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Chapter 21
Open Economy
Macroeconomic
Policy and
Adjustment
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Topics to be Covered
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Internal Balance vs. External Balance
Macroeconomic Equilibrium
The IS Curve
The LM Curve
The BP Curve
Monetary Policy and Fiscal Policy under
Fixed Exchange Rates
• Monetary Policy and Fiscal Policy under
Floating Exchange Rates
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Open Economy Goals:
Internal and External Balance
• Internal Balance—a steady growth of the
domestic economy consistent with a low
unemployment rate.
• External Balance—the achievement of a
desired trade balance or desired
international capital flows.
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Tools of Macroeconomic
Policy
• Fiscal Policy—government spending and
taxation.
• Monetary Policy—central bank control of
the money supply and credit.
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Macroeconomic Equilibrium
• Macroeconomic Equilibrium requires equilibrium
in three major markets:
– Goods Market Equilibrium: the quantity of goods and
services supplied is equal to the quantity demanded.
– Money Market Equilibrium: the quantity of money
supplied is equal to the quantity demanded.
– Balance of Payments Equilibrium: the current account
deficit (surplus) is equal to the capital account surplus
(deficit), so that the official settlements balance equals
zero.
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IS–LM–BP Model
• The IS curve represents the goods market
equilibrium.
• The LM curve represents the money market
equilibrium.
• The BP curve represents the balance of
payments equilibrium.
• Macroeconomic equilibrium is achieved at
the point where all the curves intersect.
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FIGURE 21.1 Equilibrium in the Goods
Market, Money Market (LM), and Balance of
Payments (BP)
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The IS Curve
• The IS curve shows combinations of the interest
rate (i) and output (Y) that provide equilibrium in
the goods market, holding other things (e.g., the
price level) constant.
• Equilibrium occurs when leakages (saving, taxes,
and imports) equal injections (investment,
government spending, and exports), that is:
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Deriving the IS Curve
• Refer to Figure 21.2 IS curve derivation
• Assumptions:
– S and IM depend positively on income
– T, I, G, and EX are independent of income
– I depends negatively on interest rate
• S + T + IM line is upward-sloping because as
domestic income rises, S and IM increase.
• I + G + EX line is horizontal since I, G, and
EX are independent of income.
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FIGURE 21.2 Derivation of the IS
Curve
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Why is the IS Curve Downwardsloping?
• When the interest rate falls, more potential
investment projects become profitable, and
thus investment increases (I + G + EX line
shifts upwards). As investment rises,
equilibrium income also rises.
• We must remember that the IS curve is
drawn holding the domestic price level and
the EXR constant.
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The LM Curve
• The LM curve shows combinations of
i and Y that provide equilibrium in the
money market.
• Graphically, money market equilibrium
occurs at the intersection of the money
supply curve and the money demand curve
(refer to Figure 21.3).
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FIGURE 21.3 Derivation of the LM
Curve
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Deriving the LM Curve
• Refer to Figure 21.3
• Assumptions:
– Money supply is determined by the central bank
and thus exogenous.
– Money demand is negatively related to i.
• Money supply curve is vertical.
• Money demand curve is downward-sloping.
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Why is the LM Curve Upwardsloping?
• As income increases, demand for money
would increase (money demand curve shifts
upward). Given a fixed money supply, there
will be an excess demand for money at the
original interest rate. The desire to hold
more money than is available will cause the
interest rate to rise to a new equilibrium
level.
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The BP Curve
• The BP Curve shows combinations of i and Y that
provide equilibrium in the balance of payments, holding
the price level, exchange rate, and foreign debt
constant.
• Graphically, equilibrium occurs at the intersection of the
current account surplus(deficit) line and the capital
account deficit(surplus) line (refer to Figure 21.4).
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FIGURE 21.4 Derivation of the BP
Curve
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Deriving the BP Curve
• Refer to Figure 21.4
• The current account line is downwardsloping because as income increases,
imports rise and the current account surplus
falls.
• The capital account line is horizontal since
the capital account is determined by i, not Y.
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Why is the BP Curve Upwardsloping?
• If the interest rate increases, domestic
financial assets become more attractive to
foreign buyers, and the capital account
deficit falls. At the old income level, the
current account surplus will exceed the
capital account deficit, so income must rise
to a new equilibrium level.
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Macroeconomic Equilibrium
• Equilibrium for the economy requires that all
three markets (goods, money, and balance
of payments) be in equilibrium.
• This occurs at the intersection point of the
IS, LM, and BP curves.
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IS–LM–BP Model with Fixed
Exchange Rates
• Effects of Expansionary Monetary Policy
• Effects of Expansionary Fiscal Policy
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Monetary Policy Under Fixed
Exchange Rates
• With fixed exchange rates, the central bank
is not free to conduct monetary policy
independent of the rest of the world.
• Given perfect asset substitutability and
perfect capital mobility, the domestic
interest rate and foreign interest rate are
equal, and the BP line is horizontal at
i = iF. (refer to Figure 21.5)
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Monetary Policy under Fixed XR
(cont.)
• If the central bank increases the money supply,
then the LM curves shifts to the right, resulting in a
higher Y and lower i.
• The lower i causes a capital outflow and pressure
on the domestic currency to depreciate.
• To maintain the fixed exchange rate, the central
bank sells foreign exchange to buy domestic
currency, thus reducing money supply and shifting
the LM curve back to restore the initial equilibrium.
• Summary: Monetary policy is ineffective in
changing Y under fixed exchange rates and perfect
capital mobility.
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FIGURE 21.5 Monetary Expansion with
Fixed Exchange Rates and Perfect Capital
Mobility
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Fiscal Policy Under Fixed
Exchange Rates
• BP curve is horizontal at initial equilibrium interest
rate (refer to Figure 21.6).
• An increase in government spending shifts the IS
curve to the right, resulting in both higher i and Y.
• Higher i causes a capital inflow and pressure on the
domestic currency to appreciate. The central bank
must buy foreign exchange with domestic currency,
thus increasing the money supply and shifting LM
curve to the right. The new equilibrium is at the
original interest rate but at a higher income level.
• Summary: Under fixed exchange rates, fiscal policy
can increase income.
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FIGURE 21.6 Fiscal Expansion with Fixed
Exchange Rates and Perfect Capital Mobility
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IS–LM–BP Model With Floating
Exchange Rates
• The IS–LM–BP model with flexible exchange
rates and perfect capital mobility is also
called the Mundell-Fleming model.
• Effects of Expansionary Monetary Policy
• Effects of Expansionary Fiscal Policy
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Monetary Policy Under Floating
Exchange Rates
• With floating exchange rates, the domestic
monetary policy is independent.
• Refer to Figure 21.7 An increase in money supply
shifts LM to the right, resulting in a lower i and
higher Y.
• The lower i causes a capital outflow and a
depreciation of the domestic currency. The
depreciation makes domestic goods relatively
cheaper and stimulates net exports, thus shifting
the IS curve to the right. The new equilibrium
settles at the original i but at a higher income.
• Summary: Monetary policy can change income
under floating exchange rates.
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FIGURE 21.7 Monetary Expansion with
Floating Exchange Rates and Perfect Capital
Mobility
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Fiscal Policy Under Floating
Exchange Rates
• Refer to Figure 21.8
• Expansionary fiscal policy shifts the IS curve to the
right resulting in both higher income and interest
rate.
• The higher i attracts capital inflow, and the
domestic currency appreciates. The appreciation
shifts IS back to the original equilibrium i and Y.
• Summary: Fiscal policy is ineffective and there is
complete crowding out, that is, the increase in
government spending is offset by a decline in
private spending.
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FIGURE 21.8 Fiscal Expansion with Floating
Exchange Rates and Perfect Capital Mobility
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The Open Economy Multiplier
• Assuming that saving and imports are each
proportional to income and that interest rate
is fixed, the equilibrium national income can
be expressed as:
where s is the marginal propensity to
save and m is the marginal propensity to
import.
• The term 1/(s+m) is the open economy
multiplier.
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Open Economy Multiplier
(cont.)
• Since s and m are fractions less than 1, then the
multiplier is expected to be greater than 1. Thus, an
increase in I, G, or EX would cause the equilibrium
income level to rise by more than the change in
spending.
• Conversely, a decline in exports to the U.S. and the
large European countries could lead to a fall in the
equilibrium income of other countries.
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Multiplier Effect
• Refer to Figure 21.9
• If exports increase, then the incomes of
factors employed in the export industry will
rise. These resource-owners (e.g., workers)
will increase their spending on goods and
services, thereby stimulating production,
and further increases in income and
spending (the multiplier effect).
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FIGURE 21.9 The Effect of an
Increase in Exports
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