International Linkages: Extensions of IS-LM in the

Context of International
Mobility of Goods and Capital

Session 16, 17, 18

 Introduction
• National economies are becoming more closely
interrelated
– Economic influences from abroad have affects on the
Indian economy
• When the U.S. or EU move into a recession, they tend to
pull down other economies
Note that US had trade
surplus in the 1950s and 60s
 2019-20
2018-19
India’s External Trade (As % of

Imports

2017-18
Export

2016-17
GDP)

2015-16
2014-15
2013-14
2012-13
2011-12

35
30
25
20
15
10
5
0
 Indian Economy Since Independence
Indicator 1950-51 1960-61 1970-71 1980-81 1990-91 2000-2001 2010-11
Per capita GDP (Rs) at Growth Rate (% CAGR)
GDP (Constant) 7,114 8,889 10,016 10,712 14,330 20,418 36,202
Growth Rate   2.25 1.20 0.67 2.95 3.60 5.89
GDP (Current) 264 373 763 1852 5621 17381 54021
Growth Rate   3.52 7.44 9.27 11.74 11.95 12.01
Population(Crores) 35.9 43.4 54.1 67.9 83.9 101.9 118.6
Components of GDP (%)
PFCE (C) 84.6 81.1 75.5 73.7 63.5 63.4 54.3
GFCE (G) 5.8 6.9 9.4 10.1 11.9 12.6 11.4
GCF (I) 9.3 14.3 15.1 19.2 26.0 24.9 38.6
Exports (X) 7.1 4.4 3.7 6.0 6.9 12.8 22.0
Imports (M) 6.8 6.7 3.8 9.1 8.3 13.7 26.3
Composition of GNP
NDP_FC 91.8 90.9 87.9 83.6 83.0 83.4 84.4
CFC (Dep.) 5.1 4.5 5.9 7.6 9.0 9.5 9.8
Indirect taxes- subs. 3.5 5.0 6.8 8.6 9.3 8.1 6.9
Net factor income -0.4 -0.4 -0.6 0.2 -1.3 -1.0 -1.1
Base year 2004-05 Source: Basic Data Back Series 2015
Smaller
economies/
countries are
likely to have
higher
linkages with
the rest of the
world

But how can a

country trade
more than its
GDP??
 National Income Identity in an Open Economy

Total demand Y = C + I + G + NX
for domestic
output Net exports
or net foreign
Investment demand
spending by
Consumption businesses Government
spending by and purchases of
households households goods
and services

• Departing from the closed economy model, we’ve added net exports, NX,
defined as X - M.
• Also, note that domestic spending on all goods and services is the sum of
domestic spending on domestics goods and services and on foreign goods
7
and services.
 Y = C + I + G + NX
So the national income accounts identity can be re-written as:

NX = Y - (C + I + G)

Net Exports Domestic

Output
Spending

• If output exceeds domestic spending, we export the difference: net

exports are positive.
• If output falls short of domestic spending, we import the
difference: net exports are negative.
8
 Economic Linkages between countries:
Two broad channels
• Trade linkage
– Some of a country’s production is exported to foreign countries leading to
increase in demand for domestically produced goods
– Some goods that are consumed or invested at home are produced abroad and
imported
• This links the price of the commodities across the world

• Financial linkages
– Residents of one country invest in another countries or vice versa
• e.g. FII (Foreign institutional investor) and FDI (Foreign direct investment). Tata’s
purchase of Jaguar or land rover in the UK is an FDI outflow.

– Some of you as a portfolio managers will go on shopping spree across the

world to buy the best deal (most attractive yields)
• This links the asset prices and interest rate across the world
 BoP and two main accounts
Balance of payments: the record of the transactions of the
residents of a country with the rest of the world

• Current account
– records trade in goods (merchandise trade balance)
– Services (Shipping, insurance, software, foreign travel, etc.)
– Investment income/Net factor income from abroad: Return of the investment in
foreign assets, and factor income from residents working abroad
– Transfer payments (Grants from world bank and external agencies, remittances)

• Capital account
– records private and government purchases and sales of assets, such as stocks,
bonds, FII, FDI
– Change in the official foreign reserves (to balance the difference between current
account and remaining items of capital account): Balance of Payment
deficit/surplus
 Debit and Credit
• Rule: When you receive foreign exchange it is an
surplus/credit entry. When you pay foreign exchange it is
deficit/debit entry
• So all exports are
Transaction Nature
credit/surplus
Credit entry and imports
Export of Tata Nano
are debit/deficit
Debit entry
Import of Jaguar
Debit
Purchase of Jaguar (firm) by Tata in UK
Credit
Stake acquisition in Jio by Microsoft

FDI coming to India Credit

Debit
Indian's buying American government bonds
 Identify the Transaction(s)
• You are dealer of apple of products in India.
You import Rs 5 Cr worth product on a credit
note (you have received the product, but not
paid at the moment, you will pay 180 days
later which fall in the next year).

• Identify credit/debit/current/capital account

transactions.
Note that US earn more investment income than it pays to other countries
Also, remember that US is net debtor nation.
• Is there any relationship
between Current account
balance and income level?

• Should there be one?

 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 or by borrowing
abroad
• Selling assets/borrowing implies the country is running a
capital account surplus  any current account deficit if of
necessity financed by an offsetting capital inflow:
Current Account + Capital Account = 0
Current account + Capital account = 0 (1)
 Link the Saving Investment Identity with Current
and Capital Account
• Open economy with firms, households, and government
• S Private = (Y + NFI+NUT – Taxes + transfers) - C
• S Government = Taxes – transfers – G

• S Total = S Household + S Government

=(Y + NFI+NUT – Taxes + transfers – C) + (Taxes – transfers – G)
= (C+ I +G+ X – M + NFI +NUT – Taxes + transfers – C) + (Taxes – transfers – G)
= I + (X- M +NFI+NUT)

• S Household + S Government = I + (X- M +NFI+NUT)

• S – I = Current Account Surplus

• Current account balance is essentially difference between domestic savings and investments.
• If the savings > investment, there is an equivalent lending abroad (capital account deficit, and vice-versa

• If the trade imbalance is due to

– increase in investment, there may not be much need to get worried.
– decline in savings, there could be many reasons to be worried about
 Exchange Rates
• You wish to buy Amul Chocolate, you can easily pay in Rs.
• If you wish to buy a foreign made Chocolate, you need to pay
the manufacturer in foreign currency.

• Exchange rate is the price of one currency in terms of another

– you could buy 1 Hershey’s chocolate for $1.5 in U.S. currency
 nominal exchange rate was e = Rs 50/USD
 Fixed Exchange Rate System
• Fixed exchange rate system
– Central bank intervene by buying and selling their currencies at a fixed price in
terms of a particular currency (dollars)
• No one will buy dollars for more than fixed rate since know that they can
get them from the central bank at the fixed rate
• No one will sell dollars for less than fixed rate since know can sell them to
the central bank for the fixed rate

• Central bank holds reserves to sell when it needs to intervene in the foreign
exchange market
• Central bank is willing to accumulate reserves by buying foreign currency when it
needs to intervene in the foreign exchange market

– Intervention: the buying or selling of foreign exchange by the central bank

 • Supply of $ in the foreign exchange
market comes from the Indian
Exchange Rate exporters and foreign funds
investing in India.
• If you export software
services, you earn $, which
you sell in the forex market
Rupee per USD

and buy Rs.

• If Meta wishes to invest in Jio,
it needs to pay Reliance in Rs.
S
• Demand for $ comes from the
Indian importers and Indians
willing to invest abroad
• If you wish to buy Hershey’s,
PE you sell Rs in the market to
buy $.
• If you wish to buy shares in
google, you need to buy it $.

D
O
USD
 Over-valued Exchange Rate
S = Export/Investment inflows/in-remittances/factor income
inflows
D= Import/Investment outflows/out-remittances/factor
Rupee per USD

income outflows
S

PE
How would undervaluation look like
India’s BOP: Surplus or deficit ??
Poffical

Intervention by RBI D
(Sells USD in market)
O
QS QD USD
 Balance of Payment
• The balance of payments measures the amount of foreign
exchange intervention needed from the central banks
– Ex. If India is running a current account deficit (CAD) but net
private capital inflows exceed the CAD, then the supply for dollars
in exchange for rupee exceeds the demand of dollars in exchange
for rupee
®Under a fixed exchange rate, RBI must absorb the excess supply
by buying dollars in exchange of rupee
®Makes it necessary to hold an inventory for foreign currencies.

• In an opposite case, the RBI can use the reserves to meet

the excess demand for dollars in exchange for the
domestic currency
 What determines the level of intervention of a
central bank in a fixed exchange rate system?
• If a country persistently runs deficits in the balance of
payments:
– The central bank eventually will run out of reserves on of foreign
exchange
– Will be unable to continue its intervention
– Before this occurs, the central bank will likely devalue the
currency
Indian Experience with Fixed Exchange Rates
• Since India was under British rule rupee was pegged to pound.
– From 1927 to 1966, it was 13.33 rupees = 1 pound.
– On September 1949, Pound was devalued from 4.03 to 2.8
USD/Pound
– Hence, it translated into Rs 4.76/USD

• This was maintained until 1966. On 6-6-66, the rupee was

devalued and pegged to the U.S. dollar at a rate of 7.5 rupees
= 1 dollar.

• This value lasted until the U.S. dollar devalued in 1971, since
then we shifted to a system somewhat resembling to crawling
peg against a basket of currency targeting to maintain real
exchange rate, and then to managed/dirty float in 1991
 Devaluation 1991
Deutsche
SDR US Dollar Pound Sterling Mark/Euro Japanese Yen
Year Average End-year Average End-year Average End-year Average End-year Average End-year
1970-71 7.5 7.5 7.6 7.5 18.0 18.1 2.0 2.1 2.1 2.1
1975-76 10.4 10.4 8.7 9.0 18.4 17.2 3.4 3.5 3.0 3.0
1980-81 10.2 10.1 7.9 8.2 18.5 18.4 4.2 3.9 3.8 3.9
1983-84 10.9 11.4 10.3 10.7 15.4 15.4 3.9 4.1 4.4 4.8
1984-85 11.9 12.3 11.9 12.4 14.9 15.5 4.0 4.0 4.9 4.9
1988-89 19.3 20.2 14.5 15.7 25.6 26.4 8.0 8.3 11.3 11.8
1989-90 21.4 22.4 16.6 17.3 26.9 28.3 9.1 10.2 11.7 11.0
1990-91 24.8 26.4 17.9 19.6 33.2 34.1 11.4 11.4 12.8 13.9
1991-92 33.4 35.5 24.5 31.2 42.5 53.7 14.6 18.4 18.4 23.3
1994-95 45.8 49.2 31.4 31.5 48.8 50.6 20.2 22.4 31.6 35.3
1995-96 50.5 50.2 33.4 34.4 52.4 52.4 23.4 23.3 34.8 32.3
1997-98 50.7 52.8 37.2 39.5 61.0 66.2 21.0 21.3 30.3 29.8
1998-99 57.5 57.6 42.1 42.4 69.6 68.4 24.2 23.3 33.1 35.3
2000-01 59.5 58.8 45.7 46.6 67.6 66.6 41.5 41.0 41.4 25 37.4
 Fixed Exchange Rate under Gold Standard
• Suppose that British gold coins have the image of King Charles
and weight of 10 gms of gold
• American gold coins had an image of Joe Biden and a weight
of 2 gms.

• What should be the exchange rate?

 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:

• Exchange rate of the rupee against the dollar is 50 rupee per dollar
 Demand for Indian products increases in the US due to the US shifting
demand away from China
 Americans must pay more rupee to Indian exporters
• RBI stands aside and allows the exchange rate to adjust
 Exchange rate could appreciate to 40 rupee/USD
 Indian goods become more expensive in terms of dollars; American goods
becomes cheaper
 Demand for Indian goods by Americans partially declines, while demand for
American goods increases
Impact of rising Demand for Indian Products
Rupee per USD

Sf

50
40

Df
O
Q0 Q1 USD
 Exchange Rate
• Or if India raises the interest rate, supply of
USD increases (e.g. more NRIs bring their
money to Indian banks) leading to
appreciation of the Rs.
Rupee per USD
• Demand for $ reduces because of
discovery of oilwells in India leading to
lesser imports (current account) or
because of lesser outward FDI (capital
account)
• appreciates against the $.

• At appreciated currency, exporters

supply less of the $ since they get
lesser Rs value while selling abroad.
S • Previously they were getting Rs 50
by selling goods worth of 1 $.

• Demand for $ increases because of

higher imports (current account) or
50 because of more outward FDI
40 (capital account)

• depreciates against the $.

D • Distinguish between shift of the

O curve ands movement along the
USD curve
 Clean vs managed/dirty float
• In a system of clean floating, central banks stand aside
completely and allow exchange rates to be freely determined in
the foreign exchange markets.
– Reserve transactions i.e., the balance of payments is zero.
– The exchange rate adjusts to make the current and capital
accounts sum to zero.

• Under managed floating, central banks intervene to buy and

sell foreign currencies in attempts to influence exchange rates.
– Official reserve transactions are not equal to zero. But there
is no fixed targeted exchange rate/explicit commitment by
the central bank for intervention
 Terminology
• Devaluation and revaluation
– Under fixed exchange rate

• Depreciation and appreciation

– Under floating exchange rate
 Nominal vs Real Exchange Rate
• The nominal exchange rate is the relative price of the currency of two
countries.
• 1 USD = Rs 50

• The real exchange rate is the relative price of the goods of two countries.
• Price of iPhone in USA = $ 500, in India = Rs 26,000

• If the nominal exchange rate is Rs 50/USD, then

Real Exchange Rate (e) = Nominal Exchange Rate (e)  Price of Foreign Good (Pf )
Price of Domestic Good (Pd)
e = (50 × 500) / 26000

A decrease in Real Exchange Rate (e) is appreciation of RER and vice-versa

(just like depreciation in nominal exchange rate makes the foreign goods expensive on
nominal basis, depreciation in real exchange rate makes the foreign goods expensive on a real
 Nominal vs Real Exchange Rate
• Suppose you wish to export some furniture to USA worth $ 1000
• Existing exchange rate is Rs 50/USD
• Same furniture is available in India at Rs 50,000
• RER: (50 * 1000)/50000 = 1

• The inflation rate in India is 15% while that in US is 1%.

• If the nominal exchange rate changes to Rs 55, what would be the
change in real exchange rate
• RER: (55* 1010)/(50000* 1.15) = 0.966087
• % Change = appreciate by 3.39%

• Think of how many Indian furnitures are required to buy an

imported furniture
• New price of Indian furniture is Rs 57,500 while the imported
furniture is Rs 55,550.
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
• The real exchange rate, R, is defined as , 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
(depreciation)
®If R < 1, goods abroad are cheaper than those at home (appreciation)

is falling over time then e should rise to maintain real exchange rate
Fixed exchange rate with high inflation rates will require constant devaluation.
Exchange Rate and Purchasing Power Parity
• Suppose a laptop costs Rs 50,000 in India, and $ 1000 in USA, what
should be the exchange rate?

• Suppose a full-time maid charges Rs 15000 per month in India and $

3000 per month in USA, what should be the exchange rate?

• Tradables and non-tradables

– Exchange rate has to be linked to the prices of tradables atleast in the long
run

• Concept of purchasing power parity

– Provide another exchange rate in terms of domestic currency required to
buy the goods & services which 1 USD can buy in USA
 Why Exchange and PPP may defer
• Transport costs and tariffs

• Differences in basket and tastes

• Tradable-vs non-tradables
 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
 Spending on domestic goods is
𝐷𝑆+𝑁𝑋=(𝐶+𝐼+𝐺)+(𝑋 −𝑀)
 DS depends on the interest rate and income:
 Relooking at National Income Identity
• How does a nation earn Where
 Y = Cd + Id + Gd + Xd • Superscript d refers to spending on
domestically produced goods &
services.
• How does a nation spend • Superscript f refers to imported goods
 C = Cd + Cf & services
 I = Id + If • Now
 G = Gd + Gf  Y = (C – Cf ) + (I - If ) + (G - Gf ) + X
 Y = C + I + G + X – (Cf + If + Gf)
• Or  Y=C+I+G+X–M
 Cd = C - Cf,
 X- M = Y – (C + I + G)
 Id = I - If
 Gd = G - Gf
 X = Xd
Domestic Income Domestic Spending
 Net Exports
• Net exports, (X-M), is the excess of exports over imports
• NX depends on:

{
 domestic income Y
 foreign income, Yf
¿
 Real exchange rate: R ¿𝑁𝑋=𝑋(𝑌 𝑓 ,𝑅)−𝑀(𝑌,𝑅)=𝑁𝑋(𝑌 ,𝑌 𝑓 ,𝑅)
¿
®A rise in foreign income improves the home country’s trade balance
and raises its AD
®A real depreciation by the home country improves the trade balance
and increases AD
®A rise in home income raises import spending and worsens the trade
balance
 Will export be an autonomous component ?
• Lets assume that there is another country RoW (rest of the world)
• RoW also have autonomous components (C RoW, GRoW, and IRoW )for YRoW.
• Imports of RoW depend on YRoW which influence MRoW level through MPCfRoW
• Since MRoW are exports of domestic economy, from the domestic economy's
perspective exports are autonomous (independent of the income level of
the domestic economy).

• Hence trade balance for the domestic economy

• NX = f(RE, YD, YRoW)
• Real exchange rate (depreciation would increase exports and decrease
imports)
• YD (higher domestic income would increase imports)
• YRoW (higher foreign income would increase exports)
 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 (Why)
– For a given reduction in interest rates, the investment
expands, but the multiplier will be smaller than the closed
economy multiplier (because MPCd < MPC): Thus, the will
be smaller for the goods market equilibrium
– Here, MPCd is marginal propensity to consumer
domestically produced goods
 Recall the Closed Economy IS Curve

𝑌 =[ 𝐶
¯ +𝑐 𝑇
¯𝑅¯ +𝑐 (1− 𝑡 )𝑌 ] +( 𝐼¯0 −𝑏𝑖)+ 𝐺
¯
¯ +𝑐 (1− 𝑡 )𝑌 − 𝑏𝑖
𝑌=𝐴
𝑌 − 𝑐(1 − 𝑡 ) 𝑌 = 𝐴¯ − 𝑏𝑖
1
¯ −𝑏𝑖 𝛼 𝐺=
𝑌 (1− 𝑐(1 −𝑡 ))= 𝐴 1− 𝑐(1 −𝑡)
¯ − 𝑏𝑖)
𝑌 =𝛼 𝐺 ( 𝐴
How should we modify this for international trade by an
OPEN ECONMY
Presume X = , and M = mY

Adjust by adding
Instead of mpc use mpcd (i.e c- m)
10-42
 Goods Market Equilibrium
• IS curve now includes NX as a component of AD

– level of competitiveness (R) affects the IS curve

• 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
 A Shift In the IS Curve
Caused by a Rise in AD AD=Y
Export Demand E2 Ā’+cd (1-t)Y-bi1

Aggregate demand
A’ Ā+cd (1-t)Y-bi1
•Higher foreign spending ∆X
on our goods raises
A E1
demand and requires an
increase in output at ∆Y=α ∆X
given interest rates
– Rightward shift of IS Y1 Y2 Y
Income, output
(a)
i

Interest rate
E1 E2
i1
∆Y=α ∆X
IS’
IS
Y1 Y2 Y
Income, output
(b)
 Goods Market Equilibrium
LM
• Full effect of an increase in
foreign demand is an increase
in interest rates and an increase i E’
in domestic output and
employment E
• The Figure can also be used to i=if
show the impact of a real
BP

Interest rate
depreciation
IS’

IS

Y
 Capital Mobility
• High degree of integration among financial markets 
markets in which bonds and stocks are traded

• Start our analysis with the assumption of perfect

capital mobility
– Capital is perfectly mobile internationally when investors
can purchase in any country, quickly, with low transaction
costs , and in unlimited amounts
– Asset holders willing and able to move large amounts of
funds across borders in search of the highest return or
lowest borrowing cost
– Interest rates in a particular country can not get too far out
of line without bringing capital inflows/outflows that bring it
back in line
 Capital Mobility
• Presume that:
– the exchange rate is fixed
– taxes are same every where,
– there are no political risks across the world
– Capital is perfectly mobile

• What will be the interest rate differential

across the world
 ‘Uncovered’ Interest Rate Parity
• The exchange rate today—let’s in 2020—is e2021 = Rs 50 /USD
• Rupee is expected to depreciate/devalue by 10 percent next year.
• The interest rate on the US treasury is 2 percent
• What should be the interest rate on the Indian treasury bills

• Consider alternative of investing in 1-year treasury bills in the United States and the
alternative of investing in 1-year Indian treasury bills.
• US treasury bill investment this year will become = $ 1.02 next year
• Indian interest rate should be attractive enough to make Rs 50 into 55*1.02 = 56.1 next
year i.e., give you an interest rate of 12.2 %

e e 202 2 ∗ (1+ 𝑖𝑈𝑆 )

𝑖𝑖𝑛𝑑𝑖𝑎 = − 1 = expected exchange rate
e 202 1
e e 202 2 e e 2022 − e 2021
𝑖𝑖𝑛𝑑𝑖𝑎 =𝑖𝑈𝑆 +
e 2021 e 202 1
e e 202 2− e 202 1
𝑖𝑖𝑛𝑑𝑖𝑎 ≈  𝑖𝑈𝑆 +
e 2021
 ‘Covered’ Interest Rate Parity
e e 202 2− e 202 1
𝑖𝑖𝑛𝑑𝑖𝑎 ≈  𝑖𝑈𝑆 +
e 2021
• There is a risk, as the exchange rate may not turn out
to be as expected. Investors may take a ‘cover’ by
buying a forward or future contract
f 202 2 − e 2021
𝑖𝑖𝑛𝑑𝑖𝑎 ≈  𝑖𝑈𝑆 +
e 2021

• What would have been the interest rate in India if it

was a fixed exchange rate regime
The Balance of Payments and Capital Flows
• Assume a home country faces a given price of imports, export demand, and world
interest rate, if, and capital flows into the home country when the interest rate is
above world rate

• Balance of payments surplus is:

where CF is the capital account surplus
where i is the domestic interest rate (adjusted for expected depreciation)

– The trade balance is a function of domestic and foreign income, real exchange
rate
 An increase in domestic income worsens the trade balance
– The capital account depends on the interest differential
 An increase in the interest rate above the world level pulls in capital from abroad,
improving the capital account
How would this Affect the IS-LM Framework

• Fiscal and monetary policies affect the interest

rate

• Thus, the policies will have an effect on the

balance of payment and capital account as
well through interest rate channel
Policy Dilemmas: Internal And External Balance

• Internal balance, when the output is at full employment

• External balance when the balance of payment is close to

balance

• Addressing one problem might worsen the other

• A good doctor gives medicine for side-effects as well
• Or if the side-effect is worse/equal to the main disease,
then avoid treatment
Internal and External Balance • When domestic
interest is equal to if,
under a Fixed Exchange Rate the Balance of
Payment is zero,
forcing the BP = 0, a
horizontal line

• Y* is the full
employment

• Each point in the figure

can be seen as an
intersection of IS-LM
Curve, with different
set of problem (other
than E)

• Check the combination

of Y and interest rate
to verify the state of
macroeconomy
 Mundell-Fleming Model

• 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

WHY?
Mundell-Fleming Model: Perfect Capital Mobility
Under Fixed Exchange Rates

• A country tightens money supply to increase interest

rates:
– Portfolio holders worldwide shift assets into country leading to huge capital
inflows
– The exchange rate tends to appreciate, and the central bank must
intervene to hold the exchange rate fixed
– The central bank buys foreign currency in exchange for domestic currency
(to ‘honor’ its exchange rate commitment)
– Intervention causes domestic money stock to increase, and interest rates
drop
– Interest rates continue to drop until return to level prior initial intervention

• BOP Surpluses meant automatic monetization of the surpluses,

taking away the independence of the monetary policy
• Consider a monetary
expansion that starts from Monetary Expansion
point E  shifts LM
down and to the right to
E’
LM
– At E’ there is a large i LM’
capital outflow, and
pressure for the
exchange rate to
depreciate E
– Central bank must i=if
BP
intervene, selling
Interest rate
E’
foreign money, and
receiving domestic
money in exchange IS
• Supply of money
falls, pushing up
interest rates as LM Y
moves back to
original position
Monetary policy is infeasible,
but fiscal expansion under
fixed exchange rates and
Fiscal Expansion
perfect capital mobility is LM
effective LM’
A fiscal expansion shifts the
IS curve up and to the i E’
right  increases interest
rates and output E
The higher interest rates i=if
creates a capital inflow E’’ BP
with the tendency to
appreciate the exchange Interest rate
rate
To manage the exchange
IS
rate the central bank
must expand the money
supply  shifting the LM Y
curve to the right What would be the impact of this entire process
Pushes interest rates back
on current account deficit ?
to their initial level, but
output increases yet Link between central bank’s interventions and
again money supply
 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
• 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
– The central bank can set the money supply at will since there is no obligation
to intervene  no automatic link between BP and money supply
 Perfect Capital Mobility and Flexible
• Perfect capital mobility Exchange Rates
implies that the balance – When i > if, the
of payments balances currency appreciates
when i = if
– 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

When i < if, the

currency
depreciates
Suppose there is an increase in
the nominal money supply:
─ The real stock of money,
Monetary Expansion
M/P, increases since P is
fixed LM
─ At E there will be an excess LM’
supply of real money
balances i
─ To restore equilibrium,
interest rates will have to E
fall  LM shifts to the right i=if
─ At point E’, goods market is E’’ BP
in equilibrium, but i is
below the world level  Interest rate E’
capital outflows depreciate
the exchange rate
─ Import prices increase, IS
domestic goods more
competitive, and demand
for home goods expands Y
─ IS shifts right to E”, where i What would be the impact of this entire process
= if on current account deficit ?
─ Result: A monetary expansion leads to an increase in output and a
depreciation of the exchange rate under flexible rates
• At a given output level,
interest rate, and exchange
rate, there is an excess
demand for goods
Fiscal Expansion
• IS shifts to the right LM
• The new equilibrium, E’,
corresponds to a higher
income level and interest i E’
rate
• Capital inflows leads to E
appreciation of the
exchange rate
i=if
BP
• Appreciation of exchange
rate reduces the net exports Interest rate IS’
till the IS curve returns
back to the original level,
with the interest rate IS
equaling world interest
rates
• Don’t reach E’ since BP in Y
disequilibrium  exchange
What would be the impact of this entire process
rate appreciation will push
economy back to E on current account deficit ?
Crowding out of net exports instead of
investment (interest rate does not change)
Expansionary fiscal policy Expansionary Fiscal Policy
raises global interest rate
Capital outflow leads to
exchange rate depreciation,
in RoW
and shift of the IS Curve LM

E’
What would be the impact i'= i’f
of this entire process on E
current account deficit ? i=if BP

Interest rate
IS’

IS

─ Result: GDP stabilizes at E’ with higher net exports

and lower investments.
 Expansionary Monetary
• Expansionary monetary
policy reduces RoW’s Policy in RoW
interest rate.
LM
• Capital inflows due to
higher domestic interest rate
leads to appreciation of
currency
• IS Curve shift leftward E
i=if
BP

Interest rate
What would be the impact
of this entire process on E’
current account deficit ?
IS

Y
─ Result: GDP stabilizes at E’ with lower net exports
though higher investments.
 Beggar-Thy-Neighbour Policy and
Competitive Depreciation
• Depreciation of the USD raises its net exports and reduces the net exports for
rest of the world

• It is like exporting unemployment to rest of the world and importing

employment to the US

• If the countries are different levels of business cycle (one is in recession and
other is in boom) then deprecation by country experiencing recession solves
troubles for both

• If both the countries are in recession, then the world demand is at a wrong
level, and this may lead to competitive depreciations

• Combined fiscal and monetary response is highly desirable in such situations

 It is impossible for a A nation must choose
nation to have free one side of this triangle
capital flows, a fixed and give up the
exchange rate, and opposite corner.
independent monetary
policy.

China has a managed

float policy since
2006, along with
capital controls
 Euro
• A fixed exchange rate across the Europe

• Creates troubles for countries facing recession, as

they cannot depreciate their currency against other
European partners to raise net exports or reduce
their interest rate to raise their investment demand

• But it saves them from competitive devaluations

which was one of the reason for the two world wars
 Indian Trilemma: 2020-21
• The monetary expansion in the US fuelled the capital
inflows in India

• RBI needed to fight both inflation and slowdown together

• With real interest rates already in negative territories, RBI

found it difficult to reduce interest rates further

• It has chose to permit exchange rate appreciation which

help in reducing inflation, though can hurt exports
• Highlighting that profit of
the central bank largely
comes due to devaluation of
Indian currency, Rajan said
keeping a portion for the
contingency reserves, RBI
usually pays entire profit.

"RBI can pay profit and not

whatever it holds for
contingency reserves for
movement up and down. For
example, rupee that
depreciated could also
strengthen...so we should
accommodate for that," he
said.
 Repercussion Effects
• Fiscal expansion by the US raises imports in the US (and exports for
China, Japan, and India)

• Increase in income for China, Japan, and India will raise demand for
the US goods as well (think of multiplier model at the global level)

• Thus, the US acted as an locomotive engine for increasing the global

demand

• An expansionary fiscal policy by the US raises aggregate demand

everywhere

• But a depreciation/devaluation by the US raises the aggregate demand

in the US, while reducing the AD elsewhere