CHAPTER 4: AGGREGATE DEMAND IN AN OPEN ECONOMY

4.1. Introduction

In Chapter 3, we assumed that countries are self-sufficient and thus policies or market driven changes in
aggregate economic variables in country A will not have any effect on other economies or vise versa. In
the real world situation, countries are not self sufficient in everything. Countries trade each other and
this is made possible by opening up their economies to economic actors of the rest of the world. Open
economy is the one, which makes trade in goods and services (exports and imports) and also involves in
global capital and labour markets.

1. Goods Market (Foreign trade): Goods and services are imported and exported. Countries
often use trade restriction policies to maximize their net gain from trade (net export) from
trade. For instance, they put on customs (tariffs) on imported goods. Customs are indirect taxes
imposed on imported goods to increase their prices relative to domestically produced goods.
They also use quotas or rationing to limit quantities of (certain) imported goods.

2. Financial Market (Capital Mobility): Bonds, shares and other securities are bought by non-
residents; then interest and dividends are paid to non-resident or foreigners in return. Opening
up financial market to the rest of the world enables to have capital mobility seeking for a better
return.

3. Labour Market: Open economy assumes also that mobility of labour across countries.
International wage differentials cause migration. Inward migration is called immigration; arising
because of offering higher opportunities. On the contrary, emigration is an outward migration
seeking for high wages or opportunities elsewhere (outside the country).

Given a change in assumption on how the economy works, the closed economy model would no longer
be valid.

Countries have different currencies as a medium of exchange, unit of account and store of value. It is
often difficult to use own currencies to buy goods from the rest of the world for a small country. There
must be a market for currencies to convert a currency of one country to the currency of another. This
is called foreign (currency) exchange market. Thus, foreign exchange market facilitates global movement
of goods, labour and capital. Countries may either make surplus or deficit in the international trade. This
new situation is likely to change the overall equilibrium condition of the economy. Thus, this chapter
attempts to explore the overall equilibrium conditions of an open economy taking into account the
balance of payment equation within the framework of IS-LM. Before that, we discuss major concepts in
an open economy model.

4.2. Exchange Rate

Nominal Exchange Rate (E): It is the price of one currency in terms of another currency. It can be
the price of US Dollars in terms of a local currency (Birr) as:

4.1. NER  xBirr / USD

where x is the amount of Birr and USD is the foreign currency. If NER declines, the domestic currency
Birr becomes stronger and if NER rises, the local currency becomes stronger. Note however that

1
exchange rate can also be written as the amount of USD per unit of local currency. It is the way, how
one wants to see. Of one inverts e, he/she would get the amount of foreign currency (USD) in terms of
per unit of local currency (Birr). In some text books, exchange rate is taken as the amount of foreign
currency per unit of local currency. Not to be confused, one has to be curious how the given exchange
rate is defined.

Real Exchange Rate: Real Exchange Rate (RER) has a more vital economic meaning than nominal
exchange rate. RER of a given country measures its competitiveness in the international market or
gauges the price of that country’s goods relative to the prices of other countries. It is given by:

ePW
4.2. RER  d
P
where Pw is foreign (world market) price level, Pd is domestic price level and e is the price of the foreign
currency (for instance, USD) in terms of local currency (for instance, Birr). Both prices are expressed in
domestic currency. To know whether Ethiopian goods become relatively cheaper or more expensive
than foreign goods, we need to assess the relative price levels or compare the price of our goods vis-à-
vis the price of other countries expressed in our own currency. A change in RER occurs if nominal
exchange rate, foreign prices or domestic prices change or a combination of these three changes occur.
In other words, it is given as:

4.3. RER  e  PW  P d

If RER increases, this may imply that e has increased, price of foreign goods has increased or the price of
local goods has declined. If this is the case, then similar goods aboard are more expensive than in the
domestic market. This situation improves the Ethiopian competitiveness in the international market and
thus people could flock into the domestic market to buy goods at cheaper prices. If RER declines, the
possible cause could be a decline in the nominal exchange rate, a fall in foreign prices or a rise in
domestic prices. This situation makes the country to lose its international competitiveness status and
push foreigners to shy away from the Ethiopian market and buy goods and services elsewhere. Ethiopian
consumers would also opt to boost imports as a substitute for local goods for the same reason.

Fixed Exchange Rate versus Flexible Exchange Rate

Fixed Exchange Rate: In this system, the nominal exchange rate is unilaterally determined by the
government or central bank. Government may want to offer higher amount of local currency per one
unit to buy foreign currencies. This process makes the local currency cheaper in terms of foreign
currencies. The process of increasing the prices of foreign currencies in terms of local currencies by
government action or policy is called devaluation. This policy enables foreigners to pay less of their
currencies to buy the same amount of local currencies than the situation before devaluation. On the
contrary, if central bank decides to offer lesser amount of local currency to buy the same amount of
foreign currency than before, then the local currency would become more expensive than before. The
process of making the local currency more expensive than it used to be by government action is called
revaluation of the local currency.

Central bank devalues local currency to increase the nominal exchange rate (e) and real exchange rate
devaluation (RER) with the aim of making the local goods cheaper as compared to foreign goods.
Devaluation makes exports cheaper and imports expensive or it encourages exports and discourages

2
imports. If exporters are motivated to increase their exports and imports are reduced. The net effect
could be a positive trade balance (surplus). Thus, fixed exchange rate is used as a trade policy
instrument. Central Bank needs to accumulate foreign exchange reserves to maintain its exchange rate
to be constant or fixed. Whenever the demand for foreign currencies increases, government or central
bank needs to supply the required foreign currencies to maintain the exchange rate fixed. If, however, a
country persistently runs the balance of payments deficits, the central bank would eventually run out of
its foreign exchange reserves and would be unable to continue its intervention. This situation may push
the Central Bank to devalue the local currency.

Flexible exchange rate, sometimes called floating exchange rate, flexible exchange rate is a system,
whereby the relative price of currencies (one currency in terms of another currency) is determined by
the market. In other words, the supply and the demand for foreign currencies vis-à-vis the local
currency determine the exchange rates. In the process, central bank does not impose any intervention.
When nominal exchange rate increases in this system (when the amount of Birr that is needed to buy
one USD increases), then we say our currency has depreciated. Thus, the process of losing the value of
local currency in terms of foreign currency is called depreciation. RER depreciates if nominal exchange
rate depreciates (or nominal exchange rate increases) or foreign prices increase or domestic prices
decline.

On the contrary, if nominal exchange rate declines (the amount of currency required to buy one USD
declines), we say the local currency is appreciated. Thus, the process of swelling the value of local
currency in terms of foreign currency in a floating exchange rate system is called appreciation. As said
above, the market is the one that determines whether there is depreciation or appreciation of
currencies; not government policies. If, for instance, there is balance of payment surplus, the economy
would accumulate foreign currencies; which could be eliminated by nominal exchange rate appreciation.
On the other hand, balance of payment deficit will be addressed through depreciation and thus boosting
of net exports. Thus, disequilibrium in the balance of payment (deficit or surplus) is self correcting,
through flexible exchange rate.

Fixed exchange rate and floating exchange rates are the two extreme decisions of government.
Literature calls clean floating exchange rate if central bank stands aside completely and allow
exchange rates completely determined freely in the exchange market. In a clean floating exchange rate,
the official foreign exchange reserve is zero and the balance of payment is also zero. The market adjusts
the sum of the CAB and CapAB to be zero despite having individually having non-zero balances. In
practice, however, there is clean floating. Central banks often intervene although the degree of
intervention may vary from one country to another. The presence of Central Bank intervention within
the floating exchange rate market is called managed or dirty floating exchange rate. The case in point is
the Ethiopian foreign exchange system.

Purchasing power parity: If domestic and foreign markets are closely integrated and commodities are
traded freely, then the same good could not be sold for different prices in different but integrated
countries. In other words, the law of one price requires that the price in country A and country B
should be the same (if expressed in a common currency) because of no-trade barriers between the two
countries. This law is called purchasing power parity (PPP). PPP states that if international arbitrage is
possible, then a currency must have the same purchasing power in every country. Arbitrage is the
process that ensures that the law of one price holds.

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4.3. Current Account and Capital Account

The transactions of goods and services with the rest of the world are recorded by the authorized
government agencies. These overall records of the different transactions of the residents of a country
with the rest of the world is called balance of payments. Balance of payments has two main accounts:
the capital account and the current account.

Capital Account: The capital account records purchases and sales of assets, such as stocks, bonds, and
land. Transactions into domestic currency or paying foreign currencies to acquire local financial assets
lead to capital inflows. On the contrary, investments of locals on financial assets in other countries
require conversion of local currency into foreign currency; which entails to capital outflows. When own
receipts from the sale of stocks, bonds, land, bank deposits and other assets exceed payments for our
own purchases of foreign assets, then the country will have a capital account surplus, also called (positive)
net capital inflow. If the situation is on the contrary, then the country will face capital account deficit.
These movements of funds into and outside of the country are motivated by asset market
considerations. Capital flows into the domestic financial market if holding domestic money and financial
assets are more attractive or pay higher return than foreign financial assets. Whether the domestic
money and financial assets are more attractive or not can be assessed by the differential between
domestic and foreign interest rates. Funds flow into the country, if there is higher return in this country
than the source of funds elsewhere or when local interest rate is higher than foreign interest rate.

Current Account: The current account records trade in goods and service, as well as transfer
payments. The current account is said to be in surplus if receipts from trade in goods and services or
value of exports plus net transfers to foreigners exceed the payments made on imports. Otherwise, it is
said to be current account deficit.

4.4. Extension of the Basic IS-LM Model

Because of international trade, GDP in the open economy differs from the closed economy. Net exports
(which are injections into the economy, as they tend to boost planned aggregate spending) and imports
(which are leakages which reduce planned aggregate spending on the economy) are added on the
planned expenditure or aggregate demand.

Thus, we have

4.4. GDP  C  I  G  X  M ,

where GDP, C and I as usual represent Gross Domestic Product, consumption and private domestic
investment respectively. X stands for receipts from exports and M stands for payments on imports. At
equilibrium in the product market, we have

4.5. Y  C  I  G  X  M

If we rearrange Equation 4.5, we get net export, which is the difference between total income or GDP
less domestic spending (consumption, private investment and government expenditure).

4.6. (X  M )  Y  C  I  G

where C  C0  c1 (Y  T ) ;

4
 I I ; GG

Equation (4.6) indicates that the economy is in equilibrium where domestic balance
[Y  C  I  G ] equals to external balance or net export [ X  M ] at Y and NX . This equilibrium
situation is depicted at point E on Figure 4.1. To the left of E, aggregate domestic spending is higher than
net export; this leads to negative trade balance. Points to the right of E show income exceeding
expenditure on domestic goods and thus leads to trade surplus.

Fig 4.1: The Equilibrium Condition of an Open Economy

Y-(C+I+G), NX(Y)

Y-(C+I+G)

NX
NX (Y )

Y
Y
Y
If NX>0, it implies that output exceeds domestic spending, and thus the country is net exporter. If net
export is negative, then output falls short of domestic spending and hence the country is net importer.

Net domestic spending Y  ( C  I  G ) curve is positively slopped and net export curve is negatively
sloped with the respective slops given in the following equations.

d [Y  C0  c1 (Y  T )  I  G ]
4.7.  1  c1
dY
d [ X  M  mY ]
4.8.  m
dY

As we have discussed in Chapter 3, from the income side, aggregate income of households is composed
of three parts; consumption, saving and taxes.

4.9. Y  C  S  T

On the expenditure side, we have

At equilibrium, Y in Equation 4.5 equals Y in Equation 4.9. Thus,

4.10 Y  C  S T  C  I G  X  M

From Equation (4.10), we get

4.11. S  T  I  G  X  M

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Equation 4.11 indicates that private saving and tax revenue finances private investment spending,
government expenditure respectively to have net exports equals zero or there is current account
balance.

4.12 ( X  M )  ( S  I )  (T  G )

Equation (4.12) is an identity showing that net export ( X  M ) equals net private saving ( S  I ) plus
net government saving (government budget balance = T- G). Current account surplus or deficit can be
interpreted either way. If there is current account deficit, one may say that because of excess payments
made on importation of goods and services over and above our export receipts, private saving falls
short of financing private investment and/or government revenue has not been able to finance
government spending. On the other hand, one may also say that inability of private saving to finance
private domestic investment and/or inability of government tax collection to finance government
spending exposes the country into current account deficit. This could be because of payments made on
imports that exceed export receipts.

Net exports or current account balance could also be written as:

4.13. ( X  M )  S  (T  G )  I or CAB  GDS  I

where GDS  S  (T  G ) . Equation 4.13, indicates that if the country is unable to finance investment
from its own sources ( GDS  I  0 ), it implies that it has depended on foreign sources; in terms of
importing goods and services exceeding its export receipts (or X  M  0 ). Equation (4.13) is written
in another way as:

4.14. I  S  [T  G ]  [ X  M ]

Equation (4.15) indicates that private investment spending is determined by (a) private saving (S),
government budget balance ( T  G ) or net export balance ( X  M  0) . One of the following
scenarios could happen.

a) If we have balanced government budget ( T  G  0 ) and zero current account

balance ( X  M  0) , then domestic private saving finances domestic private investment.
b) If we have balanced government budget ( T  G  0 ) but ( X  M )  0 , then private investment
depends on private saving and net exports. If the country has private savings exceeding its
private investment ( S  I ), then it implies that the country has a positive net exports or
NX  0 or the country is a net lender.
c) If S  I and T  G  0 , then the country’s import bill is more than its export revenue; thus part
of the private investment is financed by foreign money.
d) If we have (T  G )  0 and ( X  M )  0 , the effect on private investment depends on the size
and direction of the government and foreign balance. If the effect of (T  G )  0 , it shows that
there could be private investment crowding out.

Considering now net export in the conventional model we had in Chapter 3, we will have the
following identities. We assume that prices and nominal exchange rate are assumed constant.

4.15. Y  C  I  G  X  M

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 4.16. C  C0  c1 (Y  tY )
4.17. I  I 0  br
4.18. M  M  mY

Equations 4.16 and 4.17 have similar interpretation or definitions as in Chapter 3. Equation 4.15 is an
equilibrium condition in the product market in an open economy setting. Equation 4.18 is import
function, where M is autonomous imports (the amount of expenditure on imports that the country
incurs even when current income equals zero) and m is marginal propensity to import or the
proportion of income that is spent on import purchases.

dM
4.19. m
dY

Inserting 4.16, 4.17 and 4.18 into 4.15, equilibrium level of income will be given by Equations (4.20)
and Equation (4.21).

4.20. Y  C0  c1 (Y  tY )  I  br  G  X  M  mY

A X M b
4.21. Y *   r
1  c1 (1  t )  m 1  c1 (1  t )  m

The effect of a one unit change in interest rate will bring the following level of income or output.
dY b
4.22 
dr 1  c1 (1  t )  m

The slope of IS curve is given by:

dr 1  c1 (1  t )  m
4.23 
dY b

Government spending multiplier: Given Equation 4.21, government multiplier is given by:
dY 1
4.24 
dG 1  c1 (1  t )  m

The open market government expenditure multiplier is lower than the closed market government
expenditure multipliers (or 1 1  c1 (1  t )  m  1 1  c1 (1  t )  1 /(1  c1 ) . The reason is simple.
When we increase government spending, income increases; but part of the income will be spent on
imports. The money spent on imports does not have a positive effect on domestic planned
expenditure. Imports are considered as leakages just like saving. An increase in import in the
domestic market will lead to an increase in foreign income. The increase in foreign income may
increase the demand for their imports; which could possibly raise the demand for our exports by
the same. This may end-up with an income expansionary effect in the local economy in the long-run.
However, in the short-run perspective, increased in imports has a contractionary effect on income
and that is the main reason as to why the new multiplier has a lower effect on income than the case
in a closed economy.

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 What is the multiplier for autonomous private investment spending? Change in autonomous
private investment spending has a similar multiplier as the change in government spending.
dY 1
4.25 
dI 1  c1 (1  t )  m

What is the multiplier for export?

dY 1
4.26 
dX 1  c1 (1  t )  m

The export multiplier is similar to government spending and autonomous private investment. Similarly,
change in autonomous consumption spending has a similar effect as government spending, private
investment spending and exports.

The multiplier for government transfer: If government transfer is in the model, the multiplier would
be given by:

dY c1
4.27 
dR 1  c1 (1  t )  m

What determine the new multipliers? The higher the marginal propensity to import and the higher
propensity to save, 1  c1 (1  t ) , the lower the multiplier. As indicated before, saving and imports are
leakages. The higher marginal propensity to save and the lower the tax rate, the higher the multiplier
would be.

Current Account Multiplier: Policy variables or autonomous spending that change income are likely to
change current account balance. Current account balance (CAB) is given by:

4.28 CAB  X  M  mY

Total change in CAB because of its components is given by:

4.28. d [CAB ]  dX  dM  mdY or
m
4.29. d [CAB ]  dX  dM  [dC0  dI  dG  dX  dM ]
1  c1 (1  t )  m

Given Equation 4.29, the multiplier for government spending on current account balance (CAB) is given
by:

d [CAB ] m
4.30.  <0
dG 1  c1 (1  t )  m

Increase in government spending leads to a deterioration of current account balance by the multiplier as
indicated in Equation 4.31 times the change in government spending.

What is the transmission mechanism as to how an increase in government spending deteriorates current
account balance? When government spending increases, it stimulates AD and thus increases equilibrium
level of income. However as income increases, import will increase by the propensity to import (m)

8
times change in income ( Y ). However, export remains constant as it is not related with income. Thus,
the net effect of government spending on CAB is given by

d [CAB ] m
4.31.  dG 
1  c1 (1  t )  m

The multiplier for export on current account balance is given by:

d [CAB ] m 1  c1 (1  t )
4.32. 1  0
dX 1  c1 (1  t )  m 1  c1 (1  t )  m

According to Equation (4.32), an increase in export boosts income by the multiplier as indicated
Equation (4.26) times the change in export ( dX ). However, part of the increased in income due to the
increase in exports is spent on import purchases; which partly offsets the increase in exports. Thus,
export multiplier for CAB takes into account both positive effect (the effect of change in export) and
the negative effect (the increase in imports due to increase in income). Thus, the export multiplier in the
1  c1 (1  t )
CAB is 0   1.
1  c1 (1  t )  m

4.5. The Mundell-Fleming Model

4.5.1. Introduction

Let us consider a simple world economy, where taxes are similar everywhere across countries and
foreign asset holders never face political risks such as nationalization, restrictions on transfer of assets,
default risk by foreign governments, etc). Capital flows from one country to the other without
restrictions. Under this situation, asset holders will pick the asset that has the highest return. We
further assume that capital is perfectly mobile internationally when investors purchase assets in any
country. They choose quickly without delays, with low transaction costs and in unlimited amount. The
analysis that extends the IS-LM model to an open economy and perfect capital mobility is called Mundell-
Fleming Model. The model has different equilibrium outcomes depending on the nature of the exchange
rate regime: fixed exchange rate and floating exchange rate.

Before we introduce the Mundell-Fleming model, let us once again show the mathematical
representations of current account and capital account as the two major components of balance of
payment. Current account is defined earlier on as ( X  M )  X  M  mY . Capital account is a
function of interest rate differential between domestic interest rate and interest rate prevailing in the
rest of the world:

4.33. CapAC  K   ( r d  r * )

where r d is domestic interest rate; r * is international interest rate. Now, it is possible to write Balance
of Payment (BP) as:
4.34. BP  X  M  mY  K   ( r d  r * )

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If we assume that BP  0 (no surplus, no deficit), we can derive the interest rate differential equation as
follows:
1
4.35 r d  r *    X  M  mY  K
 
In an open economy framework, the following adjustments are made in the IS-LM framework. The LM
equation in open economy is the same as the LM equation in closed economy. The IS equation is
modified and BP equation is introduced. Thus, we have the following system of equations.

A X M b
4.36 IS : Y   r
1  c1 (1  t )  m 1  c1 (1  t )  m
1

4.37 LM : r  kY  M / P
h

1
4.38 BP: r d  r *    X  M  mY  K
 

The position and slope of the IS and the LM curves are as usual except that the slope of the IS curve this
time depends also on the marginal propensity to import (m). Equation 4.38 is the BP schedule or curve;
whose slope is given by:

dr m
4.39   
dY  

The slope of the BP curve depends on m and  .  measures the sensitivity of capital to changes in
interest rate differential between home and the rest of the world. More specifically, it measures how
much would a one percent change in interest rate differential brings a change in the amount of capital
flows in or out. With interest rate on the vertical axis and income on the horizontal axis, there could be
four possibilities given m:

a.   0 ; the slope of the curve tends to be infinity and the BP curve becomes vertical. This
implies that there is no correlation between interest rate differential and capital mobility.
b. If  is small; the BP curve is steep and there is less capital mobility.
c.    the slope of the curve approaches to zero and thus the BP is horizontal. There is
perfect capital mobility.
d. If  is large; the slope of the BP curve is very low or tends to line near to the ground. Thus,
capital mobility is very sensitive to interest rate differential.
r r r
r Fig 4.2b Fig 4.2d
Fig 4.2a
Fig 4.2c

BP BP
BP

Y Y Y

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4.5.2. The Mundell-Fleming Model: Perfect Capital Mobility under Fixed Exchange Rates

Monetary Policy Measure: Under perfect capital mobility, the slightest interest differential provokes
infinite capital inflows. Central banks cannot bring real effects by conducting monetary policy under fixed
exchange rate. To observe the effect of monetary policy, let us consider a country that wants to raise
interest rate. Central bank tightens the monetary policy that results a shift from to the LM curve to LM2
in Figure 4.3. This leads to a higher domestic interest rate. Because of the assumption of perfect capital
mobility, asset holders worldwide will shift their wealth to take advantage of the new increase in interest
rate. Subsequently, capital will flow in which causes capital account and balance of payment surplus. As
foreigners try to buy domestic assets, exchange rate tens to appreciate. However, government has to
intervene to make the exchange rate constant or fixed. The intervention is made through the purchase
of foreign money or currency in exchange for domestic money. As government pumps domestic money
to buy the foreign currency, money stock will increase. This process results a shift in the LM curve
towards LM3 and reduces domestic interest rate. This will cause capital outflow and depletion of foreign
reserves and also the balance of payment surplus. A monetary expansion that causes interest rates cut
as seen at point E’ tends to cause the local currency to lose its value or deprecation. Since the exchange
rate is determined by government action, monetary authorities will sell foreign currencies and buy
domestic currencies until the LM curve goes back to the initial position. The process ends when the
home interest rate is pushed back to the initial level. This whole process brings back to the initial
equilibrium condition. Thus, under fixed exchange rates and perfect capital mobility, a country cannot
pursue monetary policy to bring tangible effect on the economy. Domestic interest rate cannot continue
deviate out of those prevailing in the world market. This process is shown in Figure 4.3 below. One
could observe a similar final outcome if government starts with monetary expansion instead of monetary
tightening.

Figure 4.3: The Effect of Monetary Expansion under Fixed Exchange Rate and Perfect Capital Mobility

LM2

r LM1
LM3

E
BP = 0
rd  r f
E’
IS
Y
Y
Fiscal Policy Measure: Fiscal expansion under fixed exchange rates with perfect mobility is extremely
effective. Assuming the money supply is constant, a fiscal expansion moves the IS curve up and to the
right (IS1 to IS2 in Figure 4.4. below). This will have an effect to increase both interest rate and output.
Higher interest rate increases the capital inflow that would lead, if unchecked, to an appreciation of the
local currency. To maintain the exchange rate constant, the central bank expands the money supply.
Thus, LM curve shifts from LM1 to LM2 in Figure 4.4 below. A new equilibrium is restored with the
original domestic interest rate equals world interest rate as sufficient money stock is pumped into the
economy. In fixed exchange rates, endogenous money supply brings back the original equilibrium level of
interest rate (thus makes interest rate fixed) but with a higher level of income. Thus, the fiscal expansion
under perfect mobility of capital and endogenous money supply ensures a perfectly fixed interest rate

11
and thus there will not be private investment crowding out. Output changes with fiscal policy changes
(such as government expenditure) times the simple Kenyesian multiplier of the type we had before with
no role in interest rate to affect private investment.

Figure 4.4: The Effect of Monetary Expansion

r LM1 LM2

LM

IS2
IS1
Y
4.5.3. The Mundell-Fleming Model: Perfect Capital Mobility under Flexible Exchange Rates

Assume that domestic prices are fixed. Under fully flexible exchange rates, the central bank does not
intervene in the foreign exchange market. The demand for and the supply of foreign exchange will
balance. Balance of payments always equals zero. The exchange rate must adjust to clear the market
without government intervention. If there is current account deficit, it will be financed by private capital
inflows. On the other hand, a current account surplus would be counter balanced by capital outflows.
Exchange rate movements by market forces adjust exchange rates that ensure the sum of the current
account and capital accounts to be zero. Under flexible exchange rate, there is a link between the
balance of payments and the money supply. In perfect capital mobility assumption, BP is always zero
at i d  i f . In any other interest rate, BP is not zero. Non-zero BP is always short-lived; it will adjust
automatically.

Figure 4.5: The Effect of Exchange Rates on AD

r
Appreciation

BP = 0
d f
i i
Depreciation
IS
Y

If domestic interests ( i d ) fall below the global interest rate ( i f ), there will be capital outflows. This will
lead to exchange rate depreciation; which in turn increases competiveness in the international market.
This situation would raise the demand for our goods and services in the international market. Net
export increases and shifts the IS curve towards the right. On the other hand, if i f  i d , there will be
capital inflow; which leads to currency appreciation. Currency appreciation is associated with loss of
competitiveness and thus a decline in the demand for exportable goods. This will lead into inward shift
in the IS curve. With foreign exchange rate flexibility, let us see what will happen as a result of change in
some exogenous shocks on equilibrium level of income.

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The Effect of Increased Demand for Export Goods: Given the initial interest rate, exchange rate and
output level, an increase in the demand for exports exceeding the supply shifts the IS schedule to the
right from IS1 to IS2 in Figure 4.6. This leads to a new equilibrium at E*, where domestic interest rate
exceeds the international interest rate. Increased export performances creates BP surplus and leads to
currency appreciation and a fall in the competitiveness status of the country. The IS curve will go back
to its initial equilibrium position step by step as a result of currency appreciation. This process continues
until the initial equilibrium is restored at E. The above process clearly shows that increased exports and
fiscal expansions do not change equilibrium level of output. For instance, a tax cut or an increase in
government spending would have expansionary effect on income in demand the same way as increased
in exports. An upward shift in IS curve because of increase in G and tax cut leads to an increase in
interest rate and this will ultimately cause an appreciation of local currency. Subsequently, a fall in
exports and an increase in imports will occur. The process leads to full crowding out of a different
nature. A rise in interest rate as a result of fiscal expansion leads to currency appreciation and this in
turn reduces net exports.

Figure 4.6: The Effects of Increased Export Demand

r
LM
E*

id  i f E
BP = 0

IS2
IS1

To conclude, fiscal expansion or real disturbances under conditions of perfect mobility is highly effective
in raising output in fixed exchange rate regime. On the contrary, fiscal expansion does not change
equilibrium output in the flexible exchange rate regime with capital mobility. Instead, fiscal expansion
produces an offsetting exchange rate appreciation and a change in the composition of domestic demand
towards foreign goods away from domestic goods.

The Effects of Money Stock Changes

A monetary expansion shifts the LM schedule from LM1 to LM2 as in Figure 4.7. A new product and
money market equilibrium occurs at point E1, where both markets clear. At this point, the domestic
interest rate ( r d ) is below the world interest rate ( r f ). Because of this, there will be capital out flow.
On the other hand, BP goes into deficit and the exchange rate depreciates. Following currency
depreciation, the competitiveness status of the country improves; which subsequently boosts net
exports. This leads into a shift in the IS schedule to the right from IS1 towards IS2. At the intersection
between IS2 and LM2 in Fig 4.7, the product and the money market are in equilibrium and r d  r f .
Monetary policy, through depreciating the exchange rate increases net exports, has been able to boost
equilibrium level of income.

What is the other transmission mechanism? Given price constant, an increase in money stock leads to an
increase in real money supply. As we discussed it in Chapter 3, the demand for real balances is function
of interest rate and income. Since domestic interest rate ( r d ) cannot differ from the world interest rate

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( r f ), income ( Y ) has to go up to equate the demand for money to the supply. Exchange depreciation
raises net exports in turn sustain higher level of employment and output.

Fig 4.7: The Effect of Monetary Expansion

LM1
r
LM2

E2
E
id  i f 2 BP = 0

E1
IS2

IS1 Y

To conclude, under fixed exchange rate monetary authorities cannot control the nominal money stock.
The attempt to expand money stock will merely lead to reserve losses and a reversal of the increase in
the money stock. In the flexible exchange rates, monetary authorities do not intervene in the exchange
market. The money stock increase is not reversed in the foreign exchange market. Depreciation of
domestic currency leads to expansion of exports and thus expansion of equilibrium level output or
income.

We can summarize the effects of both fiscal and monetary policy changes in the fixed and flexible
exchange rate regimes as follows.

(a) Under fixed exchange rates and perfect capital mobility, monetary policy is powerless to affect
output. An attempt to reduce domestic interest rate by increasing the money stock leads to
capital outflow. This in turn leads to depreciation which the monetary authorities have to offset
by buying domestic money in exchange for foreign money. This action reduces the domestic
money stock until it turns into its original level.
(b) On the other hand fiscal policy is effective in the fixed exchange rate regime. Fiscal expansion
raises interest rate. This leads monetary authorities to increase money stock to maintain the
exchange rate constant, reinforcing fiscal effect.
(c) Under floating rates, monetary policy is highly effective. Monetary expansion leads to
depreciation of currency, increased exports and increased outputs. Thus, expansionary
monetary policy shifts the demand from foreign goods to domestic products.  M  the
value of local currency  competitiveness  NX  Y. Income and employment has
increased in the domestic economy as the expense of losses in the foreign economy. Recall in a
closed economy:  M  r  I  Y;
(d) Fiscal policy is ineffective in changing output under floating rates. Fiscal expansion causes an
appreciation of domestic currency and completely crowds out net exports. Note in a closed
economy: fiscal policy somehow crowds out investment by causing the interest rate to rise.

4.6. Exchange Rate as Trade Policy Instrument

In a fixed exchange rate regime, one of the possible discretion of the central bank is determine the
exchange rate. Central Bank may reduce the value of the domestic currency in terms of foreign
currency, and it is called devaluation. The purpose of devaluation as discussed before is to increase

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competitiveness of the domestic market. Devaluation encourages exports and discharges imports.
However, the effect of devaluation on trade balance depends on one important condition. The sum of
elasticity of demand for exports (  X ) and elasticity of imports (  M ) is greater than unity. This is called
the Marshall-Lerner Condition. What is the Marshall-Lerner Condition?

Let us define local absorption or spending on local goods as:

4.40. LA  C  I  G
where C, I and G have similar definitions as before. Thus, aggregate income equals

4.41. Y  LA  NX

Net export is defined as

4.42. NX  X ( RER )  M ( RER, Y  AD )

Equation 4.42 indicates that import

dX RER
4.43.  X  / 0
X dRER

Elasticity of import demand to changes in RER is given by

dM RER
4.44.  M  / 0
M dRER

When RER increases through manipulation of nominal exchange rate, it is said to be devaluation.
Devaluation improves the competitiveness of a country and thus boosts exports. Thus, it is possible to
have elasticity of export, which is positive and relatively big. On the other hand, the currency is devalued,
imports become more expensive than before. Thus, elasticity of import demand to changes in real
exchange rate would become negative. The Marshall-Lerner condition requires that for devaluation to
have a positive effect on the current account, the sum of export demand elasticity and import demand
elasticity has to be greater than unity.

4.45. M  M  1  0

This is to mean that devaluation has to generate export revenue that compensates the effect of the fall
in prices on export earning and also able to discourage sufficiently imports so as to have a positive
overall effect on the trade balance. If we simplify the import function as the RER times quantity imported;
the following are possible reasons for devaluation.

eP f
4.46. M  d Q
P

Equation 4.46 captures the value of our imports in terms of domestic goods. Assume that both domestic
prices and foreign prices remain constant for the time being and there is nominal exchange rate
depreciation. This leads a rise in the relative price of imported goods. (a) In the first instance, if the
physical volume of imports does not change; import expenditure in domestic currency increases because
of higher prices of imports. Higher import spending (measured in terms of domestic currency may

15
worsen trade balance. (b) On the positive side, however, exports should rise because our goods are
now cheaper for foreigners to buy and the volume of imports should decline because imports are more
expensive. The question now is: whether the volume effects on imports and exports are sufficiently
strong to outweigh the price effect? In other words, the question is whether devaluation or depreciation
leads to a positive or negative effect on net export.

Figure 4.8: The J-Curve Effect of Current Account as a Consequence to Devaluation/Depreciation

Current Account

Surplus

O Time

Deficit

Based on Ellen and Meade (1989) empirical evidence, Dornbush and Sischer outlined the following
conclusion. In the short-term volume effects, say within a year, are quite small and thus they do not
outweigh the price effect. The long-term volume effects are quite substantial and sufficient enough to
make the current balance respond the expected way. Why could be reason? Both consumers and
producers take some time to adjust. Thus, in the short term the increased prices will dominate the
reduced volume of imports and thus leads to worsening current account balance as said above.
However, over time, trade volume (both import and export) adjusts to change in relative prices:
exports rise and import volume progressively declines. The volume effects come to dominate the price
effect. In the long run therefore, trade balance would continue to improve over-time. This pattern of
adjustment is captured by the J-curve. Thus, the Marshall-Lerner condition may not be fulfilled.

4.7. Limitations of the Mundell-Fleming Model

I. Difficulties to meet the Marshall Lerner condition: The model assumes that the Marshall
Lerner condition holds, but it may not necessarily be met at least in the short-run

II. Failure to take into account the interaction of stocks and flows: The model ignores the
problem of the interaction of stocks and flows. According to the model, current account deficit
can be financed by a capital inflow. In the short run, the policy could be feasible. However, a
capital inflow over time increases the stock of foreign liabilities owed by the country to the rest
of the world. Interest and the principal payments have to be paid abroad and this would worsen
the current account in the future. Thus, countries cannot continue financing a current account
deficit indefinitely as the process would worsen the foreign debt condition of the country.

III. Neglect of the long run budget constraints: The model ignores the long run constraints that
govern both the private and public sectors. In the long run, government expenditure has to fully
finance its expenditure through its revenue from taxation; given money supply being constant.
This is tantamount to mean that private sector spending equal disposable income
( C  S  Y  T ). What is the implication of budget constraint? Increased government
expenditure implies higher taxation in the enar future. Forward looking private sector operators
would realize this and they would increase their savings today. Saving is leakage and thus an
increase of which will undermine the effectiveness of fiscal policy.

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4. Wealth Effect: The model ignores wealth effects on the process of restoring long run
equilibrium. A fall in foreign assets associated with a current account deficit is tantamount to
mean a decline in the wealth stock in the economy. This is likely to lead to a reduction in import
expenditure and help to reduce the current account deficit. This omission may not be significant
in the short run.

5. Neglect of supply side factors: The model concentrates on the demand side of the economy
and implicitly assumes that supply adjusts with changes in demand.

6. Exaggerated expectation about capital flows: The model assumes that a rise in the
domestic interest rate leads to a continuous capital inflow or perfect mobility of capital from
abroad. This is unrealistic. After sometime foreign investors could rearrange the stocks of their
portfolios to their desired content and the net capital inflows into the country may cease. To
continue attracting capital inflows requires a further rise in the domestic interest rate. Thus,
country that needs a continuous capital inflow to finance its current account deficit has to
continuously raise its interest rate. This implies that capital inflows should be stated as a function
of the change in the interest differential rather than the interest rate differential itself.

7. Exchange rate expectations: The model does not explicitly model exchange rate
expectations. It implicitly presumes that the expected change in exchange rate is zero.
According to the model, monetary expansion leads to a depreciation of the local currency under
floating exchange rates. It seems unreasonable to assume that economic agents do not expect
depreciation to occur as a result of increased in money supply. If agents expect depreciation,
this may require a rise in the domestic interest rate to encourage them to continue to holding
the currency. This may have an adverse effect on domestic investment. Thus, the effect of
expansionary monetary policy could be compromised by the depressing effect of declining
private investment on output. The need to maintain market confidence in exchange rates or the
desire to ensure stability in exchange rates can severely restrict the ability of government to
pursue expansionary fiscal and monetary policies.

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