As such the balance of payments surplus at point B in panel (a) of Figure 3.10

will cause an expansion of the domestic money supply following intervention

by the authorities to maintain the ¬xed exchange rate. This causes the LM

curve to shift downwards to the right and long-run equilibrium will occur at

point C, where the balance of payments is zero and the goods and monetary

markets are in equilibrium.

In contrast to ¬scal expansion under a regime of ¬xed exchange rates,

with imperfect capital mobility, monetary expansion will always lead to a

deterioration in the balance of payments, and vice versa, regardless of whether

or not the LM curve is steeper than the BP curve. This is illustrated in Figure

3.11, where the economy is initially operating at point A, the triple intersec-

tion of the three curves IS, LM0 and BP, with equilibrium in the goods and

money markets, and in the balance of payments. Expansionary monetary

policy shifts the LM curve from LM0 to LM1 and results in a reduction in the

domestic rate of interest from r0 to r1 (worsening the capital account) and an

increase in the level of income from Y0 to Y1 (worsening the current account).

Figure 3.11 Monetary expansion under imperfect capital mobility

130 Modern macroeconomics

With adverse interest and income effects on the capital and current accounts

respectively, the overall balance of payments is unambiguously in de¬cit at

point B (that is, the curves IS and LM1 intersect at a point below the BP

curve).

In a similar manner to that discussed for expansionary ¬scal policy, point B

cannot be a long-run equilibrium. The implied balance of payments de¬cit

causes a contraction in the money supply, shifting the LM curve backwards.

The long-run adjustment process will cease at point A where the LM curve

has returned to its original position. In other words, in the absence of sterili-

zation, monetary policy is completely ineffective as far as in¬‚uencing the

level of income is concerned. This assumes that the domestic country is small

relative to the rest of the world so that expansion of its money supply has a

negligible effect on the world money supply.

Readers should verify for themselves that, for a small open economy

operating under a regime of ¬xed exchange rates, in the limiting case of

perfect capital mobility, the equilibrium level of domestic income is in the

long run established at the intersection of the IS and ˜horizontal™ BP curves.

In this situation ¬scal policy becomes all-powerful (that is, ¬scal expansion

results in the full multiplier effect of the simple Keynesian 45° or cross model

with no crowding out of private sector investment), while monetary policy

will be impotent, having no lasting effects on aggregate demand and income.

Before considering the effectiveness of ¬scal and monetary policy under

¬‚exible exchange rates it is interesting to note that Mundell (1962) also

considered the appropriate use of monetary and ¬scal policy to successfully

secure the twin objectives of internal (output and employment at their full

employment levels) and external (a zero overall balance of payments posi-

tion) balance. Mundell™s solution to the so-called assignment problem follows

his principle of effective market classi¬cation (Mundell, 1960). This princi-

ple requires that each policy instrument is paired with the objective on which

it has the most in¬‚uence and involves the assignment of ¬scal policy to

achieve internal balance and monetary policy to achieve external balance.

We now consider the effects of a change in ¬scal and monetary policy on

income and the exchange rate under a regime of ¬‚exible exchange rates. The

effects of ¬scal expansion on the level of income and the exchange rate again

depend on the relative slopes of the BP and LM curves. This is illustrated for

imperfect capital mobility in panels (a) and (b) of Figure 3.12, which are the

¬‚exible counterparts of Figure 3.10 discussed above with respect to ¬xed

exchange rates.

In panel (a) of Figure 3.12 the BP curve is steeper than the LM curve. The

economy is initially in equilibrium at point A, the triple intersection of curves

IS0, LM0 and BP0. Expansionary ¬scal policy shifts the IS curve from IS0 to

IS1. As we have discussed above, under ¬xed exchange rates ¬scal expansion

131

Figure 3.12 Fiscal expansion under (a) and (b) imperfect and (c) perfect capital mobility

132 Modern macroeconomics

would result in a balance of payments de¬cit (that is, IS1 and LM0 intersect at

point B below BP0). With ¬‚exible exchange rates the exchange rate adjusts to

correct potential balance of payments disequilibria. An excess supply of

domestic currency in the foreign exchange market causes the exchange rate

to depreciate, shifting the IS1 and BP0 curves to the right until a new equilib-

rium is reached along the LM0 curve to the right of point B, for example at

point C, the triple intersection of the curves IS2, LM0 and BP1 with an income

level of Y1. In this particular case the exchange rate depreciation reinforces

the effects of domestic ¬scal expansion on aggregate demand, leading to a

higher level of output and employment.

Panel (b) of Figure 3.12 depicts the case where the LM curve is steeper than

the BP curve. The economy is initially in equilibrium at point A, the triple

intersection of curves IS0, LM0 and BP0. Fiscal expansion shifts the IS curve

outwards from IS0 to IS1 with the intersection of curves IS1 and LM0 at point B

above BP0. This is equivalent to a balance of payments surplus under ¬xed

exchange rates and causes the exchange rate to adjust to eliminate the excess

demand for domestic currency. In contrast to the situation where the BP curve

is steeper than the LM curve, the exchange rate appreciates, causing both the

IS1 and BP0 curves to shift to the left. Equilibrium will be established along the

LM curve to the left of point B, for example at point C. In this situation ¬scal

policy will be less effective in in¬‚uencing output and employment as exchange

rate appreciation will partly offset the effects of ¬scal expansion on aggregate

demand. As noted above, panel (b) is more likely to represent the true situation.

In the limiting case of perfect capital mobility illustrated in panel (c) of

Figure 3.12, ¬scal policy becomes completely ineffective and is unable to

affect output and employment. In the case of perfect capital mobility the BP

curve is horizontal; that is, the domestic rate of interest is tied to the rate

ruling in the rest of the world at r*. If the domestic rate of interest were to rise

above the given world rate there would be an in¬nite capital in¬‚ow, and vice

versa. Fiscal expansion (that is, a shift in the IS curve to the right from IS0 to

IS1) puts upward pressure on the domestic interest rate. This incipient pres-

sure results in an in¬‚ow of capital and leads to an appreciation of the exchange

rate. As the exchange rate appreciates net exports decrease, causing the IS

curve to move back to the left. Equilibrium will be re-established at point A

only when the capital in¬‚ows are large enough to appreciate the exchange

rate suf¬ciently to shift the IS curve back to its original position. In other

words ¬scal expansion completely crowds out net exports and there is no

change in output and employment. At the original income level of Y0 the

current account de¬cit will have increased by exactly the same amount as the

government budget de¬cit.

Finally we consider the effects of monetary expansion on the level of

income and the exchange rate under imperfect and perfect capital mobility.

The orthodox Keynesian school 133

The case of imperfect capital mobility is illustrated in panel (a) of Figure

3.13. The economy is initially in equilibrium at point A, the triple intersec-

tion of curves IS0, LM0 and BP0. Monetary expansion shifts the LM curve

from LM0 to LM1. Under ¬xed exchange rates this would result in a balance

of payments de¬cit. With ¬‚exible exchange rates the exchange rate depreci-

ates to maintain balance of payments equilibrium and both the BP and IS

curves shift to the right until a new equilibrium is established along the

curve LM1 to the right of point B, such as point C, the triple intersection of

curves IS1, LM1 and BP1. The effect of monetary expansion is reinforced by

exchange rate depreciation, leading to a higher level of income. In the

limiting case of perfect capital mobility illustrated in panel (b) monetary

expansion (which shifts the LM curve from LM0 to LM1) will put downward

pressure on the domestic interest rate. This incipient pressure results in

capital out¬‚ows and a depreciation of the exchange rate, causing the IS

curve to shift to the right (from IS0 to IS1) until a new equilibrium is

established at point C, the triple intersection of curves LM1, IS1 and BP at

the given world interest rate r* and a new income level Y1. In this limiting

case monetary policy is completely effective and contrasts with the position

of ¬scal policy discussed above.

In summary, under a regime of ¬xed exchange rates with imperfect capital

mobility, while ¬scal expansion will result in an increase in income, its

effects on the overall balance of payments (assuming sterilization takes place)

are ambiguous (depending on the relative slopes of the LM and BP curves).

In contrast, there is no ambiguity following a change in monetary policy.

Monetary expansion will result in an increase in income and always lead to a

deterioration in the balance of payments. However, in the absence of sterili-

zation, monetary policy is completely ineffective in in¬‚uencing the level of

income. Furthermore, in the limiting case of perfect capital mobility ¬scal

policy becomes all-powerful, while monetary policy will be impotent, having

no lasting effects on aggregate demand and the level of income. Under a

regime of ¬‚exible exchange rates, with imperfect capital mobility, while

¬scal expansion will result in an increase in income, it could (depending on

the relative slopes of the LM and BP curves) cause the exchange rate to

depreciate or appreciate, thereby reinforcing or partly offsetting the effect of

¬scal expansion on aggregate demand and income. In contrast, monetary

expansion results in an increase in income, with the effects of monetary