EC 340

Lecture 10 - Open Economy Macroeconomics with Fixed Exchange Rates

from last time
macroeconomic equilibrium
the multiplier
effects of AD and AS on the trade balance
effect of devaluation on national income
fixed exchange rates and economic policy
perfect capital mobility
shocks to the economy
assignment rule

From Last Time

Macroeconomic Equilibrium

Assume that the price level is fixed so that the level of output is determined by just the level of aggregate expenditures.

AD = C + I + G + X

Equilibrium is a situation in which there is no tendency for change. The economy will be in equilibrium when there is no reason for the level of income to change. Unplanned changes in inventory, equal to the difference between real GDP (Y) and aggregate demand will cause firms to alter the level of production:

Graphically, the economy is in equilibrium at the point where the AD function intersects the 45 degree line. At this level of real GDP, AD equals Y.
AE = Y
Equilibrium Conditions:
  1. Y = AD
  2. no unplanned changes in inventories
  3. leakages = injections
Leakages are income that is not spent on domestic consumption. The leakages are savings, taxes, and imports. Leakages cause real GDP to fall. Injections are spending on domestic production other than consumption spending. The injections are investment spending, government spending, and exports. Injections cause real GDP to rise. In equilibrium, real GDP does not change. So, the leakages must balance out the injections.

The Multiplier

The simple multiplier is equal to 1 divided by the marginal propensity to save or 1/s.

Suppose m is the marginal propensity to import. Then the spending multiplier in a small, open economy equal 1/(s + m).

This formula assumes that our imports have no effect on foreign economies. For a large open economy this is unlikely to be the case. The spending multiplier with foreign repercussions is

[1 + (mf/sf)]/[s + m + (mfs/sf)]

Effects of AD and AS on the Trade Balance

  1. an increase in C + I + G will likely worsen the trade balance as imports will rise more than exports
  2. an increase in exports will improve the trade balance
  3. an increase in AS will lower prices and improve the trade balance as we export more and import less

Effects of Devaluation on National Income

Suppose the U.S. exports aircraft and imports shoes. U.S. net exports would be equal to
Price in $aircraft x Quantity of Aircraft Exported - Price in $shoes x Quantity of Shoes Imported

Suppose the dollar depreciates. The dollar price of shoes rises for American buyers while the price of aircraft falls for foreign buyers. Shoe imports fall and aircraft exports rise.

However, since imports have become more expansive, their real value may rise even though the quantity of imports falls. If the change in the exchange rate causes a large change in the quantity of imports and exports, then net exports will rise. Typically, in the short run the quantity of imports and exports does not change much. So, net exports fall. After consumers and firms have had time to adjust their spending patterns, net exports will rise.

Generally, the exchange rate and the trade balance move in opposite directions.

So, a devaluation will cause national income to rise if

  1. devaluation actually improve the trade balance
  2. the terms of trade do not worsen so that import prices rise while export prices fall

The IS/LM/BP Model

The IS curve tells us what value of the real interest rate clears the goods market for any given value of real income. It shows combinations of Y and r for which the goods market is in equilibrium. S equals I at all points along the IS curve. The IS curve is downward sloping because higher Y leads to higher S which requires a lower r to bring the goods market into equilibrium.

The LM curve traces out those combinations of r and Y for which the asset market is in equilibrium, holding everything else constant.

Assume a fixed exchange rate regime. There are two policy problems under fixed exchange rates:

  1. external balance - maintaining the BOP so the exchange rate can remain fixed because a BOP deficit puts downward pressure on the value of the dollar while a BOP surplus puts upward pressure
  2. internal balance - control AD to maintain full-employment without inflation
With fixed exchange rates, the BOP reflects private trading between the domestic and foreign currency. A BOP surplus causes a net inflow of money from abroad while a BOP deficit causes a net outflow.

influences on BOP

  1. current account balance = NX(Y, R)
  2. financial capital flows = F(r)
The BP line shows combinations of Y and r that allow equilibrium in the foreign exchange market. Point to the left of the BP line represent a BOP surplus while points to the right of the line represent a BOP deficit.

BP line
In the short run the economy is in equilibrium at the intersection of the IS and LM curves. Equilibrium can be at any BOP position: surplus, deficit, or balanced.

Fixed Exchange Rates and Economic Policy

monetary policy

An expansionary monetary policy worsens the balance of payments. An increase in the money supply has three effects:
  1. the real interest rate falls causing an outflow of capital, so the BOP worsens
  2. real income rises, so imports go up and the BOP worsens
  3. the price level rises causing imports to rise and exports to fall, so the BOP worsens
effect of expansionary monetary policy on the BOP

fiscal policy

Expansionary fiscal policy worsens the balance of payments in the long run. A rise in government spending, for example, causes
  1. Y to rise so imports go up, worsening the BOP
  2. r to rise, leading to an inflow of money which improves the BOP, but only in the short run
effect of expansionary fiscal 
policy on the BOP

Fiscal policy is more effective than monetary policy when exchange rates are fixed.

Perfect Capital Mobility

Perfect capital mobility means that money is free to move between countries in search of the highest interest rate. So, the interest rate all over the world is fixed at rw.

monetary policy

monetary policy with perfect capital mobilityAn increase in the money supply pushes the domestic interest rate below rw. This causes an outflow of money and the money supply shrinks. A contractionary monetary policy has the opposite effect. So, the LM curve is horizontal at rw and monetary policy has no effect on the LM curve. Monetary policy is ineffective under fixed exchange rates and perfect capital mobility.

fiscal policy

policy with perfect capital mobilityA rise in government spending causes the interest rate to rise. With r above rw, money flows into the economy from abroad. The inflow causes the money supply to rise until r falls back to rw. Fiscal policy is effective under fixed exchange rates and perfect capital mobility.

Shocks to the Economy

  1. domestic monetary shock - e.g. increase in money demand
  2. domestic spending shock - flexible rates are procyclical
  3. international capital flow shocks - e.g. capital outflow
  4. export demand shock
  5. import supply shock

Fixed exchange rates stabilize internal shocks but magnify external shocks.

Assignment Rule

In the long run, both expansionary fiscal and monetary policy worsen the BOP through their effects on income. Which means that in some cases, it is impossible to improve both the level of domestic demand and the BOP.


  1. abandon fixed exchange rates (our subject for next week)
  2. abandon controlling the domestic economy
  3. develop new policy tools
  4. use both monetary and fiscal policy
An increase in the money supply lowers the interest rate while expansionary fiscal policy raises the interest rate. So, a combination of expansionary monetary policy and contractionary fiscal policy that kept AD unchanged would decrease the interest rate and worsen the BOP. Monetary and fiscal policy can be mixed to achieve any combination of AD and BOP position.

The assignment rule suggests using fiscal policy to control the domestic economy and monetary policy to influence the BOP.

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917