MAC 11&12

International Linkages

1
 Introduction
• Introducing external sector in the model.
• But before that need to understand the interlinkages
of world economy, which has increased significantly
• National economies are becoming more closely
interrelated
– Economic influences from RoW (U.S.A.) have affects on
the Indian economy
– Economic occurrences and policies in the RoW (U.S.)
affect the Indian economy
When the U.S. moves into a recession, it tends to pull down
other economies: WHY?
When the U.S. is in an expansion, it tends to stimulate other
economies: WHY?
• Economies are linked through two broad
channels
1. Trade in goods and services
• A trade linkage:
 Some of a country’s production is exported to foreign countries  increase
demand for domestically produced goods
 Some goods that are consumed or invested at home are produced abroad
and imported  a leakage from the circular flow of income

2. Finance
• Indian citizens can hold Indian assets OR assets in foreign
countries and vice-versa
 Portfolio managers shop the world for the most attractive yields
 As international investors shift their assets around the world, they link assets
markets here and abroad  affect income, exchange rates, and the ability of
monetary policy to affect interest rates
 The Balance of Payments and Exchange Rates
• Balance of payments: the record of
the transactions of the residents of [Insert Table 12-1 here]
a country with the rest of the world
– Any transaction that gives rise to a
payment by a country’s residents is a
deficit item in that country’s
bop(imports of car, deposit in banks
abroad)
• Two main accounts:
 Current account: records trade
in goods and services, as well as
invisibles.(net investment
income, interests, profits)
[ Note : C.A.B. = Trade Balance +
Net Invisibles ]
 Capital account: records
purchases and sales of assets,
such as stocks, bonds, and land
 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 (foreign exchange) or by borrowing from abroad
– Any current account deficit is of necessity financed by an offsetting capital
inflow
– After incorporating the net capital inflow, what remains (if any) is the BoP
Deficit
– Any BoP Deficit is necessarily financed by a decrease in official foreign
exchange reserves
Overall Balance = Current Account Balance + Capital Account Balance (1)
Overall Balance + Change in Official Foreign Exchange Reserves = 0 (1a)
BoP Deficit = Current Account Deficit - Net Capital Inflow
= Decrease in Official Foreign Exchange Reserves (1b)
Current Account Deficit = Net Capital Inflow + Decrease in Official Foreign Exchange Reserves
(1c)
Current Account Deficit = Net Capital Inflow + ( Errors & Omissions ) +
Decrease in Official Foreign Exchange Reserves
(1d)
 Exchange Rates
• Exchange rate is the price of one currency in terms
of another
– Ex. In august 2022 you could buy 1 USD for Rs 79 in
Indian currency  nominal exchange rate was e = Rs 79/
dollar

• Two different exchange rate systems:

– Fixed exchange rate system
– Floating exchange rate system
 Exchange Rate System
• System being followed in the 19th and 20th centuries -
Gold Standard
• What is Gold Standard?
• The origin of the gold standard dates back to ancient
times when gold coins were a medium of exchange,
unit of account, and store of value
• With industrial revolution the volume of trade
increased, so more convenient means of financing IT
was needed as shipping large quantities of gold and
silver not practical
• To facilitate trade, a system was developed so that
payment could be made in paper currency that could
then be converted to gold on demand at a fixed rate
of exchange
• The gold standard refers to the practice of pegging
currencies to gold and guaranteeing convertibility
– Under the gold standard one U.S. dollar was
defined as equivalent to 23.22 grains of "fine
(pure) gold
• The exchange rate between currencies was based on
the gold par value (the amount of a currency needed
to purchase one ounce of gold)
• $1= 23.22 grains of gold
• 1 oz = 480 grains
• 1oz = 480/ 23.22= $ 20.67
• £1 = 111 grains
• 1 oz = 480/111 = £ 4.25
• £1 = $ 20.67/4.25= $4.87
• All currencies exchange rate worked out
accordingly
 Strength of the Gold Standard
• Strength of the gold standard mechanism for
simultaneously achieving balance-of-trade
equilibrium (when the income a country’s residents
earn from its exports is equal to the money its
residents pay for imports) by all countries
• Suppose Japan has trade surplus with USA , then
what happens- inflation in Japan and cheaper goods
in US- David Hume’s argument
• Many people today believe the world should return
to the gold standard
• Worked fairly well from 1870s until the start of World
War I
• Off gold standard during the war because printing to
finance the war
• US returned to gold standard in 1919, UK in 1925,
France in 1928
• UK maintained the convertibility at 1 oz = £ 4.25 , but
with inflation in UK, goods became uncompetitive
leading to depression
• Countries started converting £ to gold, UK suspended
convertibility in 1931
• US also followed in 1933, but returned soon with 1oz
= $35 (from $20.67)
• Devaluation(£1 = $ 8.24) by US- making exports
cheaper and imports expensive. Output and
employment increased
• Others also followed
• In an effort to encourage exports and domestic
employment, countries started regularly devaluing
their currencies
• Devaluation war. Uncertainty , no one willing to hold
another currency
• Proved self defeating- world trade declined sharply
from more than $ 3000 mn in 1929 to less than
$1000 mn in 1933
• Confidence in the system fell, and people began to
demand gold for their currency putting pressure on
countries' gold reserves, and forcing them to
suspend gold convertibility
• The Gold Standard ended in 1939
 The Bretton Woods System
• New international monetary system designed in
1944 in Bretton Woods, New Hampshire- 44
countries
• Goal : to build economic order to facilitate postwar
economic growth
• Consensus on fixed exchange rate, but wanted to
avoid competitive devaluation
• Bretton Woods Agreement established two
multinational institutions
– International Monetary Fund (IMF) to
maintain order in the international monetary
system
– World Bank to promote general economic
development
 The Bretton Woods System

• Decided for fixed exchange rate, peg currency to gold but no

convertibility, only dollar to gold at $ 35= 1 oz

• Under the Bretton Woods Agreement

– US dollar was the only currency to be convertible to gold,
– Each country to decide its exchange rate vis-à-vis dollar
and then calculate the gold par value of the currency
– To maintain value of their currencies within 1% of the par
value by buying or selling currencies (or gold) as needed-
ex: if dealer selling currency then country to buy the
currency to maintain demand/par value
– devaluations were not to be used for competitive
purposes, unless too weak to defend
– a country could not devalue its currency by more than
10% without IMF approval
 The Collapse of the
Fixed Exchange Rate System

• The collapse of the Bretton Woods system can be

traced to U.S. macroeconomic policy decisions (1965
to 1968)
• During this time, the U.S. financed huge increases in
welfare programs and the Vietnam War by increasing
its money supply which then caused significant
inflation
• The Bretton Woods system relied on an economically
well managed U.S.
• So, when the U.S. began to print money, run high
trade deficits, and experience high inflation, the
system was strained to the breaking point
• Speculation that the dollar would have to be
devalued
• Bretton Woods underlied that $ remained robust through no
trade deficit, speculation, inflation.
• Precisely, these happened- Vietnam war, Johnson’s Great
Society programs (welfare programme) led to high spending
and inflation/Imports exceeded exports
• $ came under speculation of devaluation/ German marc
speculated to be revalued
• Dollar could not be devalued because other countries had to
agree to revalue against dollar , as other currencies pegged
– Many countries not agreeing because their products would
become more expensive relative to US products
• US announced in 1971 that $ no longer convertible to gold
• 10% import tax by US to force other countries to agree to
revalue
– In Dec 71, agreement reached to devalue dollar by about
8% against other currencies
• $ devalued, but more speculation that $ overvalued
• Dealers started converting dollars to other currencies
• Yen and other European currencies started floating against $
• Thought to be temporary, but became permanent
• The Bretton Woods Agreement collapsed in 1973
– Achilles’ heel if $ under speculative attack
– Could work only if US inflation rate low and US did not run
bop deficit
• Free to choose any form of exchange arrangement (except
pegging to gold): float freely, pegging to another currency or a
basket of currencies, adopting currency of another country,
etc
 The Jamaica Agreement
• Following the collapse of the Bretton Woods agreement, a
floating exchange rate regime was formalized in 1976 in Jamaica
• The rules for the international monetary system that were
agreed upon at the meeting are still in place today
• At the Jamaica meeting, the IMF's Articles of Agreement were
revised to reflect the new reality of floating exchange rates
• Under the Jamaican agreement
– floating rates were declared acceptable
– gold was abandoned as a reserve asset, returned to members
at market prices and proceeds placed in trust fund
– total annual IMF quotas - the amount member countries
contribute to the IMF - were increased to $41 billion (today,
this number is $755billion) and 189 countries
– Access to IMF funds by developing countries
 Exchange Rates
• Exchange rate is the price of one currency in
terms of another
– Ex. In august 2022 you could buy 1 USD for Rs 79
in Indian currency  nominal exchange rate was e
= Rs 79 / dollar

• Two different exchange rate systems:

– Fixed exchange rate system
– Floating exchange rate system
• In a fixed exchange rate system central banks (RBI)
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 rupees (dollars) for more than fixed rate since
he knows that he can get them for the fixed rate
No one will sell rupees (dollars) for less than fixed rate since he
knows he can sell them for the fixed rate
• Central banks (RBI) hold reserves to buy/sell when
they have to intervene in the foreign exchange
market
– Intervention: the buying or selling of foreign exchange by
the central bank
• 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. If India were running a current account deficit vis-à-vis
U.S.A., the demand for dollars in exchange for Rupees would
exceed the supply of dollars in exchange for Rupees, the RBI
would sell some dollars, accepting Rupee in return.
®Under a fixed exchange rate, price fixers (i.e., the central
bank) must make up the excess demand or take up the
excess supply.
®Makes it necessary for the central bank to hold an inventory
of foreign currencies that can be provided in exchange for
the domestic currency.
– 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 of
foreign exchange( INDIA IN 1991)
• Will be unable to continue its intervention
• Before this occurs, the central bank will likely devalue the
currency
 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
– Suppose the following ( IF India had a floating exchange rate system) :
Exchange rate of the Rupee against the USD is Rs 79 per dollar
Indian imports from the U.S. increase (say, an exogenous shock )
Indians must pay more dollars to American exporters
Trade Balance in India would deteriorate
Central Bank stands aside and allows the exchange rate to adjust
(depreciate) as demand for dollar increases, and so price of dollar
increases
Exchange rate could increase to, say, Rs 85 per dollar
Indian goods become cheaper in terms of dollars
Demand for Indian goods by Americans increases/imports become
expensive
Indian exports to the U.S. increase
Trade Balance improves
• Clean floating no foreign exchange reserves reqd, because no
intervention by central bank
• Dirty float: central banks intervene to buy and sell in attempts to
influence exchange rate. Most countries, including India follow this
• Direct and Indirect quote:
– Direct: when price of foreign currency(as quantity) in terms of domestic
currency
– Indirect: when domestic currency is quantity and price in terms of foreign
currency
• Depreciation/Appreciation in the flexible exchange rate
• Devaluation/Revaluation as govt policy in fixed exchange rate
system, or otherwise

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 The Exchange Rate in the Long Run
• In the long run, the exchange rate between a pair
of countries is determined by the relative
purchasing power of currency within each country
– 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
ePf is measured
• The relative purchasing power of two currencies
R
by the real exchange rate P
• The real exchange rate, R, is defined as
(2) where Pf and P are the price levels abroad and domestically,
respectively
®If R =1, currencies are at PPP
®If R > 1, goods abroad are more expensive than at home
®If R < 1, goods abroad are cheaper than those at home
 The Exchange Rate in the Long Run
• In long run, exchange rate between pair of countries is
determined by relative purchasing power of currency within
each country
• 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
• The relative purchasing power of two currencies is measured
by the real exchange rate
ePf
• The real exchange rate, R, is defined as
R
P
(3), where Pf
and P are the price levels abroad and domestically,
respectively
 The Exchange Rate in the Long Run
ePf
R
P
• If R =1, currencies are at PPP

• If R > 1, goods abroad are more expensive than at home

• If R < 1, goods abroad are cheaper than those at home

• If basket of goods cost $200 in US, and Rs 20,000 in India then $1 =
Rs 100
• Economist comes out with Big Mac PPP- exchange rate that
hamburgers would be costing the same in each country
• Selling in so many countries with almost same recipe
• In US $ 3.41, in Estonia Kroon 30; at actual exchange rate of $= 11.5,
value of burger $2.61(30/11.5)
• PPP is local price divided by price in US (30/3.41), i.e., 8.8 Kroon
• Comparing actual exchange rate with PPP exchange rate is a test on
whether a currency is undervalued or not
• 8.8/11.5 so Kroon undervalued ( also same result if 2.61/3.41)- by
about 23%
 The Exchange Rate in the Long Run
• Over time :
• If R is rising, then goods abroad are getting relatively more expensive
than at home.
• That is, a rising R (called a RER depreciation) will boost exports from
home, and discourage imports from abroad.
• So, Trade Balance ought to improve.
• Eventually this should either drive up domestic prices or drive down
exchange rate, moving closer to PPP
• If R is declining, then goods abroad are getting relatively cheaper
than at home.
• That is, a declining R (called a RER appreciation) will reduce exports
from home, and encourage imports from abroad.
• Trade Balance would worsen.
• Market forces prevent the exchange rate from moving too
far from PPP, or remaining away from PPP indefinitely
• However, this works slowly. Why?
– Market baskets differ across countries
– Many barriers to movement of goods like transportation costs,
tariffs , actual movement of labor
– Non- traded goods like land
• Best current estimate is that it takes about 4 years to
reduce deviations from PPP by half.
• PPP implies that the exchange rate will fall.

30
 The Exchange Rate in the Long Run
• Figure 13-2 shows the cost of barley in England relative to
that in Holland over a long time period
– Real barley exchange rate tended towards equalization
– However, long time periods of deviation from equality
 The Exchange Rate in the Long Run
• Best estimate for modern times is that it takes about 4 years
to reduce deviations from PPP by half
– PPP holds in the LR, but only one of the determinants of
the exchange rate
Trade in Goods, Market Equilibrium, and the
Balance of Trade
• Need to incorporate foreign trade into the IS-LM model
– Assume the price level is given, and output demanded will be supplied
(flat AS curve)
• With foreign trade, domestic spending no longer solely determines domestic
output  spending on domestic goods determines domestic output

• Spending by domestic residents is DS  C  I  G

• Spending on domestic goods is DS  NX  (C  I  G )  ( X  Q )

 (C  I  G )  NX
• Assume DS depends on the interest rate and income
 Trade in Goods, Market Equilibrium, and
the Balance of Trade
• Need to incorporate foreign trade into the IS-LM model
– Assume the price level is given, and output demanded will be supplied
(flat AS curve)
• With foreign trade, domestic spending no longer solely
determines domestic output  spending on domestic goods
determines domestic output
Spending by domestic residents is AD  C  I  G (3)
 Spending on domestic goods is AD  NX  (C  I  G )  ( X  Q )
 (C  I  G )  NX (4)
Assume ‘AD’ depends on the interest rate and income:
AD  A(Y , i ) (5)
 Net Exports
• Net exports, (X-Q), is the excess of exports over imports
– NX depends on:
domestic income, Y
foreign income, Yf  (6)
 Real Exchange Rate, R 
 NX  X (Y f , R )  Q (Y , R )  NX (Y , Y f , R )


®A rise in foreign income (Yf) improves the home country’s trade
balance and raises home country’s AD
®A real depreciation (i.e., an increase in “R”) by the home country
improves the trade balance and increases AD
®A rise in home income (Y) raises import spending and worsens the
trade balance, decreasing AD
 Goods Market Equilibrium

• Marginal propensity to import = fraction of an extra Rupee of income

spent on imports
– IS curve will be steeper in an open economy compared to a closed
economy(because part of income will be spent on imports, rather
than on domestic goods)
• For a given reduction in interest rates, it takes a smaller
increase in output and income to restore equilibrium in the
goods market
• IS curve now includes NX as a component of AD
IS : Y  A(Y , i)  NX (Y , Y f , R) (7)
– level of competitiveness (measured by R) affects the IS
curve
• A real depreciation (i.e., an increase in “R”) 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 shifts IS to the right
 Goods Market Equilibrium
• Marginal propensity to import = fraction of an extra dollar of
income spent on imports
– 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

• IS curve now includes NX as a component of AD:

IS : Y  DS (Y , i )  NX (Y , Y f , R )

• A real depreciation 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 shifts IS to the right
 Goods Market Equilibrium
• Figure shows the effect of a rise
in foreign income [Insert Figure 12-3 here]
– Higher foreign spending on our
goods raises demand and requires
an increase in output at given
interest rates
• Rightward shift of IS
– Full effect of an increase in foreign
demand is an increase in interest
rates and an increase in domestic
output and employment
• Figure can also be used to show
the impact of a real
depreciation(exports increasing
IS shifting to right: rise in
equilibrium income)
 INCREASE IN INCREASE IN REAL
HOME FOREIGN DEPRECIATION
SPENDING INCOME
INCOME + + +
NET EXPORTS - + +

39
• Since interdependent world, policy changes
affect other countries, and then feedback
– Increase govt spending, imports rises, income
abroad rises, increase demand for our exports,
increase domestic income expansion
• Repercussion effects: US expands, pulls ROW;
similarly China

40
 Capital Mobility
• High degree of integration among financial markets  markets in which
bonds and stocks are traded
– No restrictions on holding assets abroad: implies look for highest return in the
world
• Perfect capital mobility; but in practice constrained by tax differences
across countries, exchange rates changes, uncertainties about capital
outflow
• However, assume perfect capital mobility
– Capital is perfectly mobile internationally when investors can purchase in any
country they choose quickly, with low transaction costs, and in unlimited
amounts
– Under this assumption, asset holders are willing and able to move large amounts
of funds across borders in search of the highest return or lowest borrowing cost
– Implies that interest rates in a particular country can not get too far out of line
with respect to international interest rates without inducing capital
inflows/outflows that bring it back in line with them.
– So because monetary and fiscal policies affect interest rates, any stabilization
policy would not only affect trade balance but also capital account
 The Balance of Payments and Capital Flows
• Assume a home country faces a given price of imports, export
demand, and world interest rate, if (rate of interest in foreign
capital market)
– Additionally, capital flows into the home country when the
interest rate is above the world rate/ flows out when below
• Balance of payments surplus (deficit) is:
BP  NX (Y , Y f , R)  CF (i  i f ) (8)

where CF is the capital account surplus (net capital inflow)

– The trade balance is a function of domestic income, foreign income and
Real Exchange Rate.
– The capital account balance (net capital inflow) depends on the
interest rate differential
An increase in the interest rate above the world level pulls in
capital from abroad, improving the capital account balance.
With increase in income trade balance worsens, but even
tiniest increase in interest rates can lead to capital inflow and
finance the trade deficit.
43
 Mundell-Fleming Model: Perfect Capital Mobility
Under Fixed Exchange Rates
• The Mundell-Fleming model incorporates foreign exchange under perfect capital mobility
into the standard IS-LM framework
– Under perfect capital mobility, the slightest interest differential provokes infinite
capital inflows  central bank cannot conduct an independent monetary policy under
fixed exchange rates (or in a managed floating exchange rate system)
WHY?
Example of Monetary Contraction & How it gets Reversed :
Suppose a country tightens money supply to increase interest rates
– Portfolio holders worldwide shift assets into home country due to higher interest rates
– Due to huge capital inflows, balance of payments shows a large surplus
– The exchange rate appreciates and the central bank must intervene to hold the
exchange rate fixed (i.e., to prevent the exchange rate appreciation)
– The central bank buys foreign currency in exchange for domestic currency
– Intervention causes domestic money stock to increase; initial monetary contraction is
reversed and interest rates drop
– Interest rates continue to drop until they return to levels prevailing prior to initial intervention
– Back to initial interest rates, money stock and Balance of Payments (BoP).
• Tightening of money
• Increased interest rates
• Capital inflows
• Pressure for currency appreciation
• Intervention by buying foreign currency
• Monetary expansion due to intervention lowers interest rates
• Back to initial interest rates, money stock and payments
balance
• So under fixed exchange rates and perfect capital mobility, a
country cannot pursue an independent monetary policy
– Interest rates cannot move out of line with those
prevailing in world market

45
 Monetary Expansion under Fixed Exchange rates and
Perfect Capital Mobility

• Figure 12-5 shows the IS-LM curves in addition to the

BP=0
– BP schedule is horizontal under perfect capital
mobility ( i = if at any other interest rates there [Insert Figure 12-5 here]
will be capital flows )
• Consider a monetary expansion that starts from point
E  shifts LM down and to the right to E’
– At E’ , because of huge capital outflows there is a
large BoP deficit, which creates pressure for the
exchange rate to depreciate.
– Central bank (committed to maintain the fixed
exchange rate) must intervene to prevent
depreciation, selling foreign money, and receiving
domestic money in exchange.
– Supply of money falls, pushing up interest rates as
LM moves back to original position. The economy
never reaches point E’.
– Back to initial interest rates, money stock and BoP.
– That is, the initially intended monetary expansion
has got reversed due to exchange rate
management compulsions.
– Contraction would lead to vast reserve losses,
forcing an expansion of money stock and return
to initial equilibrium.
 Impossible Trinity under Fixed Exchange rates and
Perfect Capital Mobility
• Monetary policy is rendered ineffective due to exchange rate management
compulsions in a system of fixed exchange rates (or managed exchange rates) and
complete capital mobility.
• Alternatively expressed, exchange rate stabilization objective dictates the monetary
policy stance of the Central Bank.
• Monetary policy becomes endogenous to the exchange rate stabilization objectives.
• If, for example, the central bank is attempting to prevent an appreciation of home
exchange rate resulting from, say, a surge in capital inflows, it would be buying
foreign currency from the foreign exchange market.
( Operationally, the central bank’s purchase of foreign exchange is no different from
open market purchases of government securities that it resorts to for increasing
money supply in the economy. )
• This would lead to an increase in money supply even though the central bank, at that
juncture, may be aiming for a tight monetary policy to rein in domestic inflation.
• It follows that, (i) an independent monetary policy, (ii) fixed exchange rate system (or
a managed floating exchange rate system), and (iii) complete capital mobility, cannot
coexist.
• This is known as the “Impossible Trinity”.
 Sterilized Intervention by the Central Bank under
Managed Exchange Rates
• Exchange rate stabilization objective of the central bank in the wake of large capital
inflows leading to appreciation of the exchange rate may conflict with the domestic
anti-inflationary monetary policy.
• This dilemma of the central bank is resolved by conducting what is known as sterilized
foreign exchange intervention.
• In this case, while the central bank buys foreign exchange to prevent appreciation
(which would increase domestic money supply), it also sells government bonds
(which would decrease domestic money supply).
• Exchange rate stabilization objective of the central bank in times of a rapidly
depreciating exchange rate may conflict with the growth facilitation objective of the
central bank.
• This dilemma of the central bank is again resolved by conducting sterilized foreign
exchange intervention of the opposite kind.
• In this case, while the central bank sells foreign exchange to prevent depreciation
(which would decrease domestic money supply), it also buys government bonds
(which would increase domestic money supply).
• Market Stabilisation Scheme (MSS): This instrument for monetary management
was introduced in 2004. Surplus liquidity of a more enduring nature arising from
large capital inflows is absorbed through sale of short-dated government securities
and treasury bills. The mobilised cash is held in a separate government account
with the Reserve Bank.
• Insufficient stock of G-sec and other approved securities in own a/c of RBI limits
effectiveness of OMOs to manage liquidity in event of large inflow of foreign capital
• Operational since 2004; just like OMO; T-bills and dated G-sec are used for
absorbing liquidity, but unlike OMO G-secs not owned by RBI
• Govt issues T-bills and dated securities under MSS in addition to its normal
borrowing requirements for absorbing liquidity ; auctioned by RBI and counts for
SLR, repo/ reverse repo, LAF
• Proceeds from sale of these securities under MSS held by govt in separate MSS a/c
maintained by RBI; amount appropriated only for purpose of redemption and or
buy-back; subsequently also used for meeting govt’s approved expn
• Interest paid from budget
• MSS empowered RBI to absorb liquidity of more enduring but temporary basis,
leaving LAF for daily liquidity management, and OMO for managing liquidity of
enduring nature
 Impossible Trinity and Capital Controls
• 1. If a country wants to have stable exchange rates, it cannot have an
independent monetary policy.
• 2. If a country wants to have an independent monetary policy, it cannot have
stable exchange rates.
• 3. If a country wants to have both stable exchange rates and an independent
monetary policy, it must have capital controls, i.e., impose restrictions on
inflows and outflows of capital.
Thus, on domestic considerations, if the central bank decides to loosen
monetary policy and lower interest rates, capital flight will not take place and
exchange rate will not depreciate, but remain stable.
Conversely, if the central bank decides to tighten monetary policy and hike
interest rates, there would be no surge in capital inflows to destabilize
exchange rates through a rapid appreciation.
• Presently, most countries are , therefore, operating around a system of
managed float, and are in favor of limiting certain types of capital flows.
 Capital Account Convertibility
• How long can capital controls be sustained in an era of rapid capital movements
and high degree financial liberalization ?
• Is full capital account convertibility inevitable ?
• Is India ready for full capital account convertibility ?
• Move towards fuller capital convertibility would necessarily be accompanied by
relaxation of the policy of exchange rate management, that is, a move away
from the managed towards a market-driven exchange rate system.
• Compelling arguments have been made for full capital account convertibility in
India.
• But, for India, potential risks from full convertibility far outweigh the benefits.
• Indeed, by developing country standards, India has done rather well in the
management of capital flows and the exchange rate.
• Full capital account convertibility is not a real possibility in India in the near
future.
 Fiscal Expansion under Fixed Exchange Rates and
Perfect Capital Mobility
• Monetary policy is ineffective, but fiscal expansion under fixed exchange rates
and perfect capital mobility is extremely effective.
– A fiscal expansion shifts the IS curve up and to the right  increases interest
rates and output
– The higher interest rates creates a capital inflow with the tendency to
appreciate the exchange rate
– To manage the exchange rate the central bank must buy foreign currency
with home currency, thus, expanding the money supply at home
 shifting the LM curve to the right thus increasing income further
• Pushes interest rates back to their initial level, hence, output increases yet again

• Equilibrium is restored when the money supply has increased enough to drive
the interest rate back to its original level, i = if
• In this case, with an endogenous money supply, the interest rate is effectively
fixed, and the simple Keynesian multiplier of (income and spending) applies for
a fiscal expansion.
 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 (this assumption is relaxed
later)
• Under a flexible exchange rate system, the central bank does
not intervene in the market for foreign exchange
– 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
must equal zero
– Current account deficit must be financed by private capital
inflows; surplus by outflows
– The central bank can set the money supply at will since there is
no obligation to intervene  no automatic link between BoP
and money supply
 Perfect Capital Mobility and Flexible Exchange Rates

• Perfect capital mobility implies

that the balance of payments
balances when i = if (9) [Insert Figure 12-6 here]
• IS : Y  A(Y , i)  NX (Y , Y f , R)
– A real appreciation means home
goods are relatively more
expensive, and IS shifts to the left
– A depreciation makes home
goods relatively cheaper, and IS
shifts to the right
• The arrows in Figure make the
link between the interest rate
and AD
– When i > if, home currency
appreciates
– When i < if, home currency
depreciates
Adjustment subsequent to a Real Disturbance or
an Expansionary Fiscal Policy (EFP)
[Insert Figure 12-7 here]
• Suppose exports increase
or
• ‘G’ is increased (EFP):
 At a given output level, interest rate,
and exchange rate, there is an
excess demand for goods
 IS shifts to the right and goods
market and money market clear
 The new (temporary) equilibrium, E’,
corresponds to a higher income
level and interest rate
 But the economy can be positioned
only temporarily at E’ since BoP is in
disequilibrium  exchange rate
appreciation will push the economy
back to E
 Point E’ will not be reached
• Increase foreign demand: output and income increase, money demand will
increase, interest rates rise( more than international rates)
• Capital inflows, pressure on exchange rate, currency appreciates
• Import prices fall and domestic goods become expensive
• Demand shifts away from domestic goods, net exports decline, IS curve
shifts back
• Exchange rate will keep on appreciating as long as interest rate exceeds
world level
• Will continue until return to point E
• Net exports back to original level( in case of increase in exports: IS)
• Exchange rate will appreciate
• Imports will rise and initial expansion in exports is offset by appreciation of
exchange rate

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 Adjustment subsequent to a Real Disturbance or
an Expansionary Fiscal Policy (EFP)
• One can show how various changes
affect the output level, interest rate, and
exchange rate
[Insert Figure 12-7 here]
• Suppose there is a fiscal expansion(tax
cut or increase in govt spending):
 Same result as with increase in
exports  tendency for demand to
increase is halted by exchange rate
appreciation
Real disturbances to demand or
an EFP (Expansionary Fiscal
Policy) do
not affect equilibrium output
under flexible exchange rates
with capital mobility.
That is, there is complete Note that crowding out over here takes place
crowding out due to exchange not because higher interest rates reduce
investment as in a closed economy, but
rate appreciation. (whereas in because the exchange rate appreciation
case of fixed exchange rate highly reduces net exports.

effective)
 Adjustment to a Change in the Money Stock
• Suppose there is an increase in the
nominal money supply:
 The real stock of money, M/P, increases
since P is fixed
[Insert Figure 12-8 here]
 At E there will be an excess supply of real
money balances
 To restore equilibrium, interest rates will
have to fall  LM shifts to the right
 At point E’, goods and money markets are
in equilibrium, but i is below the world
level  capital outflows depreciate the
exchange rate
 Import prices increase, domestic goods
become more competitive, and demand
for home goods expands
 IS shifts right and continues doing so until
depreciation has raised demand and
output to E”, where i = if
 Goods and money market are now in
equilibrium compatible with world rate of
interest.
 Adjustment to a Change in the Money Stock
• So increase in the nominal money
supply:
 Result: A monetary expansion
leads to an increase in output [Insert Figure 12-8 here]
and a depreciation of the
exchange rate under flexible
exchange rates.

Under a fixed exchange rate system,

the central bank
cannot control the nominal money
stock. Any increase leads to reversal
Under a flexible exchange rate system,
the central bank does not intervene;
can control the nominal money stock,
and that is a key aspect of the
floating exchange
rate system.
• A fiscal expansion will raise world’s output through imports, whereas a
monetary expansion will reduce output abroad through currency
depreciation.
• Depreciation induced change in trade balance, or for raising demand
domestically is called beggar-thy-neighbour policy
• It is a way of exporting unemployment abroad, or creating domestic
employment at the expense of ROW. Practised during great depression
with disastrous results
• Implication, useful when countries are in different stages of business cycle:
one in boom and the other in recession
• If business cycles are highly synchronised such as in 1930s or in post oil
shock of 1973, then this policy can only allocate given world demand
amongst countries instead of raising world demand.
• Will lead to competitive depreciation
• Coordinated monetary and fiscal policies rather than depreciation would
be needed to increase demand and output in each country when
worldwide aggregate demand is at the wrong level.
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