Mundell- Fleming model (IS-LM- BP model)
The balance of payments is a summary statement of all the transactions of the residents of a nation with the residents of all other nations recorded during a particular period of time, usually a calendar year.
The Mundell-Fleming model addresses how both internal balance and external balance can be achieved with just expenditure-switching policies. The conclusions of the Mundell-Fleming model can be developed using IS-LM-BP analysis.
Determination of exchange rate
In the diagram, BOP equilibrium at given exchange rate is maintained at point A where IS,LM and BOP curves are intersect with each other by determining equilibrium income and interest rate OY and OR respectively.
A. Expansionary monetary Policy: Monetary policy is concerned with change with money supply, interest rate etc. Central bank may increase money supply or decrease interest rate during this policy.
In the diagram, Initially, all markets ( i.e. goods, money and foreign) are in equilibrium at point A where IS0, LM(Mo) and BOP curves are intersect with each other by determining equilibrium income and interest rate OY0 and OR0 respectively at given exchange rate.
Suppose the monetary authority increases the money supply from Mo to M1, LM curve shifts parallel towards the right from LM(M0) to LM(M1). As a result, equilibrium is reached to point B, with a fall in interest rate to OR1 and income increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP curve.
At point B, there is infinite outflow of money due to increase in import demand at higher income and domestic investors seek to purchase higher returning foreign assets due to lower domestic interest rate (i.e. higher foreign interest rate)
But the central bank cannot accept this as it has already committed to fixed exchange rate. For this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves and buys excess domestic currency. It reduces the high powered money as well as money supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve back to the initial position LM(Mo) and income and interest rate also decreases to their initial position OY0 and OR0 respectively.
B. Contractionary monetary Policy:
Thus, it can be concluded that monetary policy is ineffective for the objective of increasing output level if a country adopts fixed exchange rate system.
C. Expansionary Fiscal Policy: In this
policy, government may increase its expenditure or decrease tax rate to encourage economic activities and to reduce unemployment. Effects of expansionary fiscal policy on exchange rate determination can be analyzed in two ways.
1. When BOP curve is less elastic than LM curve In the diagram, Initially, all markets ( i.e. goods, money and foreign) are in equilibrium at point A where ISo, LMo and BOP curves are intersect with each other by determining equilibrium income and interest rate OY0 and OR0 respectively at given exchange rate.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP curve.
At point B, there is infinite outflow of money due to increase in import demand with the increase income which makes the current account deficit. Similarly, foreign investors seek to purchase higher returning domestic assets due to higher domestic interest rate (i.e. lower foreign interest rate). It makes the capital account positive. Here, deficit current account is so powerful that it outweighs the positive capital account ( i.e. direct effect Y0Y1>induced effect Y1Y2).Which shifts the LM curve towards the left.
If economy wants to stay at point B in the long run, devaluation of domestic currency is needed which shifts the BOP curve towards the right and finally BOP equilibrium is maintained at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves and buys excess domestic currency. It reduces the high powered money as well as money supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve towards the left to the new position LM1 (M1) and finally, BOP is in equilibrium at point c by determining equilibrium income and interest rate OY2 and OR2 respectively.
2. When BOP curve is more elastic than LM curve In the diagram, Initially, all markets ( i.e.
Suppose that government expenditure increases from Go to G1, IS curve shifts parallel towards the right from IS0(G0) to IS1(G1). As a result, equilibrium is reached to point B and interest rate and income increases to OR1 and OY1 respectively.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP curve.
At point B, there is outflow of money due to increase in import demand with the increase income which makes the current account deficit. Similarly, foreign investors seek to purchase higher returning domestic assets due to higher domestic interest rate (i.e. lower foreign interest rate). It makes the capital account positive. Here, positive capital account is so powerful that it outweighs the deficit current account ( i.e. direct effect Y0Y1>induced effect Y1Y2). It shifts the LM curve towards the right.
If economy wants to stay at point B in the long run, overvaluation of domestic currency is needed which shifts the BOP curve towards the left and finally BOP equilibrium is maintained at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For this, central bank intervenes in foreign exchange market. It buys excess foreign exchange reserves (i.e. increases the foreign currency reserves) and sells domestic currency (i.e. increases the domestic money supply). It increases the high powered money as well as money supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve towards the right to the new position LM1 (M1) and finally, BOP equilibrium is achieved at point c
2. Flexible exchange rate: It is an endogenous variable determined by market forces. It fluctuates with the change in economic condition of country.
A. Expansionary monetary Policy:
In the diagram, Initially, all markets ( i.e. goods, money and foreign) are in equilibrium at point A where IS0, LM0 and BOP0 curves are intersect with each other by determining equilibrium income and interest rate OY0 and OR0 respectively at given exchange rate.
Suppose the monetary authority increases the money supply from Mo to M1, LM curve shifts parallel towards the right from LM(M0) to LM(M1). As a result, equilibrium is reached to point B, with a fall in interest rate to OR1 and income increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP curve.
balance of payment bettered i.e. BOP curve shift towards the right to BOP1. Finally, the system will be equilibrium at point C where IS1, LM1 and BOP1 curves are intersect with each other by determining the equilibrium income and interest rate OY2 and OR2.
B. Expansionary Fiscal Policy: In this policy, government may increase its expenditure or decrease tax rate to encourage economic activities and to reduce unemployment. Effects of expansionary fiscal policy on exchange rate determination can be analyzed in two ways.
3. When BOP curve is less elastic than LM
curve
In the diagram, Initially, all markets ( i.e. goods, money and foreign) are in equilibrium at point A where ISo, LMo and BOP0 curves are intersect with each other by determining equilibrium income and interest rate OY0 and OR0 respectively at given exchange rate.
Suppose that government expenditure increases from Go to G1, IS curve shifts parallel towards the right from IS0(G0) to IS1(G1). As a result, equilibrium is reached to point B, with a rise in interest rate to OR1 and income increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP curve.
