I

NTERNATI
ONALMACROECONOMI
CS

This deals withi nt

ernat
ionalli
nkages among open economies.Since inr eal
i
ty
economiesar eopen,i mply
ing t
hatthelevelofAggregat
edemand f orgoodsand
servi
cesandt helevelofmoneysuppl yaresubst
anti
all
yaff
ectedbytheact i
vit
iesof
othercountr
ies,t
henweneedt oexpandtheIS-
LM modeltoi
ncl
udetheseinf
luences.

Theopeneconomyislinkedtoothercountr
iesthr
ough2br
oadchannel
s:
1.Throughtrade:ExportsandImports
2.ThroughFinance.Invest
ingi
nf i
nancial
assets

Theset
wol i
nkageshavei
mplicat
ionsont
heeconomy ’
sdomesti
clev
elofequi
l
ibr
ium
i
ncome,andsotheIS-
LM modelshoul
dbeexpandedt
oincl
udet
heseeffect
s.

Exportsandimport
sbecomekeydeter
minant
softheposit
ionoftheIScur
ve,whil
e
i
nterestr
atedi
ff
erent
ial
sbet
weencount
ri
eshaveani
nfl
uenceontheeconomy
’sasset
s
market.

Thus an equi
l
ibr
ium posi
ti
on forthe ent
ire economy necessi
tat
es si
mul
taneous
equi
l
ibri
um i
nbothdomesti
c(i
nter
nal
)andforei
gn( ext
ernal
)sect
or.

Equil
i
bri
um i
nthef
orei
gnsect
ori
saposi
ti
oni
nwhi
cht
heBal
anceofPay
ment
s(B.
O.P)
i
sz er
o.

B.
O.Pi
sdefinedasthedi
ffer
encebetweenthedemandandsupplyoff
orei
gncurrency.
 Ifthesupplyisgreaterthanthedemand,thenthereisaB. O.
P sur
plus.The
rev
ersei st
rueforadef i
cit
.Whensupplyisequaldemand,t
hentheB.O.Pi si
n
equil
i
br i
um.

Thesupplyoff
orei
gncur
rencycomesaboutbyei
therexpor
ti
nggoodsandser
vicesor
for
eigner
sbuyi
ngdomest
icsecur
it
ies.

The demand comes aboutbyi

mpor
ti
ng goods and ser
vices ornat
ional
s buy
ing
secur
it
iesf
rom abr
oad.

TheB.O.Pisasummar yst
atementofacount
ry’
sfi
nanci
alt
ransact
ionswi
thot
her
count
ri
es.I
tisdi
vi
dedi
nto2account
s.

1)TheCurrentAccount:repr
esent
sthemar ketv al
ueofacount r
y’svisi
bleand
i
nvi
sibl
eexportsandimport
s.Thecur
rentaccountbalanceisthenetexports.
2)TheCapitalAccount
:Showsthemovementofcapi tal.I
trecordspurchasesand
sal
esofassets.

Thecur
rentaccountandt
hepr
oductmar
ketequi
l
ibr
ium

1
Expor
tsdependont
hecount
ry’
spr
icel
evel(
P)andexchanger
ate(
e).Ther
elat
ionshi
p
i
snegat
ive:

I
mports(M)dependonthedomest
icl
evelofi
ncome(
y),t
hedomest
icpr
icel
evel(
P)
andexchanger
ate(
e).

Capi
tal
accountandB.
O.Pequi
l
ibr
ium

Thecapitalaccountdependsont heint
erestrat
edif
fer
enti
als.I
fthedomestici
nterest
rat
eisgreaterthanthefor
eigni
nterestr
ate,t
henther
ewill
becapital
inf
low.Ther
ev erse
wil
lbr
ingaboutcapitalout
flow.

B.
O.Pequat
ion

B.
O.P=cur
renta/
c+capi
tal
a/c

=X-
M +CF

NetExpor
ts(
X-M)=X(
P,e)
-M(
y,e,
P)

CF=cf
(i
-i
f)

HenceB.
O.P=Nx(
y,P,
e)+cf
(i
-i
f)

Tostudytheeff
ectsofot hercountri
esonthedomest i
ceconomy ,anew curv ecal
l
ed
theBPcurveisint
roduced.Itconsist
sofpairsofincomeandinterestratesthatyi
eld
equi
li
bri
um i
ntheforei
gnsectorinthesensethatAD=ASoff or
eigncurrency.

DERI
VINGTHEBPCURVE

Supposet
hatini
ti
all
yADf
c=ASf candthenthecount
ry’
sincomei
ncr
eases.I
mpor
t
spendi
ngwi
ll
incr
easewhi
l
enetexpor
tsr
educe.

ADfcwi l
lincrease,creat
ingatradedef
ici
tonthecurrentaccount
.Thedefici
thast
obe
corr
ectedf orthroughcapit
ali
nflowsonthecapi
talaccount
.Thatis,
thecountr
ysel
l
sit
s
assets.

I
nor dertoat
tracti
nvest
ors,t
hecount
ryhast
orai
set
hedomest
ici
nter
estr
atepai
don
assets.

Thusanydi
sequi
l
ibr
ium i
ntheB.
O.Pbr
oughtaboutbyaposi
ti
vechangei
nincome

2
woul
dhavetobemat chedbyachangei
nthei
nter
estr
atei
nthesamedi
rect
ion,i
fthe
B.
O.Pequi
l
ibr
ium i
stoberegai
ned.

Thusahi
gheri
ncomelevelmustbepai
redwi
thahi
gheri
nter
estr
atei
mpl
yi
ngan
upwar
dsl
opi
ngBPcur
ve.

i
nter
estr
ate
BP=0
BP>0sur
plus
i
1

i
0
BP<0def
ici
t

y
0 y
1 i
ncome

Theslopeofthecurv
edependsbot hont hesensiti
vi
tyofthedemandf ori
mportsto
i
ncomeandt hesensi
tiv
ityofthecapit
alaccountt
omov ementsi
ninter
estrat
es.E.
g.
thecurvewil
ltendtobef l
atifimportsarenotv erysensi
ti
vetoincome,andwhen
capi
talf
lowsarehi
ghl
yresponsiv
etointer
estrat
es.

CAPI
TALMOBI
LITY

1.PerfectCapit
alMobi l
it
y.
WhentheBPcur veishor i
zontal
,iti
mpli
esthatther
eisonlyoneinterestrateatwhich
t
heB.O.Pwil
lbalance.i
.e.domestici
nter
estrat
eisequalt
oforei
gninterestrate.Capi
tal
f
lowsfr
eel
yacrossbor ders.
Inter
estrate

i
=if BP

I
ncome

Here,a sli
ghtesti nt
erestrat
e dif
fer
enti
alwi llprovoke inf
init
e capi
talflows.This
si
tuat
ionari
sesi fdomest i
casset
sandf orei
gnasset sareperfectsubst
it
utes.Soasset
hol
dersareindiff
erentastowhichassettohold.Theywi l
lchooset ohol
dtheonewhi ch
hasahigherinter
estrate.

3
2.Perf
ectCapit
alImmobi l
i
ty
Herethedomest i
ceconomy ’
scapit
almarketistotal
lydisconnect
edfr
om theworld
market.Thecapi
talaccountbal
anceisal
wayszeroir
respecti
veofthedomest
ici
nter
est
rat
e.

TheBPcur
vei
sver
ti
cal
att
hei
ncomel
evel
atwhi
cht
hebal
anceoft
radei
szer
o.

3.ImperfectCapitalMobili
ty
Heredomest icsecur i
ti
esar eimperf
ectsubst i
tut
esf orforei
gnsecuri
ti
es.Thecapi
tal
accountbalancei safunctionoft
heinter
estratedif
ferenti
al.
Ast hedomest i
ci nt
erestrateri
ses(whenf orei
gninterestrat
eisconstant
),t
hecapi
tal
accountimprov es.Thereforeanincr
easeint heint
erestratemustbeaccompaniedby
anincreaseinincomel evel.

TheBPcur
vei
supwar
dsl
opi
ng.

I
nter
nal
andExt
ernal
Bal
ance

Int
ernalequi
l
ibr
ium i
sdet
ermi
nedbythei
nter
sect
ionoftheI
SandLM cur
ves.Exter
nal
equil
ibr
ium i
sachiev
edwhentheB.O.Par
einequili
bri
um.Thi
soccur
salongt heBP
curve.

Simul
taneousint
ernalandexternalequil
i
bri
um isachi
evedwhent hevaluesofi
nterest
rat
eandincomet hatmaintai
ninter
nalequil
i
bri
um aret
hesamev al
uesthatmai
ntai
nt he
count
ry’
sB.O.Pinequil
ibr
ium.WhenI S,LM,andBPcurvesint
ersectatt
hesamepoi nt.

I
nter
estr
ate
LM
I
S
BP

i
0

y
0 I
ncome

However,suchasituat
ionmaynotalway sbeachiev
ed.Acountrymayachiev
einter
nal
equi
li
bri
um wheni ti
8soffitsBPcurve,i
mplyi
ngthatiti
sachiev
ingi
nter
nalequi
l
ibri
um
whil
eincurr
ingei
therabalanceofpay
ment sdef
ici
torsurpl
us.

B.
O.Pdef
ici
t

4
 I
S BP
LM

i
0 E
Def
ict

y
0

Thisimpli
est hatt
hedomestici
ncomei stoohighandinterestrat
etoolowforexternal
equil
ibr
ium tobemaint
ained.Becauseofthelowinter
estrate,f
orei
gnerswil
lnotinvest
i
ndomest i
cassets.Alsolocal
swi l
lprefert
oi nv
estinf orei
gnassets.Thi
sl eadst o
capit
aloutf
lowandhenceaB. O.Pdefi
cit
.Therever
sewi l
lhappenincaseofasur pl
us.

Adjustmenttowar
dssimult
aneousequi
l
ibr
ium woul
dnecessi
tat
erai
singorr
educi
ng
i
nterestr
atesandi
ncomelevel
s.

Howev
er,t
heprocessi
slar
gelydet
ermi
nedbyt
heexchangerater
egimebei
ngpur
sued
byt
hecountr
y.Ther
ear
ebasical
lyt
woregi
mes;
Flexi
bleandFi
xedsyst
ems.

FLEXI
BLEEXCHANGERATESYSTEM

Thi
sist
heonei
nwhi cht
hegover
nmental
l
owst
hef
reef
orcesofsuppl
yanddemandt
o
det
ermi
net
heexchangerat
e.

Incaseofadef i
ci
t(ADfc>ASf c),peopleholdi
ngt helimi
tedsupplyoff or
eigncurr
ency
areunwil
li
ngtopartwit
hi t
.Inor dertodoso,t heyraisei
tsprice,accepti
ngmor elocal
curr
encyfori
t.Ther
efor
eal ocalcurrencynowbuy slessforei
gncur r
ency.Theexchange
rat
efall
simpl
y i
ngadepreci
ationoft helocal
currency.

A depreci
ati
ontendstomakei mpor
tsmor eexpensi
vethanexport
s,andhencet he
demandf orimpor
tsfal
lsl
eadi
ngtoanincr
easeinthedemandforlocalgoods.Thi
sis
becausetherel
ati
vepri
ceoff
orei
gngoodshasincr
eased.

TheIScur
veshi
ftst
other
ight
,andt
heBPcur
veal
soshi
ft
stot
her
ightunt
ilbot
hcur
ves
i
nter
sectt
heLM cur
veatt
hesamepoint
.

5
 I
S1

I
S0

LM

Theef
fectofani
ncr
easei
nmoneysuppl
yundert
hef
lexi
bleexchanger
ate

I
S1
I
S0 LM0
2 LM1
1
BP0

3 BP1
A
C
B

Ini
ti
all
ythereissi
multaneousequi
li
bri
um atA.Whenmoneysupplyincreases,t
heLM
curveshi
f t
stotheri
ght,leadi
ngtoadefi
citatB.Thi
sisaresul
tofar educti
oninthe
i
nterestratewhi
chdiscouragescapi
tali
nfl
owsintot
hecountry
.Therewi l
lbecapital
outf
low.

Eventuall
yther
eisadepr eciati
onoft hel
ocalcur
rency
.Export
sincr
easeandi mports
reduceduet ochangesi
nt heirpri
ces.TheISandBPcurvesshi
fttot
herightunti
lthey
bothinter
sectt
heLM curv
eatt hesamepointC.

Ef
fectofanI
ncr
easei
ntheGov
ernmentExpendi
tur
e

6
 I
S1
I
S2 LM
I
S0
1 2 B BP1

C 3 BP0

Whengov er
nmentexpendi
turei
ncreases,
t heIScurveshift
stotheri
ghtcreat
ingaB.O.P
surplusatB.AtBASf c>ADfc.Peoplehol
di ngtheexcesssupplyoffor
eigncurr
encyare
unablet ofi
ndbuyersforit
.Tosel lt
hisexcesscur rency,t
heyhavetol owerit
spri
ce,
acceptingfewerlocalcurr
encyfori t.i
.e.al ocalcur r
encynow buysmor efor
eign
currency,i
mply
inganappreci
ati
onoft hel
ocal curr
ency.

TheIScur
veshi
ft
st otheleftsincet hedemandfordomesticgoodsr
educes.TheBP
cur
veshi
ft
supwardstotheleftunti
lthethr
eecur
vesint
ersectatt
hesamepointC.

FI
XEDEXCHANGERATE

Thi
sisasy st
em wher
etheexchangerat
eisfi
xedatagivenlevelbythegov
ernment
,
andi
tisnotal
lowedt
ochangei
nt hef
aceofei
theradef
ici
torsur
plus.

Theref
orethegovernmenthastheobl
igat
iont
obuyandsel
lfor
eigncur
rencywhenev
er
ther
eisexcesssupplyordemandforf
orei
gncurr
ency
.

I
ncaseofadef i
cit(ADf c>ASf c),peopleholdi
ngt helimi
tedsupplyofforei
gncurrency
areunwi
ll
i
ngt opar twi t
hit,becauset heyarenotsupposedt orai
seitsprice.Theref
ore
peopl
ewhowantt hef orei
gncur r
encywi l
lgot otheirbanktobuytheforei
gncurrencyat
thefi
xedex changer ate.Moneysuppl yreduces.TheLM cur veshiftstot helef
tand
B.O.
Pdefi
citiseli
minat ed.

7
 I
nter
estr
ate LM1
BP
I
S
LM0

I
ncome

Ef
fect
sofFi
scal
Pol
i
cy

I
nter
estr
ate I
S1
I
S0 LM0
LM1

B BP

A C

I
ncome

I
nit
iall
ythereissimult
aneousequi
l
ibr
ium atA.Theexpansi
onar
yfi
scalpol
i
cywi
l
lshi
ft
t
heI Scurvetotheri
ght,l
eadi
ngtoaBPsurplus.

Toprev entt
hecur r
encyf rom appr
eciating,thecentr
alBankmustsuppl
ytheaddit
ional
l
ocalcur r
encyt
ot heforeignexchangemar ket.Butasmorecur
rencyi
spri
ntedt
obuyup
theforeigncurr
ency ,moneysuppl yi ncreases.TheLM curveshift
stotherightand
event
ual l
yB.O.
Pequi l
ibr
ium isrest
ored.

Ef
fectofMonet
aryPol
i
cy

Undert
hefixedexchangeratesy st
em,thegov ernmentgivesupi tscont
roloft
he
domest
icmoneysuppl y
.Thati s,thegovernmentcannotusemonet arypoli
cyf
or
domest
icst
abil
i
zat
ionpurposesaslongasitmaintai
nsafixedexchanger
atesyst
em.

8
 I
S LM0
LM1
BP

AtAi fthegover
nmentincr
easesmoneysupply
,t heLM curvewillshi
fttother
ight
,
resulti
nginaBPdef i
ci
t.I
fthegover
nmentthentr
iestost abi
l
izet
heexchangerat
eby
buyingupt heexcessdomesti
ccurr
ency
,theori
ginalexpansi
onar
ymonet ar
ypoli
cyis
reversed.

Ther
efor
e,t
hemonet
arypol
i
cyi
sincompat
ibl
ewi
tht
hef
ixedexchanger
atepol
i
cy.