
as transfers of money between residents of different countries.

The BOP is divided into two main components: the current account and the capital and financial
account. The current account includes all transactions related to the import and export of goods
and services, as well as income earned from foreign investments and transfers of money between
countries. The capital and financial account includes all transactions related to the purchase and
sale of financial assets, such as stocks, bonds, and currencies, as well as foreign direct
investment and other capital flows.

A positive balance of payments indicates that a country is earning more from exports and foreign
investments than it is paying for imports and foreign investments. This means that the country
has a surplus of foreign currency and can use it to invest in other countries or build up its foreign
currency reserves. A negative balance of payments indicates that a country is paying more for
imports and foreign investments than it is earning from exports and foreign investments. This
means that the country has a deficit of foreign currency and may need to borrow from other
countries or use its foreign currency reserves to pay for its imports.

The BOP is an important indicator of a country's economic health and its ability to pay its debts
to other countries. A sustained deficit in the BOP can lead to a depletion of foreign currency
reserves, a devaluation of the currency, and a reduction in economic growth. Therefore,
governments and central banks closely monitor the BOP and may use various policy instruments,
such as exchange rate policies, capital controls, and fiscal and monetary policies, to manage the
balance of payments and stabilize the economy.

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International Capital Flows

International capital flows refer to the movement of capital across international borders for
investment purposes. These flows can be categorized into three main types: foreign direct
investment (FDI), portfolio investment, and other investments.

1. Foreign Direct Investment (FDI): This refers to the investment made by a foreign
corporation in the production facilities or assets of a domestic company. FDI typically
involves a long-term commitment and ownership of at least 10% of the voting rights in a
foreign company.
2. Portfolio Investment: This refers to the purchase of stocks, bonds, and other financial
assets by foreign investors. Portfolio investment is typically short-term.
3. Other Investments: This category includes all other types of investments, such as loans,
trade credits, and deposits. These investments are typically short-term and involve low-
risk transactions.

The impact of international capital flows on the domestic economy can be both positive and
negative. On the positive side, capital inflows can increase investment, stimulate economic
growth, and improve the balance of payments. On the negative side, capital inflows can also lead
to currency appreciation, which can hurt exports and domestic industries that compete with
imports. Moreover, sudden capital outflows can lead to financial instability and currency crises.

Therefore, policymakers need to carefully manage international capital flows to maximize the
benefits and minimize the risks. They can use various policy instruments, such as capital controls
and exchange rate policies to influence the volume and composition of capital flows. The
optimal policy mix will depend on the specific circumstances of each country, including its
economic fundamentals, institutional framework, and external environment. Net capital flows
(the difference between capital inflows and capital outflows) are an increasing function of the
interest rate differential (That is, capital flows to where the interest rates are higher). Thus, the
higher the domestic interest rate in relation to the foreign interest rate, the greater will be the
incentive to capital inflows.

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The Current Account

The current account is a component of the balance of payments that measures the flow of goods,
services, income, and transfers between a country and the rest of the world over a specific period
of time, typically one year. Current account records an economy’s earnings and spendings
abroad and it consists of the balance of trade, net primary income or factor income (earnings on
foreign investments minus payments made to foreign investors) and net unilateral transfers, that
have taken place over a given period of time.

The Balance of Trade Account

The balance of trade (or trade balance) is a component of the balance of payments and represents
the difference between the value of a country's exports of goods and services and its imports of
goods and services over a specific period of time, typically one year. A positive trade balance,
also known as a trade surplus, occurs when a country exports more than it imports, while a
negative trade balance, also known as a trade deficit, occurs when a country imports more than it
exports.

The trade balance is affected by a variety of factors, including changes in the exchange rate,
changes in the level of domestic and foreign demand for goods and services, changes in the level
of trade barriers and tariffs, and changes in the availability and cost of inputs and raw materials.
In general, a country with a positive trade balance is able to generate more income from exports,
which can help to stimulate economic growth and development. However, a persistent trade
surplus can also lead to inflation and appreciation of the currency, which can make exports more
expensive and reduce the competitiveness of domestic producers.

On the other hand, a country with a negative trade balance may need to borrow from other
countries or use its foreign currency reserves to pay for its imports, which can lead to a depletion
of reserves and a devaluation of the currency. However, a trade deficit can also reflect high
levels of domestic consumption and investment, which can stimulate economic growth and
development. Therefore, the trade balance is an important indicator of a country's economic
health and competitiveness, but it should be interpreted in the context of other economic
indicators and policy objectives.

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The Relationship between Capital Flows and the Trade Balance Account

Capital flows refer to the movement of capital (especially financial capital) into and out of an
economy. Net capital outflow is therefore the difference between the capital invested to the rest
of the world by a country and the capital invested by the rest of the world into the country.

A trade deficit occurs when a country’s value of exports is less than that of imports. That is,
when X-M is negative.

When there are capital inflows, the domestic currency appreciates in value relative to other
currencies. This is because the foreigners (for example foreign investors) will have to exchange
their foreign currency (for example dollars) for the Kenyan shilling. This means that the demand
for the shilling will increase, thereby pushing up its value relative to the dollar. When this
happens, the appreciation of the shilling ends up making the imports cheaper while Kenyan
exports become expensive. This worsens Kenya’s trade balance position and so if it persists the
trade balance account falls into a deficit since the value of imports will be greater than that of the
exports. That is X<M.

On the other hand, if there are capital outflows, then capital is leaving the country. Therefore, the
foreign investors will be demanding the dollars while exchanging them for the Kenyan shilling.
So the demand for the dollar will rise relative to the demand for the shilling. Therefore, the value
of the shilling against the dollar will fall. That is, the shilling will depreciate against the dollar.
The depreciation will make Kenya’s exports cheaper and therefore more appealing and more
competitive in the international markets. So exports will increase. On the other hand, imports
will become more expensive and less appealing and therefore Kenyans will buy less. The end
effect will be a improvement in the trade balance account since X>M. So if it persists, then the
trade balance will be in surplus.

Fixed Exchange Rate Regime

Fixed exchange rate refers to a type of exchange rate system in which the value of a country's
currency is fixed, or pegged, to the value of another currency, a basket of currencies, or a
commodity, such as gold. Under a fixed exchange rate system, the central bank of a country has

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to intervene in the foreign exchange market to maintain the exchange rate within a narrow band
of fluctuation, by buying or selling its own currency against the pegged currency or asset.

There are several advantages of a fixed exchange rate system:

i. It provides greater certainty and predictability for businesses and investors, as they
know the exchange rate will not change abruptly. This can help to promote
international trade and investment, and reduce transaction costs and exchange rate
risk.
ii. A fixed exchange rate system can help to anchor inflation expectations and promote
macroeconomic stability, as it limits the ability of the central bank to pursue an
independent monetary policy.

However, a fixed exchange rate system also has several disadvantages.

i. It can lead to loss of competitiveness and external imbalances, as the fixed exchange
rate may not reflect the changing economic fundamentals of a country, such as its
productivity, inflation rate, and terms of trade.
ii. It can lead to speculative attacks and capital flight, as investors may lose confidence
in the ability of the central bank to defend the exchange rate.
iii. A fixed exchange rate system may require a high level of foreign exchange reserves
and impose constraints on fiscal and monetary policies, as the central bank has to
intervene in the foreign exchange market to maintain the exchange rate.

EXCHANGE RATE REGIMES

An exchange rate regime refers to the framework within which a country's currency exchange
rate is determined. It encompasses the set of rules, policies, and practices that a country adopts to
manage its exchange rate.

There are different types of exchange rate regimes, ranging from fixed exchange rate regimes to
floating exchange rate regimes, and various hybrid systems in between.

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1. Fixed exchange rate regime: In a fixed exchange rate regime, a country's currency is
pegged to another currency or a basket of currencies, or to the value of gold. The central
bank intervenes in the foreign exchange market to maintain the exchange rate at a
predetermined level.
2. Floating exchange rate regime: In a floating exchange rate regime, the exchange rate is
determined by the market forces of supply and demand without any intervention from the
central bank.
3. Managed float exchange rate regime: In a managed float exchange rate regime, the
exchange rate is allowed to fluctuate within a certain range, and the central bank
intervenes in the market to stabilize the exchange rate within that range.
4. Crawling peg exchange rate regime: In a crawling peg exchange rate regime, the
exchange rate is adjusted gradually over time to reflect changes in economic conditions,
such as inflation, without abandoning the peg altogether.

The choice of exchange rate regime depends on various factors, such as the country's economic
conditions, external shocks, and policy objectives. Each exchange rate regime has its advantages
and disadvantages, and no one regime is suitable for all countries under all circumstances.

Flexible Exchange Rate Regime

A flexible exchange rate is a system where the exchange rate between two currencies is
determined by market forces of supply and demand, without any interference or manipulation by
the government or central bank. In other words, the exchange rate is allowed to float freely and
adjust based on the changing economic conditions and global trade flows.

Under a flexible exchange rate system, the exchange rate is determined by a range of factors
such as inflation, interest rates, trade balance, capital flows, and political stability. For example,
if a country experiences a high inflation rate, its currency value may decrease relative to other
currencies, as investors are less likely to hold onto it due to its declining purchasing power.

The primary advantage of a flexible exchange rate system is its ability to adjust to changing
economic conditions and external shocks, which allows for a more efficient allocation of

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resources and promotes international trade. However, it can also result in increased volatility and
uncertainty, as the exchange rate can fluctuate rapidly in response to changes in the market.

Many countries, including the United States and Canada, use a flexible exchange rate system,
while others such as China and Saudi Arabia maintain a fixed exchange rate system, where the
exchange rate is pegged to the value of another currency, typically the US dollar.

Devaluation and Depreciation

Devaluation and depreciation are both concepts related to the value of a country's currency
relative to other currencies, but they have different meanings:

1. Devaluation

Devaluation is the process whereby the monetary authority deliberately decreases the value of a
currency relative to another (exchange rate. This is typically done by central bank lowering the
official exchange rate of its currency relative to other currencies. The aim of devaluation is to
make the country's exports cheaper and more competitive in international markets, while making
imports more expensive, which could help reduce trade deficits. Devaluation can be seen as a
form of monetary policy, which can have both positive and negative effects on a country's
economy, depending on the circumstances.

2. Depreciation

Depreciation refers to the decrease in the value of a currency that occurs naturally in the foreign
exchange market due to market forces. In contrast to devaluation, depreciation is not a deliberate
policy choice by a government or central bank, but rather a result of supply and demand in the
currency market. Factors that can cause a currency to depreciate include a decrease in demand
for the currency due to a weak economy or political instability, or an increase in supply of the
currency due to a high trade surplus or foreign investment outflows.

The Impossible Trilemma

The impossible trilemma, also known as the trilemma or the Mundell-Fleming trilemma, is a
concept that suggests that it is impossible to have all three of the following things at the same
time:

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 A fixed foreign exchange rate

 Free capital movement
 An independent monetary policy

In other words, an economy can only choose two out of the three options, and attempting to have
all three will lead to conflicts or inconsistencies in economic policy.

This is how it works:

If a country wants to have a fixed exchange rate and free capital movement, it cannot have an
independent monetary policy. This is because in order to maintain the fixed exchange rate, the
central bank must be willing to buy and sell its own currency on the foreign exchange market.
But if there is free capital movement, investors can easily move their money in and out of the
country, which puts pressure on the exchange rate. In order to counteract this pressure, the
central bank must adjust its monetary policy to be in line with the country or region it is fixed
against. This limits the central bank's ability to control inflation, interest rates, and other
economic variables independently.

If a country wants to have a fixed exchange rate and an independent monetary policy, it cannot
have free capital movement. This is because if there is free capital movement, investors can
easily move their money in and out of the country in response to changes in the monetary policy.
If the central bank raises interest rates to combat inflation, for example, investors may move their
money into the country to take advantage of the higher interest rates, which could put pressure
on the exchange rate. In order to maintain the fixed exchange rate, the central bank would have
to intervene in the foreign exchange market, which could be costly.

If a country wants to have free capital movement and an independent monetary policy, it cannot
have a fixed exchange rate. This is because a fixed exchange rate would require the central bank
to buy and sell its own currency on the foreign exchange market in order to maintain the
exchange rate. If the central bank wanted to pursue an independent monetary policy, it would
have to allow the exchange rate to float freely in response to market forces.

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THE MUNDELL-FLEMMING MODEL

This is an extension of the closed economy IS-LM model. It incorporates international capital
flows. This model examines various dynamics but at this level we will examine these dynamics
while assuming perfect mobility of capital. This means that the BP curve (Balance of payments
curve) is perfectly elastic. It is perfectly interest-elastic. The IS and LM curves maintain their
usual slopes. In our analysis, we will always assume a case of a small open economy (This
implies that the domestic interest rates must always match up to the worlsd interest rates,
∗ ∗
i.e, = : I is the domestic interest rate and is the world interest rate )

Points below the the BP curve are points of BoP deficits, while points above the BP curve are
points of BoP surplus.

An increase in the exchange rate lowers the relative price of domestic goods and therefore
increases the demand for domestic goods.

The interest rate also varies in relation to money demand. It increases if there is positive excess
demand and falls if there is negative excess demand.

We will therefore examine the adjustments in the simultaneous equilibrium in the goods, money
and external markets and the effects of monetary and fiscal policies on this joint equilibrium
under both the fixed and floating exchange rate regimes.

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Adjustments Under the Fixed Exchange Rate Regime

When considering a case of FIXED EXCHANGE RATES in the Mundell-Flemming model,

both prices and exchange rates are fixed. Since the exchange rate is fixed, exports are now
exogenous. As usual, aggregate expenditure negatively depends on the interest rate and
positively on income.

Suppose, for example, that the equilibrium is initially at point A. Point B lies under the BP curve
and therefore it is a point of BoP deficit.

At point B, we can also see that there is a domestic equilibrium since IS is intersecting the LM
curve. However, it is an overall point of disequilibrium. There is also positive excess demand for
money at point B because it is associated with low interest rates. There will thus be pressure on
the interest rates to increase so as to eliminate the excess money demand. Money supply will
forced to decrease so as to re-establish a joint equilibrium at Point A. The LM curve will shift
backwards until all the three curves intersect at the same point.

1. The Effect of a Change in Monetary Policy

Under fixed exchange rates the exchange rate is a policy variable. Income Y and money supply M are the
endogenous variables. Let us assume that the authorities pursue an expansionary monetary policy through
domestic credit expansion. The increase in money supply shifts the LM curve from LM0 to LM1. The
domestic equilibrium is now at point B but there is a disequilibrium when we consider an open the
economy (There is an external disequilibrium).

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We can see that point B is associated with a BoP deficit. There is also positive excess demand for money
at point B because it is associated with low domestic interest rates. However, domestic interest rates can
not fall since they will cause a depreciation of the exchange rate. To avoid this (remember the exchange
rate is fixed), the authorities have to defend the exchange rate by selling foreign reserves in exchange for
domestic currency. This will reduce the amount of domestic currency circulating and the LM curve will
shift back from LM1 to LM0. The output in the economy does not change. This, in general, implies that
the monetary policy is impotent as a stabilization tool under a fixed exchange rate regime.

2. The Effect of a Change in Fiscal Policy

Let us assume the case of an expansionary fiscal policy. Once again, Under fixed exchange rates the
exchange rate is a policy variable. Income Y and money supply M are the endogenous variables.

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The increase in government spending will lead to an outward shift of the IS curve from IS0 to IS1. The
new point of domestic equilibrium, Point B, is associated with a disequilibrium when we consider the
open economy. Point B is also associated with a BoP surplus. There is also excess negative demand for
money at point B because it is associated with high domestic interest rates.

The higher domestic interest rates might attract capital inflows which may lead to an appreciation of the
exchange rate. But remember that the exchange rate is fixed. To avoid the changes in exchange rates, the
monetary authority buys the foreign exchange reserves in exchange for the domestic currency. This leads
to an increase in money supply and the LM curve shifts outwards from LM0 to LM1. This shift of the LM
curve also re-establishes the joint equilibrium in the economy . Output in the economy increases from Y0
to Y1. We can therefore see that fiscal policy is very effective as a stabilization tool under the fixed
exchange rate regime.

Adjustments Under the Flexible Exchange Rate Regime

1. The Effect of a Change in Monetary Policy

Under flexible exchange rate regimes, the exchange rate and output Y are now endogenous. The monetary
authorities control money supply, and so money supply is assumed to be exogenous.

Let us assume that the authorities pursue an expansionary monetary policy through domestic credit
expansion. The increase in money supply shifts the LM curve from LM0 to LM1. The domestic
equilibrium is now at point B but there is a disequilibrium when we consider an open the economy (There
is an external disequilibrium).

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Point B is characterized by BoP deficit. Due to the low domestic interest rates at this point, there is capital
outflow since i < i∗. This causes the exchange rate to depreciate so as to restore the equilibrium.
The depreciation of the exchange rates makes domestic goods cheaper resulting in an increase in
the expenditure on domestic goods (expenditure-switching effect) and this has an expansionary effect on
the goods market. So the IS curve shifts from IS0 to IS1. This restores the joint equilibrium at point C.
As a consequence output increases from Yo to Y1. It is clear that monetary policy is very effective

as a stabilization tool under the flexible exchange rate regime.

2. The Effect of a Change in Fiscal Policy

Under flexible exchange rate regimes, the exchange rate and output Y are now endogenous. The monetary
authorities control money supply, and so money supply is assumed to be exogenous.

Let us assume that the authorities pursue an expansionary fiscal policy through increase in government
spending. The increase in government spending shifts the IS curve from IS0 to IS1. The domestic
equilibrium is now at point B but there is a disequilibrium when we consider an open the economy (There
is an external disequilibrium).

Point B is characterized by a BoP surplus. Due to the high interest rates relative to the world interest rates,
there is capital inflow. This leads to an appreciation of the domestic currency (appreciation of the
exchange rate). However, the stronger domestic currency makes the domestic goods expensive and
therefore expenditure switches away from them and this has a contractionary effect on the goods market.
So the IS curve shifts backwards from IS1 to IS0. This leaves output Y unchanged. Therefore, fiscal policy
is not effective as a stabilization tool under the flexible exchange rate regime.

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Dr. Mwito M.M