MACROECONOMICS

Unit 5: Open Economy and Macroeconomic Policy

St. Xavier’s College (Autonomous), Kolkata

CONTENTS
Balance of Payment Accounting
Current Account and National Saving.
Market for foreign exchange – fixed versus flexible exchange rates
BOP equilibrium and external balance schedule
IS-LM Model with flexible exchange rate.

2
INTRODUCTION
3
 HOW TO MEASURE OPENNESS OF THE
ECONOMY?
If a country is engaged in transactions with any other foreign country, then the
concerned country is considered to be an open economy.
The degree of openness depends on the following:
1. The share of import and export (share of foreign trade) as a proportion of total value
of GDP.
 Greater the value → greater the degree of openness (Widely used)
2. Value of import duties as proportion of total value of imports
 Lesser the value → greater the degree of openness

4
 OPENNESS OF THE ECONOMY REFERS TO
THREE IMPORTANT FACTORS:
1. Goods market openness: Trade of goods and services across borders
(e.g. Trade of commodities)
1. Capital market openness: Trade of financial assets across countries (only
financial capital not physical capital)
(e.g. Investors choosing between foreign and domestic assets, suppose
foreigner purchasing share of domestic company)
1. Factor market openness: Movement of factors of production across
national boundaries
(e.g. MNCs employing workers from different countries)

5
THE BALANCE OF PAYMENTS
(BOP)
6
THE BALANCE OF PAYMENTS (BOP)
The Balance of Payments (BoP) is a systematic record of all
transactions between the economic units of a country (households &
firms) and the rest of the world.
The BoP of a country is a comprehensive measure/statement of
 all the receipts of a country from rest of the world (RoW) and
 all the payments by the country to the Rest of the world (RoW).

7
THE BALANCE OF PAYMENTS (BOP)
CONTD..

The values are usually expressed

 either in terms of the domestic currency
 or in terms of Internationally/Universally accepted currency like dollars ($)

Classification of BoP:
 Current account (CA)
 Capital Account (KA)

8
RECEIPTS AND PAYMENTS OF A COUNTRY
CAN ARISE IN FOUR WAYS
Balance of
Payments (BoP)

Balance of Current Balance of Capital

Account (CAB) Account (KAB)

Balance of Trade Unilateral

Transfers
(4)Capital Inflow
and Outflow
Trade in Visibles Trade in Invisibles

(1) Export and (2) Export and (3) Gifts and

Import of Goods Import of Services Grants
Note: Obligations as
Repayments
(That is why KA)
Note: No obligations as Repayments
(That is why CA) 9
BALANCE IN CURRENT ACCOUNT
(CAB)
CAB = Total Receipt – Total Payments
= (Receipts from Visible and invisible exports + Unilateral Receipts)
– (Payments for visible and invisible imports + Unilateral Payments)
or, CAB = Balance of Trade + Net Unilateral Transfers
Or, CAB = Value of Exports – Value of Imports + Net Transfers from Abroad
= Net Exports + Net Transfers from Abroad
If CAB > 0
→ the country has current account surplus → favourable balance in CA

If CAB < 0
→ the country has current account deficit → unfavourable balance in CA

If CAB = 0
→ the country has current account balance

10
BALANCE OF TRADE (BOT) AND NET TRANSFER FROM
ABROAD

Net Export is nothing but trade balance

(BoT)
BoT> 0 → Trade Surplus
BoT< 0 → Trade Deficit
BoT= 0 → Trade Balance
If Net Transfer from Abroad > 0
It implies that, foreign residents are transferring
less out of India (e.g. Gifts, Remittances) than
Indians are transferring from abroad.

11
CURRENT ACCOUNT → NO
OBLIGATIONS
Note that, all items in the current account of the BoP have the
characteristics that they do not affect the assets and future liabilities
of the citizens and institutions of the country or it’s government.
These are current receipts and payments without any implications in
the future.

12
BALANCE IN CAPITAL ACCOUNT (KAB)

For Capital Account the transaction gives rise to

future claims such as acquiring foreign assets or
shares in companies located abroad.
Note: Capital account transactions yield interest income for domestic
citizens and shareholders from next period onwards and this constitute a
part of current account transactions
Capital Accounts Balance (KAB)
= Receipt form sale of assets to foreigners
– spending on buying assets from foreigners

13
 BALANCE IN CAPITAL ACCOUNT (KAB)
Balance of Capital
Account (KAB)

A. Capital B. Capital
Receipts Payments

(i) Foreign (ii) External (iii) Recovery of (ii) External

(i) International
Investments Borrowing External Loan Lending
Investment

[1] Foreign Direct [1] Commercial [1] Commercial

Investment (FDI) Borrowing lending

[2] As a form of [2] As a form of

[2] Foreign Portfolio
Aid Aid
Investment (FPI)

[3] In banks as [3] Capital

Fixed Deposits payments by the
banks

14
 A. CAPITAL RECEIPTS: COMPONENTS
i) Foreign Investments
 [1] Foreign Direct Investment (FDI): In this case, the investor has real control over the assets. e.g.
If a foreigner sets up a factory in India or buys and Indian firm or purchases a significant
percentage of shares of and Indian company it is considered as FDI.
 [2] Foreign Portfolio Investment (FPI): Here the investors do not purchase significant share of an
Indian company. e.g. If a foreigner buys less than 10% of the shares of an Indian Company, it is
treated as FPI.
ii) External Borrowing
 [1] Commercial Borrowing: Domestic country may borrow from abroad for commercial purposes
like opening up a factory and the loans taken on the rate of interest.
 [2] As a form of Aid: Domestic company borrowing from abroad in a situation of economic crisis
and the loan is taken on lower rate of interest.
 [3] In banks as Fixed Deposits: Some commercial banks in India are authorized by RBI receive
deposits in foreign currency. It can give fixed deposits in banks and this will also be considered as
investment from foreigners.
iii) Recovery of External Loan: If foreign country pays back the loans which they had taken earlier,
flow of capital increases in the given year.

15
 B. CAPITAL PAYMENTS: COMPONENTS
(i) International Investment: Investment in foreign countries in terms of buying
shares of foreign companies or buying any foreign assets.
(ii) External Lending: It can be of three types (similar to external barriers)
 [1] Commercial Lending: lending for commercial purpose
 [2] As a form of Aid: Lending as a formal aid (to help)
 [3] Capital payments by the banks: when the fixed deposits of the NRI
becomes matured for repayment and they are not renewed

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BALANCE OF PAYMENT (BOP) OF A
COUNTRY

RECEIPTS PAYMENTS
Export of visibles Import of visibles
Export of invisibles Import of invisibles
Unilateral Receipts Unilateral Payments
Capital Receipts Capital Payments

Inflow of foreign currency (credit) Outflow of foreign currency

(Debit)

17
 CAN THERE BE ANY DISEQUILIBRIUM IN THE
BALANCE OF PAYMENT (BOP) OF A COUNTRY?
In the accounting sense, there can not be any disequilibrium in the BoP. Any tendency
towards such inequality will be corrected by accommodating transactions. However in
economic sense, there is no reason to believe there cant be disequilibrium in the BoP.
If receipts from the rest of the world (other than accommodating receipts) falls short of
payments to the RoW (other than accommodating payments), there will be BoP deficit
i.e. If,
receipts from RoW (except accommodating receipts) <payments to the RoW (except
accommodating payments)
→There will be BoP deficit
If Payments to the rest of the world (other than accommodating payments ) falls short of
receipts from the RoW (other than accommodating receipts), there will be BoP Surplus
i.e. If,
receipts from RoW (except accommodating receipts) > payments to the RoW (except
accommodating payments)
→ There will be BoP Surplus

18
 CAN THERE BE ANY DISEQUILIBRIUM IN THE BALANCE
OF PAYMENT (BOP) OF A COUNTRY?
CONTD…
In economic sense, the BoP is in equilibrium only when,
autonomous payments to the RoW = autonomous receipts from RoW.
BoP in equilibrium when,
Total value of Receipts = Total value of payments
→ Balance on CA and KA
Suppose there is imbalance in CA and KA
Imbalance in CA: 1) Surplus
2) Deficit
Imbalance in KA: 1) Surplus
2) Deficit
E.g. CA deficit = 60
KA surplus = 40
BoP Deficit of 20

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 DISEQUILIBRIUM TO EQUILIBRIUM IN BOP OF A
COUNTRY
(IN ECONOMIC SENSE)
Disequilibrium in BoP
of a country

Deficit in BoP a/c Surplus in BoP a/c

Autonomous Receipts Autonomous Receipts are

are less than (<) More than (>)
Autonomous Payments Autonomous Payments

Accommodating Accommodating
Capital Receipts Capital Payments
Equilibrium in BoP of a
country
20
 BoP Deficit
Receipts < Payments
Lack of foreign currencies
→Central Bank buys foreign
exchange from domestic
citizens & in return gives
domestic currencies
→BoP in balance because of
inflow of foreign currencies
→Money Supply rises
BoP Surplus
Receipts > Payments
Excess supply of foreign
currencies
→Central Bank sells foreign
exchange to domestic citizens
& in return takes domestic
currencies
→BoP in balance because of
outflow of foreign currencies
→Money Supply falls
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 BASIC ACCOUNTING RULE OF BOP
Any transaction leading to a net receipt of foreign exchange creates a surplus or credit
in the corresponding account
Any transaction leading to a net payment of foreign exchange creates a deficit or debit
in the corresponding account
If, India’s Export > Import by India
➔Net Export (NX) >0 ➔ current account surplus
If, India’s Export <Import by India
➔Net Export (NX) <0 ➔ current account deficit
If Sales of Bonds to foreigners > Purchase of foreign bonds
(borrowing from abroad) > (lending to foreigners)
➔ Surplus in Capital account (KA) [reason: acquiring foreign currency]
If Sales of Bonds to foreigners < Purchase of foreign bonds
(borrowing from abroad) < (lending to foreigners)
➔ Deficit in Capital account (KA) [reason: foreign currency depletion]
Hence, Surplus in KA → Net Inflow and Deficit in KA → Net Outflow

22
BASIC ACCOUNTING RULE OF BOP CONTD..

When India borrows from abroad to fill up the gap between export and import, it’s current account
deficit is offset by capital account surplus
Repayment of foreign Loan → Deficit (debit) in Capital account
[Reason: it involves payments (outflow) of foreign exchange]
An increase in country’s foreign assets or A decrease in country’s foreign liability → Debit Entry
An increase in foreign asset → is a purchase or import of assets
→ Hence ‘Imports’ in CA or KA carries a –ve (-) sign
→ It is associated with payments to foreigners → Debit
A decrease in country’s foreign assets or An increase in country’s foreign liability → Credit Entry
A decrease in foreign asset → is a sale or export of assets
→ Hence ‘Exports’ in CA or KA carries a +ve (+) sign
→ It is associated with receipts from foreigners → Credit

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 AN IMPORTANT IDENTITY
(BALANCE OF PAYMENT ALWAYS BALANCES)
Asset Trade has two components:
A) Trade among private Citizens (Private capital Account)
B) Purchase and Sale by Central Bank of the country (Official Reserve
Transactions or ORT)
Given this we have,
Current account balance + Capital account balance + ORT = 0
Or, CAB + KAB + ORT =0
Example: Suppose India exports iron ore to Japan.
Any three of the following will take place:-
A) There can be equal amount of import from Japan, such that, KAB=ORT=0;
B) Credit extended by Indian exporter to Japanese importer. → Capital outflow
from India →CAB>0 & KAB<0; ORT=0
C) Official intervention i.e. Japanese importer sells Yen to get INR. → CAB>0,
KAB=0, ORT<0 (RBI holding ‘Yen’, a foreign asset increases)

24
AN IMPORTANT IDENTITY
(BALANCE OF PAYMENT ALWAYS BALANCES)
CONTD..
If importer gets INR by selling Yen to the bank of Japan, even then ORT<0 for India

[since Bank of Japan’s stock of INR decreases and it is a debit component in India’s capital account(KA)]

Alternatively, if we assume that foreign exchange is the only type of foreign asset the central bank is holding,

Note that,

Hence,

Surplus in BoP → increase in FER

→fall in ORT (affects monetary base) → Ms rises through money multiplier

Deficit in BoP → decrease in FER

→rise in ORT (affects monetary base) → Ms falls through money multiplier

25
FOR EACH OF THE FOLLOWING TRANSACTIONS STATE TO WHICH ACCOUNT
(CURRENT/CAPITAL) IN INDIA’S BOP IT BELONGS AND WHETHER IT IS A
SURPLUS (CREDIT) OR DEFICIT (DEBIT) ITEM. (HINT ANSWERS)

1. Purchase of South Korean Camera by an Indian Citizen.

Ans. Import of goods (visible) → Deficit (Debit) in Current account
2. Purchase of share of Indian Company by a German Mutual Fund
Ans. Capital Inflow → Surplus (Credit) in capital Account
3. Govt. of India borrowing from US bank
Ans. Net Capital Inflow →Surplus(Credit) in capital account
4. Export of handmade cotton fabric from India to Australia
Ans. Export of goods → Credit (Surplus) in current account
5. An Indonesian tourist paying in cash for a stay in a hotel in Delhi
Ans. Export of services (Invisible) →Credit (Surplus) in current account
6. An Indian citizen purchases a house in Sao Paolo, Brazil
Ans. Spending on purchase of asset abroad from foreigners
→ Deficit (Debit) in capital account
7. An US investor making a deposit in State Bank of India
Ans. Net Capital Inflow → Surplus (Credit) in Capital account
26
EXCHANGE RATE
27
 EXCHANGE RATE: INTRODUCTION
Domestic Foreign
Currency (INR) Currency ($)
Nominal
Exchange
Rate (75)

Definition: The exchange rate is usually defined as the number of

units of domestic currency required to purchase one unit of
foreign currency
It is the purchase of foreign currency in terms of domestic
currency

28
TYPES OF EXCHANGE RATE: NOMINAL VS.
REAL
Nominal Exchange
Rate
It is the exchange rate of a
currency against any other
currency. i.e. the price of foreign
currency in nominal terms
India’s nominal exchange rate with
respect to USA is the amount of
rupee need to be given
up/sacrificed to get one dollar ($)
Denote Home Price Level (P) &
Foreign price Level P*
NER = RER (P/P*)
Real Exchange Rate
It is designed to measure the rate at which
home goods exchange for foreign goods
rather than the rate at which currencies
themselves can be traded
India’s real exchange rate is the quantity
of domestic goods which needs to be
sacrificed/given up to get one unit of US
goods
Denote Home Price Level (P) & Foreign
price Level P*
RER = NER (P*/P)
29
TYPES OF EXCHANGE RATE: SPOT VS.
FORWARD
Spot Exchange Rate
A spot exchange rate between
two currencies is the rate
applicable for immediate
delivery
A spot exchange rate represents
a contracted price for the
purchase or sale of a commodity,
security, or currency for
immediate delivery and payment
on the spot date, which is
normally one or two business
days after the trade date.
Forward Exchange
A forward exchange rate applies to
agreements forRate
an exchange of two
currencies at an agreed date in future. It is
designed for protection against foreign
exchange risk.
Depending on the security being traded,
forward rates are calculated from the spot
rate and are adjusted for the cost of carry
to determine the future interest rate that
equates the total return of a longer-term
investment with a strategy of rolling over
a shorter-term investment.
30
 DETERMINATION OF EXCHANGE RATE
Exchange Rate
Market

Demand for foreign Supply of Foreign

exchange Exchange

Citizens visiting Foreigners visiting

foreign country domestic country
Outflow
of Inflow of
Foreign Import of Goods Export of Goods and Foreign
Exchange and Services Services Exchange

For purchasing
Foreign Direct
foreign Assets
Investment (FDI) or
(bonds/shares)
Foreign Portfolio
Investment (FPI)

31
 A) DEMAND FOR FOREIGN EXCHANGE
Let, ‘e’ be the exchange rate or price of foreign currency in terms of domestic currency

DEMAND SIDE
Change in ‘e’ Events in Market Impact Relation
Value of Value of Foreign Value of
If ‘e’
Import tourism Investment Demand
increases If ‘e’ increases
increases increases increases (not for
→ Demand →Demand for return) Foreign
→ to buy 1$, →demand for
for import tourism falls →Demand for Exchange
need to pay foreign
falls foreign falls
more INR exchange falls
investment falls
Value of Value of foreign Value of
Demand →-ve relation
If ‘e’ falls import tourism Investment falls
decreases decreases (not return) for
Foreign →Down-ward
→ to buy 1$, →Demand →Demand for →Demand for
sloping
Exchange
need to pay for import tourism foreign
demand curve
increases increases investment rises
less INR
increases 32
 B) SUPPLY OF FOREIGN EXCHANGE
Let, ‘e’ be the exchange rate or price of foreign currency in terms of domestic currency

SUPPLY SIDE
Change in ‘e’ Events in Market Impact Relation
Value of Exports Foreign tourists If ‘e’
from domestic to have to pay less Supply of increases→
If ‘e’ increases
foreign country to visit domestic Foreign supply of
→foreigners
increases spots Exchange foreign
find INR cheaper
→ More tourists rises exchange
will come rises
Value of Exports Foreign tourists
from domestic to have to pay →+ve
Supply of relation
If ‘e’ falls foreign country more to visit Foreign
→foreigners falls domestic spots Exchange →Upward
find INR dearer → Less tourists falls sloping
will come
supply curve
33
 THE DEMAND FOR AND SUPPLY OF FOREIGN
EXCHANGE (NOTE: P AND P* CONSTANT)
When demand and supply of foreign exchange
Exchange equates with each other
Rate (e)
SFE → Capital inflow = capital outflow
In domestic market we consider equilibrium in BoP
If Demand> Supply → BoP Deficit
If Demand< Supply → BoP Surplus
e* E

Here e* optimum or equilibrium exchange rate

and FE* is optimum or equilibrium level of foreign
exchange

DFE

O
FE* Foreign
exchange
(FE)

34
 EXCHANGE RATE SYSTEM
Exchange Rate System

Fixed exchange rate Dirty Float or Managed Flexible exchange rate

system float system

‘e’ fixed institutionally by
the central bank of the
country at a certain level
Dirty float is
a floating exchange rate Gap between demand and
where a country's central supply of foreign exchange
bank occasionally is adjusted by changing the
intervenes to change the ‘e’. Central bank does not
direction or the pace of intervene
change of a country's
currency value

35
 FIXED EXCHANGE RATE SYSTEM
Exchange When supply of foreign exchange shifts
Rate (e) rightward from SFE 1 to SFE 2
SFE 1
SFE 2 E1E2 → Excess supply of foreign
exchange

E1 E2
Here central bank buys this excess amount
e* of foreign exchange to bring equilibrium
(fixed)
back to E1.
Here the exchange rate is kept fixed at e*
by the central bank.
DFE

O
FE1 FE2 Foreign
exchange
(FE)

36
 FLEXIBLE EXCHANGE RATE SYSTEM
Suppose FDI increases
Exchange
Rate (e) When supply of foreign exchange shifts rightward from SFE
1 to SFE 2
SFE 1
SFE 2 Excess supply of foreign exchange
Exchange rate starts adjusting to get back to equilibrium
Here central bank does not intervene
E1
e1 Exchange rate falls from e1 to e2 and equilibrium shifts from
E1 to E2
E2
When the value of ‘e’ falls in the flexible exchange rate
e2 system due to change in market conditions, there is
appreciation of currency.

DFE

O
FE1 FE2 Foreign
exchange
(FE)

37
 DIFFERENCE BETWEEN FIXED AND
FLEXIBLE EXCHANGE RATE SYSTEM
Criteria Fixed Flexible

Definition The central Bank of the When exchange rate is

country fixes the exchange determined purely by the
rate at some value. Market demand and supply forces
forces can not influence without any intervention by
central bank
Determined Central bank Supply and Demand forces
by
Changes in Devaluation (rise in e) and Depreciation (rise in e) and
currency Revaluation (fall in e) Appreciation (fall in e)
price
Speculation Takes place only when there Very common
is rumor about some policy
announcement
Self adjusting Operates through variation in Operates to remove the
Mechanism supply of money, domestic external instability by change 38
 DIFFERENCE BETWEEN DEVALUATION AND
DEPRECIATION
Flexible Fixed
When the value of ‘e’ increases in the
exchange exchange
flexible exchange rate system due to change
rate rate
in market conditions, there is depreciation of
currency.
When the value of ‘e’ falls in the flexible
Increase
Depreciation Devaluation exchange rate system due to change in
in ‘e’
market conditions, there is appreciation of
currency.
When the value of ‘e’ increases in the fixed
Decrease exchange rate system as part of the policy
Appreciation Revaluation
in ‘e’ this is called devaluation of currency.
When the value of ‘e’ falls in the fixed
exchange rate system as part of the policy
this is called revaluation of currency.

39
ISLM WITH FOREIGN TRADE OR
EXTERNAL SECTOR
40
 THE OPEN ECONOMY: IS CURVE & LM
In anCURVE
open economy, Y = C + I +G + NX Or, Y = C + I +G + (X - M)
Net Export Depends on:
a) Income of the country or ‘Y’: If Y rises →People demand more goods and services from
abroad → Hence Import (M) rises → (X-M) falls → -vely affects NX
b)Foreign Income or ‘Yf’: If Yf rises →Foreigners demand more domestic goods → Export or X
rises → (X-M) rises → +vely affects NX
c)Exchange Rate ‘e’: If e rises
→Export (X) rises as foreigners find domestic goods cheaper
→Import (M) falls as domestic citizens find imports expensive
→(X-M) rises or NX rises→ -vely related to NX
Hence we have the equation of IS curve as follows:
Y = C(Y-T) + I(r) + G + NX(Y, Yf , e) ………..(1)
- + -
We have the equation of LM: Ms/P = kY – lr ……….(2)
This model differs from the closed economy ISLM only in terms of NX. Hence equation of IS curve is
different and Lm has it’s usual form
41
 THE OPEN ECONOMY ISLM EQUILIBRIUM
Interest
IS: Y = C(Y-T) + I(r) + G + NX(Y,
Rate (r)
Yf , e)
LM
LM: Ms/P = kY – lr

r*
At E, the equilibrium is achieved, where
E rate of interest is r* and level of income
or output is Y*

IS

O
Y* Income
(Y)

42
 POLICY IMPLICATION IN OPEN ECONOMY
ISLM
[A] (NO CAPITAL[B]FLOW) [C] [D]
Monetary
Fiscal Expansion Rise in Foreign Devaluation
Expansion
(rise in G or fall in T) Income (Yf) (rise in e)
(increase in Ms)
Income (Y) Rises Rises Rises Rises
Rate of
Rises Falls Rises Rises
interest (r)
Net Export
Falls Falls Rises Rises
(NX)

A If Govt. Expenditure rises → AD rises → IS shifts rightward → Y and r rises

When Y rises → M rises → NX falls
B Ms rises → LM shifts rightward → r falls → Y rises → M rises → NX falls
C Yf rises → X rises → NX rises → Rightward shift of IS curve due to autonomous rise in NX
D If e rises →X rises and M falls → NX rises → Rightward shift of IS curve due to rise in NX
→ Y and r rises
43
 THE OPEN ECONOMY WITH
CAPITAL FLOWS
-THE MUNDELL FLEMING MODEL
44
 CASE A: FIXED EXCHANGE RATE AND FISCAL POLICY
When r=r* →there is no capital flow → hence BoP is
Interest in balance. Thus BB line is a horizontal line
Rate (r)
representing balance in BoP.
LM1 LM2
The economy is initially at E1
If G rises, IS shifts rightward from IS1 to IS2 and
r1
domestic Rate of interest r goes up
E1 E2
Since r>r* →Domestic bonds become more rewarding
r= r* BB → there will be massive capital flow into the country
immediately
Since exchange rate is fixed and it cannot change, the
foreign exchange reserve of the country rises and
IS1 IS2 monetary base goes up → leading to an increase in
domestic money supply (Ms)
O Income(Y)
Y1 Y2
 With increase in Ms, LM curve shifts rightward from LM1 to LM2 and domestic rate of
interest r starts falling and will continue to fall until and unless r=r* holds again
 New equilibrium is achieved at E2 where capital flow stops. Initial Fiscal expansion here
leads to an increase in Y in the economy. (Maximum possible expansion)
 Hence, under fixed exchange rate system Fiscal policy is fully effective.
45
DR. DEBANJANA DEY_ST. XAVIER'S COLLEGE (AUTONOMOUS), KOLKATA
 CASE B: FIXED EXCHANGE RATE AND MONETARY
POLICY
Interest When r=r* →there is no capital flow → hence BoP is
Rate (r) in balance. Thus BB line is a horizontal line
LM1 LM2 representing balance in BoP.
The economy is initially at E1
If Ms rises, LM curve shifts rightward from LM1 to LM2
E1 and domestic Rate of interest r falls to r1
r= r* BB Since r<r* →Foreign bonds become more rewarding
→ there will be massive capital outflow from the
r1
country immediately
Since exchange rate is fixed and it cannot change, the
IS foreign exchange reserve of the country falls and
monetary base gets reduced → leading to a reduction
O Income(Y) in domestic money supply (Ms)

 With decrease in Ms, LM curve shifts leftward again from LM2 to LM1 and domestic rate of
interest r starts rising and will continue to rise until and unless r=r* holds again
 Equilibrium gets back to the initial level at E1 where capital flow stops. Initial Monetary
expansion here has no impact on Y in the economy. (Completely ineffective policy)
 Hence, under fixed exchange rate system Monetary policy is fully ineffective.
46
DR. DEBANJANA DEY_ST. XAVIER'S COLLEGE (AUTONOMOUS), KOLKATA
 CASE C: FLEXIBLE EXCHANGE RATE AND FISCAL
POLICY
Interest When r=r* →there is no capital flow → hence BoP is in
Rate (r) balance. Thus BB line is a horizontal line representing
LM1 balance in BoP.
In case of Flexible exchange rate system the central
bank does not intervene in foreign exchange market.
r1
E1 E2 The economy is initially at E1. If G rises, IS shifts
r= r* BB rightward from IS1 to IS2 and domestic Rate of interest r
goes up
Since r>r* →Domestic bonds become more rewarding
→ there will be massive capital flow into the country
immediately
IS1 IS2

O Income(Y)
 Since exchange rate is flexible, increase in supply of foreign exchange, exchange rate (e)
falls or domestic currency appreciates.
 As e falls, NX falls and this leads to leftward shift of the IS curve from IS2 to IS1. The capital
flow & change in e stops and r=r* holds again.
 Fiscal action is completely ineffective to increase Y. This is in sharp contrast with the Fixed
Exchange rate system. Note that, here crowding out occurs through fall in NX induced by fall
in e. 47
DR. DEBANJANA DEY_ST. XAVIER'S COLLEGE (AUTONOMOUS), KOLKATA
 DR. DEBANJANA DEY_ST. XAVIER'S COLLEGE (AUTONOMOUS), KOLKATA

CASE D: FLEXIBLE EXCHANGE RATE AND MONETARY POLICY

Interest When r=r* →there is no capital flow → hence BoP is in
Rate (r) balance. Thus BB line is a horizontal line representing
LM1 LM2 balance in BoP. In case of Flexible exchange rate
system central bank does not intervene in market.
The economy is initially at E1. If Ms rises, LM curve shifts
E1 E2
rightward from LM1 to LM2 and domestic Rate of
r= r*
interest r falls to r1
BB
Since r<r* →Foreign bonds become more rewarding →
r1 there will be massive capital outflow from the country
immediately
Since exchange rate is flexible, increase in supply of
IS1 IS2
foreign exchange, exchange rate (e) rises or domestic
O
currency depreciates.
Income(Y)
Y1 Y2

 As e rises, X rises, M falls and NX rises. and this leads to rightward shift of the IS curve
from IS1 to IS2. The capital flow & change in e stops and r=r* holds again.
 New equilibrium is achieved at E2 where capital flow stops. Initial Monetary expansion
here leads to maximum increase in Y in the economy. (Maximum possible expansion)
 Monetary policy is fully effective. Note that, here monetary policy does not operate 48
through rate of interest. Here it operates through exchange rate and NX.