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Economics of International Finance
Econ. 315
Chapter 6
Open Economy Macroeconomics:
Adjustment Policies
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Introduction

Adjustment policies used to achieve full employment with price stability
and equilibrium in BOP are examined in this chapter.

Adjustment policies are needed because automatic adjustments (the topic
of the last two chapters) have some serious side effects (James Mead).
Objectives of the nation are:

Internal balance

External balance

Reasonable rate of growth

Equitable distribution of income, and

Adequate protection of the environment

To achieve these objectives we have the following instruments:

Expenditure-changing policies

Expenditure-switching policies, and

Direct controls
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Expenditure changing policies: include fiscal and monetary policies.

Fiscal policy refers to changes in G, T or both which can be expansionary
or contractionary. Therefore, we need to introduce the government
sector, which means that the equilibrium condition would be:

I+X+G=S+M+T
This equation can be rearranged as
(G – T) = (S – I) + (M – X)

Monetary policy involves changes in MS that affect domestic interest
rates. It can be easy or tight, which would affect interest rates,
investment and income.

Expenditure switching policies: refers to changes in exchange rates
(devaluation or revaluation), which affects exports, imports and income.

Direct Controls: consists of tariffs, quotas and other restrictions (wage
and price controls) on the flow of international trade and capital.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Equilibrium in Goods Market, in the Money Market and the
BOP

We now introduce Mundell-Fleming model to show how a
nation can use fiscal and monetary policies to achieve
internal and external balance without the need to change R
(fixed exchange rates). For this reason we use the IS
(combinations of i and y at which goods market is in
equilibrium (AD=AS)), LM (combinations of i and y at which
money marker (MS=MD) is in equilibrium (MS=MD)), and
BP (combinations of i and y at which BOP is in equilibrium
X=M at a given R) curves.

We assume that short run capital flows are responsive to
international interest differentials.

The IS is negatively slopped because the higher the interest
the lower is I
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

The LM is positively slopped because the higher the interest,
the smaller is MD for speculation and the higher is MD for
transactions.

BP is positively inclined because the higher the interest, the
greater the capital inflows.

Look at figure 2. Note that at point E there is a less than full
employment output, even though all markets are in eq. Point
E is our starting point for analysis (here we have
unemployment but external balance)
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
BOP eq.
Money Market eq.
Possible eq. rates.
All markets are in eq.
But there is unemployment
Goods market eq.
Inflation
FIGURE 2 Equilibrium in the Goods and Money Markets and in the Balance of Payments.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Fiscal and Monetary Policies for Internal and External
Balance with Fixed Exchange Rates.
a - Fiscal and Monetary Policies from External Balance and
Unemployment.

Note that an expansionary fiscal policy ↑ G (↓ T) shits the IS to the
RHS, while a contractionary fiscal policy shifts the IS to the LHS.

An easy monetary policy (↑ MS) shifts LM to the RHS, and a tight
monetary policy shifts the LM to the LHS.

We assume that R is fixed, that is why BP curve will remain
unchanged.

Look at figure 3, the nation can reach full employment (internal
and external balance) by combining expansionary fiscal policy
(shift in IS to the RHS) and tight monetary policy (shift in LM to
the LHS). Equilibrium will be achieved at point F.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Note that full employment can be achieved by an easy monetary
policy at point U, BOP will be in deficit because at i=2.5, BOP
deficit will be accompanied by smaller capital inflows. On the
other hand the expansionary fiscal policy that shifts the IS to the
RHS to cross LM at Z will increase capital inflows (reduce capital
outflows), but capital inflows are still insufficient to avoid the
deficit in BOP.

To reach full employment and have equilibrium BOP, the nation
should pursue a stronger expansionary fiscal policy to shift LM to
point F, and tight monetary policy to raise interest to 8% as
required for BOP balance. These two conflicting policies are
required for simultaneous balance.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
i
BP
Tight M. Policy
LM’
LM
Equilibrium is achieved with expansionary
fiscal policy and tight monetary policy
F
8
Z
IS’
5
E
U
Expansionary
Fiscal Policy
2.5
IS
Y
YE=1000
Economics of International Finance
Prof. M. El-Sakka
YF=1500
CBA. Kuwait University
BP
i
LM
F
We could use easy
monetary policy at
8
point U, but BOP will
be in deficit
Z
IS’
5
E
U
2.5
IS
Y
YE=1000
Economics of International Finance
Prof. M. El-Sakka
YF=1500
CBA. Kuwait University
BP
i
LM
F
Or expansionary fiscal
8
policy, at point Z, but
BOP still in deficit
Z
IS’
5
E
2.5
IS
Y
YE=1000
Economics of International Finance
Prof. M. El-Sakka
YF=1500
CBA. Kuwait University

Fiscal and Monetary Policies from External Deficit and
Unemployment

Look at figure 4, at point E the domestic economy is in equilibrium
(IS intersects LM), but BOP is not, there is a deficit in BOP (point E is
on the RHS of BP. External balance requires Y to be 700 ant i=5%.

At point B’ there is a deficit in BOP equals excess level of Y time
MPM (note X is exogenous), = (1000-700) × .15 = 45. (in case of
foreign repercussions the deficit would be smaller). At Y=1000,
interest rate should be 6.5% for capital inflows to be larger by 45 (or
less capital outflows by 45), for BOP to be in equilibrium.

Starting from E the nation can reach full employment level of output
YF=1500 with external balance by using expansionary fiscal policy (to
shift IS to IS’) and tight monetary policy (to shift LM to the left to
LM’, so that i = 9% to achieve balance.

Note a tight monetary policy was required because the BP curve was
steeper than the LM curve.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
i
All markets are in eq.
Equilibrium is achieved with expansionary
fiscal policy and tight monetary policy
BP
9
LM’
F
BOP deficit =(1000-700)×.15=45
6.5
5
LM
B’
Z
IS’
E
B
Unemployment
IS
Y
Y=700
Economics of International Finance
YE=1000
Prof. M. El-Sakka
YF=1500
CBA. Kuwait University

Fiscal and Monetary Policies with Elastic Capital Flows

Suppose that BP is flatter, and is located to the RHS of the
LM as in figure 5.

At eq., the nation has unemployment and BOP deficit.
Internal and external balance can be reached by
expansionary fiscal policy (shifts the IS to IS’ as well as easy
monetary policy (shifts the LM to LM’), such that LM’ and
IS’ intersects BP at F at YF = 1500, where i = 6%.

As compared with last figure, interest rate has to rise only by
1% instead of 4%.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
i
Equilibrium is achieved with expansionary
fiscal policy and easy monetary policy
LM
LM’
BP
F
6
B’
B
IS’
E
5
unemployment
and BOP deficit
IS
Y
Y=500
Economics of International Finance
YE=1000
Prof. M. El-Sakka
YF=1500
CBA. Kuwait University

Fiscal and Monetary Policy with Perfect Capital Mobility

With perfect capital mobility, BP will be horizontal, the nation can
borrow or lend any desired amount of capital at 5%. This condition is
particularly relevant for small open economy.

In this case the small nation can reach full employment by appropriate
fiscal and without monetary policies.

Look at figure 6. Starting from point E. expansionary fiscal policy shits
the IS to IS’. Intersection with LM at E’ indicates a tendency of interest
rate to increase to 6.25%. Because of perfect capital mobility, there will
be capital inflows from abroad, which increase MS and shifts LM to LM’.
There will be an eq. at point F on the horizontal BP, with YF=1500 and
i=5%.

If the small nation attempted to reach eq. by easy monetary policy that
shifts LM to LM’, interest will decline to 3.75%, which leads to capital
outflows. This reduces MS and LM shifts back to its original level.

Conclusion: with fixed exchange rates, monetary policy will be ineffective
if international capital flows are highly elastic.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
i
Use fiscal policy alone. Higher i causes capital inflows and LM to shift
LM
E’
6.25
LM’
E
F
5
BP
IS’
3.75
E”
IS
YE=1000
Economics of International Finance
Prof. M. El-Sakka
YF=1500
Y
CBA. Kuwait University
i
Using easy monetary policy alone causes i to fall and
capital outflow shifting LM back. M. policy is ineffective
LM
E’
6.25
LM’
E
F
5
BP
IS’
3.75
E”
IS
YE=1000
Economics of International Finance
Prof. M. El-Sakka
YF=1500
Y
CBA. Kuwait University

The IS-LM-BP Model with Flexible Exchange Rates and imperfect capital
mobility

Look at figure 8. At point E all markets are in equilibrium with external balance
and unemployment. When the government uses easy monetary policy to reach full
employment at U where YF=1500 and i=2.5%. There is a BOP deficit (Y is higher
and i is lower than what is at point E).

Under flexible exchange rate system, the nation’s currency depreciates, and BOP
shits to the right (if ML conditions are satisfied), also the IS to the RHS. Domestic
prices increase and LM shifts to LM’ (real money supply declines as a result of
higher prices). Equilibrium will be achieved at E’ where all the markets are in
eq., but output=1400 and i=4.5% (unemployment still existing).

Further doses of easy monetary policy eventually lead to equilibrium at full
employment. Note that under flexible exchange rate system the BOP shifts due to
exchange rate changes.

If expansionary fiscal policy is used to shift the IS to point Z. Since this point is on
the RHS of BOP, there will be a deficit, the national currency depreciates and
BOP shifts to the RHS, which induces a further shifts the IS to the RHS and LM
to the LHS until IS and LM intersect the BP curve simultaneously at YF=1500.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Depreciation improves BOP
High Prices shift LM back
Initial shift (easy monetary policy
High Y and low i cause a BOP deficit causing depreciation
FIGURE 8 The IS-LM-BP Model with Flexible Exchange Rates.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

The IS-LM-BP Model with Flexible Exchange Rates and perfect capital
mobility.

Starting from point E in figure 9, with domestic unemployment and
external balance, perfect capital mobility and flexible exchange rates.
Expansionary fiscal policy shifts the IS to IS’ to point F at Y=1500. But
this tends to increase i to 6.25% at point E’. This leads to massive capital
inflows and appreciation. Exports decrease and imports increase and
shifts IS back to it original position (IS). Thus with flexible exchange
rates and perfect capital mobility, fiscal policy is completely ineffective at
influencing the level of national income.

An easy monetary policy shifts LM to LM’ which lowers interest to 3.5%
at E”. This leads to capital outflows and depreciation, which shifts the IS
to IS’ and LM shifts little back to LM” (real MS falls as P increase), such
that IS’, LM” and BP cross at point F where Y=1500 (full employment).
Internal and external balances are achieved using monetary policy only.

Thus with flexible exchange rates and perfect capital mobility, monetary
policy is effective and fiscal policy ineffective, while both policy are
effective under fixed exchange rate system.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Expansionary fiscal policy causes rise in i and
massive capital inflows, appreciation and less
Xn. IS shifts back. Fiscal policy in ineffective
Monetary policy is effective
Capital outflows
and depreciation
FIGURE 9 Adjustment Policies with Perfect Capital Flows and Flexible Exchange Rates.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Policy Mix and External Balance

The IB line in figure 10 shows the various combinations of fiscal and
monetary policies that result in internal balance (full employment and
price stability). It is positively related as an expansionary fiscal policy
must be balance by a tight monetary policy of a sufficient intensity to
maintain internal balance.

The EB shows the various combinations of fiscal and monetary policies
that result in external (BOP) balance. Starting from point F, an
expansionary fiscal policy stimulates national income and causes a BOP
deficit. This must be balanced by a tight monetary policy that increases
interest rates and capital flows for the nation to remain in external
balance.

Following the principle of effective market classification, monetary policy
should be assigned to achieve external balance and fiscal policy to achieve
internal balance. If the nation did the opposite, it would move farther and
farther away from internal and external balance.

The more responsive international short-term capital flows are to interest
rate differentials across nations, the flatter is the EB line in relation to the
IB line.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Expansionary fiscal policy leads to a deficit can
be corrected by tight monetary policy (Point A”)
Excess AD and inflation to
Be corrected by tight
Monetary Policy (point A’)
FIGURE 10 Effective Market Classification and the Policy Mix.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms

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










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
BP curve
Direct controls
Exchange controls
Expenditure-changing policies
Expenditure-switching policies
External balance
Internal balance
IS curve
Key Terms
LM curve
Multiple exchange rates
Phillips curve
Principle of effective market classification
Speculative demand for money
Trade controls
Transaction demand for money
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University