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Block 1
Block 1
MACROECONOMIC
ANALYSIS
1.1 OBJECTIVES
After going through the unit, you should be in a position to
bring out the salient features of classical economics;
analyse the classical approach to the determination output and employment;
explain the quantity theory of money and its implication on price
determination;
explain the classical dichotomy in the economy and the neutrality of money
in a classical system; and
describe the behavior of prices in the long-run and short-run.
1.1 INTRODUCTION
Being a student of economics, you must be aware that macroeconomic theory has
evolved over time in response to the dynamic macroeconomic environment.
Initially, during the nineteenth and early twentieth century, there was a consensus
among economists and economic historians that an economy could run smoothly
without much fluctuation in income, output and employment. The perception
Dr. Jagannath Mallick, Independent Researcher, New Delhi writer
Traditional Approaches was that there should be minimum state intervention in economic variables such
to Macroeconomics
as wages, prices and interest rates. The market forces (supply and demand) would
take care of economic equilibrium in an economy. Such an assumption, however,
is unrealistic – all governments have in place certain economic policies (such as
monetary policy and fiscal policy) and they carry out amendments to these
policies from time to time!
Economic theory refers to a set of ideas and principles which are used to explain,
analyse and predict certain ‘phenomenon’ or observable events. As you know,
macroeconomic theory deals with macroeconomic phenomena, which are
aggregative in nature. The need for a special branch of macroeconomics arises
because what holds for the individual units may not hold good for the economy
as a whole. For example, suppose a firm employs labour for production of output
(say, cement). It can hire as many workers it requires at the ongoing wage rate.
Thus, increase in demand for labour by a single firm does not have any impact on
the wage rate. However, if all the firms in a country increase their demand for
labour (say due to economic boom and optimism in the country), there will be
shortage of labour and increase in wage rate. Further, the number of workers
available for work in the country is limited; thus demand for labour beyond this
limit will increase wage rate only, not the supply of labour.
Let us look into the global energy crisis of 2022. This took the form of global
shortages and increased the prices of oil, gas and electricity throughout the world.
The crisis was caused by a variety of social and economic factors: labour
shortages, political disputes, climate concerns, and the war between Russia and
Ukraine. The world economy responds to such crises in certain ways. During the
global energy crisis of 2022, for example, the oil-exporting countries witnessed
an increased inflow of income while petroleum-importing countries experienced
a rise in the cost of production. There was severe inflation in most countries. In
order to control inflation, policy makers resorted to increase in interest rates and
reduction in money supply.
Countries design their monetary and fiscal policies for the welfare of people by
controlling inflation and boosting economic growth. Macroeconomic theory
guides economists and policymakers to explain the situation and design
appropriate policy measures. Among economists, however, there is no agreement
on how equilibrium levels of output, prices and employment are determined.
Historically economic data are the same, but economists differ on the reasons and
solution for economic problems. In microeconomics there is more or less some
consensus. In macroeconomics, as you will see, there are sharp and often
altogether different explanations and policy recommendations for the same
phenomenon.
Macroeconomics has been subjected to debates, particularly since the 1930s. The
reasons behind such differences among economists are the basic assumptions and
the models they take. Two major schools of thought – Classical and Keynesian –
have interpreted economic events differently. Accordingly, they have accorded
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different explanations for the same economic issue. In this unit, we focus on the The Classical
classical theories while Keynesian theories will be discussed in Unit 2. Approach
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2) What are the main features of new-classical economics? The Classical
Approach
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Real Wage
3𝑊 2𝑊 𝑊
= =
3𝑃 2𝑃 𝑃
𝑊
𝑀𝑃𝑁 = 𝑁 = 𝑓
𝑃
N1 N
Ns(P3)
Ns(P2)
3𝑊 Ns(P1)
Normal Wage
2𝑊
N0 N1 N2 Labour
Employment
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Let us assume that there are only two factors of production, i.e., labour and The Classical
capital. Output is determined by the production function Y=F(K,N) as given in Approach
Fig. 1.2, panel (b). Equilibrium in the labour market (see panel (a) of Fig. 1.2)
determines the full employment labour supply and real wage rate. Based on that
full employment out is given in panel (b) of Fig. 1.2. As you can see, the
economy operates with full employment output (Y0) and full employment labour
supply (N0).
Labor Market Equilibrium
𝑊
𝑃 𝑁
Real Wage
𝑊 A
𝑃
𝑀𝑃𝑁 = 𝑁
N
Employment N0
Output Determination
𝑌 = 𝐹(𝐾, 𝑁)
A
𝑌
Output
N
Employment N0
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Traditional Approaches Since there is full employment in the economy all the time, with a given
to Macroeconomics
production function and capital, the Aggregate Supply (AS) is inelastic at full
employment level of output. In Fig 1.3 we have shown the AS curve as a vertical
straight line. Note that the AS curve will shift if there is a change in the level of
technology (production function) or the level of capital.
P AS
3P1
Output Y1 Y
As mentioned earlier, the terms V and T are constants in equation (1.6). Thus, the
equation indicates that money supply directly affects price level. For instance, if
M is increased by four times, price level P will rise by four times. Therefore,
classical QTM is known as a theory of price level.
The other approach of classical QTM describes the relationship between the
demand for money and ‘nominal output’ by taking directly real output instead of
number of transactions. In equation form, it can be expressed as
MV = PY … (1.7)
where,
M is the money supply
V is the velocity of money that is the number of times the money changes
hand.
P is the output price, and
Y is the real output level.
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Traditional Approaches The total stock of money in the economy, measured by money supply times the
to Macroeconomics
velocity of circulation (MV), equals the nominal value of transactions or the
nominal value of income or output in the economy (PY). The identity given at
(1.7) is converted into the QTM under the assumption that Y and V are stable or
constant in the short run. With Y and V being constant, the assumption that price
level is passive means that P depends on changes in M rather than M depends on
changes in P. These assumptions indicate that any short-run decrease (or
increase) in M must lead to a proportional decrease (or increase) in P. Relaxation
or invalidity of any one of these assumptions would not hold the proportionality
relationship of P with M.
According to classical theory, under perfect competition with full employment in
the economy, the output level is fixed (𝑌⃑ ). The velocity of circulation is
predetermined (𝑉⃑) and money supply is exogenously given. From equation (1.6),
Price level (P) is proportional to the money supply (M).
𝑃 = (𝑉⃑⁄𝑌⃑) × 𝑀 … (1.8)
P AS
AD0
𝑌 Y
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The Classical
1.6 SAY’S LAW OF MARKET Approach
The Say’s law of market has been a basic pillar of classical economic theory.
According to this law, every supply generates its own demand. An implication of
the above is that if a commodity is produced, it will create sufficient income for
the owners of factors such as land, labor and capital to purchase the produced
commodity. After all, the price of the commodity is divided into its components
such as rent, wages and profits. Hence, this income will be sufficient to realize
the price of the commodity.
According to the Say’s law, enough income will always exist to purchase the
entire produced output, so that there will not be any surplus left under the laissez-
faire orientation. Using this logic, it can be concluded that there should not be
any major depression. If it occurs, it must be caused by some interference with
the free flow of commodities and money. The Say’s Law thus supported the
laissez-faire orientation of classical economics. The law is heavily dependent on
the assumption of perfect flexibility in prices. Under this assumption, whatever
quantity is produced can be sold in the market. In the short run, supply (or
demand) may exceed demand (or supply). Such discrepancy is adjusted
automatically, and instantaneously, through a decline (or rise) in prices. Such
instantaneous adjustment exists for all commodities and factor inputs. Says’ law
is also regarded as a natural consequence of perfect competition.
The proponents of the Say’s law believe that the law is valid both in a barter
economy as well as a money economy. The law states that income received from
the production of output is always spent on aggregate demand, i.e., consumption
and investment. In other words, the law suggests that money is never hoarded and
that the money or expenditure stream (MV) remains neutral. There is no doubt
that the law is valid under a barter economy where production was primarily for
consumption, i.e., whatever is produced is exchanged for goods and services. But
one may doubt its validity in the present era, when production is based on future
expectations and anticipations of demand; there is bound to be some
overproduction. It is often said that the Say’s law is valid if a substantial portion
of production is used for consumption and the rest, if saved, is invested.
Check Your Progress 2
1) Describe how output and employment are determined in the classical
model.
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Traditional Approaches 2) What are the implications of the quantity theory of money?
to Macroeconomics
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The Classical
Approach
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Traditional Approaches exceeds labour supply. According to classical theory, this causes the nominal
to Macroeconomics wage rate to increase to W1 (in equal proportion to the increase in price level)
such that the original level of real wage is maintained (that is, W1/P1 = W0/P0).
Thus, there is no change in the equilibrium level of employment NF. (See panel
(a) of Fig. 1.5). At the earlier wage rate and employment level, the real output is
not affected, as seen in panel (b) of Fig. 1.5. To conclude, when there is an
expansion of money supply, the nominal wage rate and price level increase
without affecting the levels of real wage, employment and output. Such
independence of real economic variables from changes in money supply is called
neutrality of money.
There is a crucial limitation to the neutrality of money. It is a basic result derived
from the full-employment equilibrium that is based on the full flexibility of
prices. If increase in money supply (resulting in higher prices) had no real effects,
then inflation would not have been a serious concern in an economy. Inflation,
however, is a serious problem as has many adverse effects such as decrease in
quality of life of people, decrease in economic growth, etc. Thus, measures are
taken to control inflation and maintain price stability in an economy.
1.4.3 Saving-Investment Equilibrium
You should note that classical theory emphasized on the function of money that it
is a medium of exchange. According to the classical school money is demanded
for transaction purposes only. Hence, supply of and demand for money in the
classical theory do not determine the equilibrium rate of interest. An increase in
the quantity of money does not affect the real rate of interest. Thus, there is no
change in the level of saving and investment (see, Fig. 1.6). This shows that
when money supply rise, it does not disturb the capital market equilibrium (or
saving-investment equality) and the level of full-employment equilibrium
remains unchanged.
Y
𝐼
S
I
𝑆
Real Interest Rate
S
𝐼
𝑆 I
X
O Saving and Investment
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An increase in money supply will lead to an increase in prices. Due to the higher The Classical
Approach
prices, nominal investment expenditure will increase. However, according to
classical theory, such increase will be proportional to the increase in prices.
Therefore, investment expenditure in real terms will not change. This is
explained diagrammatically in Fig. 1.6. We measure real interest rate on the y-
axis and nominal value of saving-invest on the x-axis. The increase in money
supply causes the supply curve of nominal saving to shift downward to the right
from SS to 𝑆 ′ 𝑆 ′. Simultaneously, the investment demand curve will shift upward
from II to 𝐼 ′ 𝐼 ′ by the same amount. It implies that the interaction of 𝑆 ′ 𝑆 ′ and 𝐼 ′ 𝐼′
determines the interest rate without affecting real saving and real investment at
the higher price level too.
Let us explain the price behavior in both the short-run and long-run in Fig. 1.7.
Aggregate supply is the total amount of goods and services that firms sell in an
economy. Aggregate demand is the total quantity of goods and services that are
purchased. In a standard AS-AD model, output (Y) is presented on the X-axis
and price (P) is on the Y-axis. The long run aggregate supply curve (𝐴𝑆 ),
which denotes the potential output (full employment output) of the economy is
given by a vertical line at 𝑌 ∗ . The short-run supply curve is upward sloping
(𝐴𝑆 ). The interaction of supply and demand determines the equilibrium level of
output (𝑌 ). In the short run, an outward shift in the supply curve (from 𝐴𝑆 to
𝐴𝑆 ) results in rising output (from 𝑌 to 𝑌 ) and falling prices (from 𝑃 to 𝑃 ). An
outward shift in the AD curve (from 𝐴𝐷 to 𝐴𝐷 ) also results in rising output
(from 𝑌 to 𝑌 ) but rising prices (from 𝑃 to 𝑃 ).
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Traditional Approaches
to Macroeconomics
ASLR
P
AS0
AS1
P1
AD1
AD0
𝑌∗ Y
Y0 Y1 Y2
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2) Why is money considered to be neutral? What are its implications? The Classical
Approach
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Traditional Approaches 3) According to the Say’s law, supply creates its own demand. It rules out the
to Macroeconomics
possibility of unemployment in an economy.
Check Your Progress 3
1) It refers to the classical proposition nominal variables do not influence real
variables in an economy. It arises from the classical assumptions of perfect
competition and full flexibility in prices and wages.
2) Classical economists emphasized that money is demanded as a medium of
exchange. An increase in money supply leads to proportionate increase in
prices and wages; real variables such as output and employment remain
unchanged.
3) Prices and wages may not be fully flexible. Rigidities in prices and wages
may not lead to instantaneous adjustment in output and employment. Thus,
classical theory may not be applicable in the short run.
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UNIT 2 THE KEYNESIAN MODEL
Structure
2.0 Objectives
2.1 Introduction
2.2 Components of Aggregate Demand
2.2.1 Consumption Function
2.2.2 Investment Function
2.3 Determination of Output in the Keynesian Model
2.3.1 Determination of Equilibrium Output
2.3.2 Investment Multiplier
2.3.3 Government Expenditure and Tax Multipliers
2.3.4 Open Economy Multiplier
2.4 An Alternative View of Equilibrium
2.4.1 Saving Function
2.4.2 Determination of Equilibrium Output
2.4.3 Paradox of Thrift
2.5 Liquidity Preference
2.5.1 Components of Demand for Money
2.5.2 Liquidity Trap
2.6 Role of Government in the Economy
2.7 Let Us Sum Up
2.8 Answer/Hints to Check Your Progress Exercises
20.0 OBJECTIVES
After going through this Unit you should be in a position to
appreciate the assumptions underlying the Keynesian model;
explain the concepts of consumption function and saving function;
identify the factors affecting investment demand;
show that equilibrium output in the Keynesian model is determined by the
level of aggregate demand;
explain the various types multipliers in the Keynesian system;
explain the paradox of thrift;
explain the concepts of liquidity preference and liquidity trap; and
discuss the Keynesian view on the role of the government in the economy .
Prof. Ananya Ghosh Dastidar
Traditional Approaches
to Macroeconomics
2.1 INTRODUCTION
In this Unit we will learn about the Keynesian model that was first developed by
the British economist John Maynard Keynes in his famous book ‘The General
Theory of Employment, Interest and Money’, published in 1936. This model
differs in several respects from the classical approach to macroeconomics that
you studied in the previous Unit. The Keynesian model allows for the existence
of unemployment as well as rigidity in wages and prices. It recognizes that lack
of effective demand may prevent the attainment of full employment of resources.
Also, it emphasizes the need for government intervention – as the market
mechanism would not be able to restore full employment equilibrium due to
rigidities in wage rate and prices.
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upward sloping straight line as in Fig. 2.1. It indicates that planned consumption The Keynesian Model
expenditure increases with an increase in the level of aggregate income.
𝐶 = 𝑎 + 𝑏𝑌
C
𝐶 = 𝑎 + 𝑏𝑌
a1
𝑏
a0
0 Y
I
I
I = c + dY
I̅
Y c
Y
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Say, the current interest rate is i and an investment project that costs Rs. A, is The Keynesian Model
expected to last for T periods. In each period it yields a return of Rt, where t =
1,2,…, T. In this case, the present value of the stream of returns from the project
P is calculated as:
P= + + + ⋯+ … (2.2c)
( ) ( ) ( ) ( )
If profit is the only motive of investment, this project will be taken up only if
(𝑃 − 𝐴) ≥ 0.
For example, if you are willing to lend Rs.100 at 10 per cent rate of interest for a
period of 1 year, then at the end of the year you will receive Rs.110. So, at the
current interest rate of 10 per cent, the present discounted value of Rs.110 is Rs.
100 [where, 100 = 110 / (1+0.1)].
Now, for the economy as a whole, for any given rate of interest, i0, the
corresponding level of investment I0 by firms would consist of all the projects for
which 𝑃 ≥ 𝐴. Now, if the interest rate increases to i1 (Rt and A remaining
unchanged), P would decrease. Consequently, some projects for which 𝑃 ≥ 𝐴,
would now be unprofitable. At a higher interest rate, therefore, all the projects for
which P < A would not be taken up, so there would be a fall in the associated
level of investment I1. Thus, when i0 > i1 we have I0 < I1.
If we include interest rate as an explanatory variable in the investment function,
we have
𝐼 = 𝑐 + 𝑑𝑌 − 𝑒 𝑖 … (2.2d)
where c > 0, d > 0 and e > 0. Here, e captures the interest responsiveness of
planned investment expenditure.
Check Your Progress 1
1) Discuss the main features of the Keynesian consumption function.
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2) Through a diagram, explain how (i) a decrease in autonomous consumption,
and (ii) an increase in the MPC, would affect the consumption function.
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Traditional Approaches 3) Distinguish between autonomous investment and induced investment.
to Macroeconomics
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4) State the reasons for the inverse relationship between interest rate and
investment level.
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Therefore, in our simple Keynesian model The Keynesian Model
AD, C
L
and I H
AD = C + I̅
E
J
G
C=a+bY
A
I̅
450
o Y
Y1 Ye Y2
In Fig. 2.3 we derive the aggregate demand curve (AD) by adding the investment
(𝐼 )̅ and consumption (C) functions. Since investment is autonomous the line AD
is parallel to the consumption function, i.e., slope of AD is the same as the slope
of the consumption function. Equilibrium output is attained at E, at the
intersection of AD with OL where aggregate demand EYe is equal to aggregate
output OYe. Note that the equilibrium is unique, as there is only one level of
income OYe at which aggregate demand is equal to aggregate supply. In this case
firms will be able to sell exactly as much as they had planned and hence there
will be no unplanned changes in their stock of inventories.
For all income levels less than OYe, i.e., to the left of E, there is excess demand
for output. For example, when aggregate income is OY1 (=AY1), the
corresponding level of aggregate demand GY1 is greater than the supply of
output AY1 (=OY1). In this case since demand is more than the output produced
by firms, they will have to run down their stock of inventories. So in the next
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period, firms will increase production and output would move toward OY e. This The Keynesian Model
process of increase in output (and hence income) will continue till OY e is
reached, where the amount produced (OYe) being exactly equal to the amount
demanded (EYe), there is no unplanned changes in the stock of inventories and
hence no further change in production levels.
Similarly, to the right of E (i.e., at all income levels greater than OYe), there will
be excess supply of output. When income is OY2, the corresponding level of
aggregate demand JY2 is less than the supply HY2 (= OY2). In this case, firms
will be unable to sell the entire amount produced (HY2 > JY2) and hence their
stock of inventories will increase (i.e., there will be unplanned inventory
accumulation by firms). This would induce firms to reduce production in the next
period. This process will continue till the equilibrium output EY e (=OYe) is
reached, where demand and supply are equal and there are no more unanticipated
changes in firms’ stock of inventories.
From this discussion we see that output market equilibrium in the Keynesian
model is stable. Any situation of disequilibrium tends to be self-correcting,
inducing a movement back towards the equilibrium level of output.
Three-Sector Economy with Government
In equation (2.4) we derived equilibrium output in a three sector model, with
households, firms and a government sector. Diagrammatically this can be shown
in Fig. 2.4. As earlier, the OL line makes an angle of 450 with the horizontal axis
along which we measure income (or output). Aggregate demand is measured
along the vertical axis. Now, this has three components, C, I and G, where
investment and government expenditure are autonomous.
AD,C, I, G
L
AD = C + I̅ + G
A
450
Y
o
Ye
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The Keynesian Model
AD, C, I L
AD1 = C + I̅1
D
E AD0 = C + I0̅
∆I A
F
450
O Y
Y0 Y1
37
Traditional Approaches Lump Sum Taxes
to Macroeconomics
When the government imposes a lump sum tax T, the equilibrium income would
be given by (2.4) above: Ye = (a – bT +I + G) / (1–b). In this case, the multiplier
for any change in autonomous expenditure (either investment or government
expenditure) would be given by: 1 / (1 – b). Thus, Y/G = 1 / (1 – b) or Y/I
= 1 / (1 – b). If there is an increase in the amount of tax collected, then income
would fall. In such a case the tax multiplier would be given by: –b / (1 – b). Thus,
Y/T = – b / (1 – b). Recall that taxes are a leakage from the income stream, so
increase in taxes leads to a decrease in disposable income. Consequently, there is
a decrease in consumption demand, leading to a decline in output (as output is
demand-determined, lower demand results in lowering of output). You should
note that there is a two-way relationship: consumption is influenced by the level
of income (evident from the consumption function) and income is influenced by
consumption demand.
Balanced Budget Multiplier
Suppose the government increases its spending (i.e., G > 0) and cut taxes by
exactly the same amount (T < 0). It implies that the government budget remains
unchanged. If B indicates budget balance, then B = G – T = 0.
Alternatively we can write G = T. You may think that such action would have
no impact on equilibrium income as the injection of additional demand (G) is
exactly offset by a leakage from the demand stream (G = T). However, we can
show that the multiplier in this case is equal to one, i.e. income increases by the
amount of increase in government expenditure. From equation (2.4) we know
that Ye = (a – bT +I + G) / (1–b), so that Y = (– bT + G) / (1– b). Since G
= T, this can be written as Y = (1 –b) G / (1– b), or Y / G = 1.
Proportional Taxes
Now suppose the government levies a proportional tax on income at tax rate t,
where 0 < t < 1. Since AD = a + b (Y – tY) +I + G, the equilibrium condition is
given by
Y = a + b (1 – t)Y + +I + G … (2.7)
By re-arranging terms, we obtain the equilibrium level of output as
Ye = (a +I + G) / {1 – b (1 – t)} … (2.8)
Equation (2.8) implies that the autonomous expenditure multiplier (for a change
in investment or government expenditure) is now lower compared to the cases
without the proportional tax. Without proportional taxes the multiplier is given
by 1/(1 – b). Now, in the presence of proportional taxes, it is given by Y / G =
Y / I = 1 /{1 – b (1 – t)). The reduction in the value of the multiplier arises
because, out of the increase in income in each round, a fraction t has to be paid in
taxes.
You can see from equation (2.8) that any increase in the tax rate would lower
equilibrium income, whereas any decrease in tax rate would have the opposite
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effect. Therefore, you should see the logic behind tax cuts offered by The Keynesian Model
governments to revive economic activity. However, remember that our
assumption is that there is excess production capacity, which is the main reason
why the increase in consumption demand spurred by a cut in taxes would lead to
an increase in output. Else, it will lead to price rise instead of increase in output.
2.3.4 Open Economy Multiplier
In an open economy there is an additional source of demand for domestic output,
viz., exports (X). Exports are autonomous as they depend on foreign incomes
(i.e., incomes of foreign residents who buy domestic products) rather than
domestic income. Therefore, an increase in exports will have multiplier effect on
income, via various rounds of induced increases in consumption. Firms and
households purchase goods and services from foreign countries in an open
economy. Such imports (M) are a leakage from the domestic expenditure and
income streams. We assume that demand for imports depend on domestic income
level. The import demand function is given by M = h + mY, where h is the
autonomous component of import demand. Here, m is the marginal propensity to
import (MPM) and m > 0. Note that both exports and imports are influenced by
exchange rate changes also (we will take up such issues later in the course on
International Economics). In the present Unit we consider any change in exports
and imports due to exchange rate fluctuation is treated as an autonomous change.
In an open economy, exports are an injection while imports are a leakage from
the stream of aggregate demand for domestic goods. Thus, aggregate demand is
given by: AD = C +I + G + X – M = a + b Y +I + G + X – h – m Y. Therefore,
the equilibrium condition is given by
Y = a + b Y + I + G + X – h – m Y … (2.9)
The equilibrium level of output or income is given by
Ye = (a – h +I + G + X) / (1 – b + m) … (2.10)
In (2.10), the autonomous components are I, G and X. Any change in these
autonomous components will have a multiplier effect. The autonomous
expenditure multiplier for investment, government expenditure or exports is
given by: Y / G = Y / I = Y / X = 1 / (1 – b + m). Clearly, the open
economy multiplier is smaller compared to the one for the closed economy (1/(1
– b). The reason is that a proportion m out of the increment in income is now
spent on imports and domestic demand is lower to that extent as compared to a
closed economy.
In general, from our discussion on multipliers you should note the following
points: (i) the multiplier would be larger, the larger is the MPC (b) and MPI (d),
the lower the tax rate (t) and the smaller the m; (ii) the multiplier is applicable
both in case of a rise as well as a fall in autonomous incomes, meaning that
income would fall by a multiple in case of a given cut in any autonomous
component of demand; and (iii) the operation of the multiplier is driven by the
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Traditional Approaches assumption that the economy has ample excess capacity and unemployed
to Macroeconomics
resources, so that output can be demand-determined.
2.3.5 Limitations of the Keynesian Model
In the beginning of this section we mentioned that the Keynesian model is more
relevant for an economy facing recessionary conditions, having excess
production capacity in place. In economies having supply constraints (i.e., where
there are supply bottlenecks), an increase in demand is likely to result in a rise in
prices rather than in output. Second, Keynesian model would not apply to
economies that are operating near full employment, where increase in output
would require increase in factor and goods prices. Third, Keynesian model is
generally used for macroeconomic analysis pertaining to the ‘short run’.
Normally, once wage contracts are written they last for some time; also, prices
printed on sales catalogues are expected to be valid for some time. So the
assumption of wage and price rigidity is quite reasonable for the short run.
Check Your Progress 2
1. State the assumptions on which the Keynesian model is based.
........................................................................................................................
........................................................................................................................
........................................................................................................................
........................................................................................................................
40
3. By using appropriate diagram of the Keynesian model, explain how The Keynesian Model
situations of disequilibrium (excess demand or excess supply) are self-
correcting.
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
The saving function is a mirror image of the consumption function that gives the
relationship between planned saving (S) and income (Y) in the economy. In the
two-sector model, with only households and firms, aggregate income is either
consumed or saved. Thus,
Y=C+S … (2.11)
The decision to consume more is essentially the same as the decision to save less.
S = Y – (a + b Y) = – a + (1– b) Y … (2.12).
Note that the intercept of the saving function is negative, indicating that ‘dis-
saving’ (running down past saving) occur at relatively low levels of income. The
slope of the saving function is (1–b), which is known as the marginal propensity
to save (MPS). Note that MPS = (1–MPC), so that higher the MPC, lower is the
MPS. In economic analysis it is often assumed that richer households have higher
MPS compared poor households.
In Fig. 2.6 we derive the saving function diagrammatically. The top panel
represents the consumption function C, while the lower panel represents the
saving function.
41
Traditional Approaches
to Macroeconomics
C L
E
C = a + bY
D
A
F
450
O Y
Y1 Y2 Y3
H S = – a + (1– b)Y Y
Y1
Y
Y2 Y3
-a
Y1
42
involves producing fewer consumer goods and freeing resources for the The Keynesian Model
production of investment goods. This can also be represented diagrammatically
as in Fig. 2.7, where equilibrium income Ye is attained at the intersection of the
saving function and the investment function.
S,I S = –a + (1–b) Y
I̅
0 Y
Ye
S1 = –a1 + (1–b)Y
S,I B
D S0 = –a0 + (1–b)Y
I̅
A
0
Y1 Y0 Y
–a1
S1
S0
S, I I0 = c0 + dY
B
A
c0
0 Y
Y1 Y0
In Fig. 2.9 the saving function shifts from S0 to S1. In this case, the reduction in
consumption demand (due to rise in planned saving), leads to lower output which
44
further leads to a decrease in induced s, thereby lowering income further. At the The Keynesian Model
This result provides an important insight into the role of saving in the short run.
In an economy that faces no supply constraints and has excess production
capacity, an increase in the desire to save essentially lowers output by lowering
aggregate demand. Therefore, at a lower equilibrium income level aggregate
saving is the same or may even be lower than before. Note that such decline in
output due to higher saving could be a short run phenomenon. In the long run,
higher saving allows for higher investment and hence for creation of additional
productive capacity. You will learn more about the role of saving in the long run
while studying economic growth.
Check Your Progress 3
1. (a) In a two-sector economy (with only households and firms) derive the
output market equilibrium condition in terms of planned saving and
planned investment.
(b) In a three-sector economy (with households, firms and government), what
would be the relation between saving and investment at equilibrium if the
government runs a budget surplus?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
45
Traditional Approaches 3. In a two-sector economy (with only households and firms), the
to Macroeconomics
consumption function is given by C = 10 + 0.75 Y and I = 20.
(i) Derive the saving function.
(ii) Derive equilibrium output in terms of the equality of planned saving
and investment.
(iii) Suppose there is an increase in the desire to save while planned
investment remains unchanged. The new saving function is given by
S = – 8 + 0.25 Y. Find out the new equilibrium income level.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
i0
i1
L(Y0) = -qY0 -ti dY
M M
p p L, M p
47
Traditional Approaches Note that the money demand function L(Y0) represents demand for money at the
to Macroeconomics
income levelY0. Movement along L(Y0) demonstrates the interest sensitivity of
the money demand function. As interest rate falls from i0 to i1, there is an increase
in the demand for money due to speculative demand for money, as discussed
above. For all income levels, demand for money greater than Y0 would be higher
at each interest rate (since transactions and precautionary demands for money
increase with income), and the money demand curve would shift to the right. For
incomes lower than Y0, money demand would be lower at each interest rate and
the money demand curve would shift to the left.
Money supply is determined by the central bank of the country (you will learn
more about it in subsequent Units) and is given by the vertical line M s/ P, where
Ms is nominal money supply, P is the price level and Ms/ P is the real money
supply. Equilibrium in the money market occurs at the intersection of money
supply and money demand. Note that with the downward sloping money demand
function, an increase in money supply (from (Ms/P)0 to(Ms/P)1) brings about a
reduction in the rate of interest (from i0 to i1).
2.5.2 Liquidity Trap
A special situation can arise if interest rates become unusually low and hit the
lowest possible level, so that the demand for money becomes infinitely elastic
and the economy faces a ‘liquidity trap’. This can happen when interest rates
have fallen so low (and bond prices have risen so high) that everyone expects
interest rates to rise (and bond prices to fall). Therefore no one wants to hold
bonds, in fear of making a capital loss and everyone wants to hold money. In this
situation, the money demand curve becomes horizontal as presented in Fig. 2.11
and t in equation (2.16) tends to infinity.
L
i*
L, M p
M M
p p
48
When interest rates hit a floor such as i*, any injection of extra liquidity in the The Keynesian Model
system is absorbed, as people willingly hold money (liquidity) rather than bonds
at an unchanged rate of interest, i*. Therefore once the economy is in a liquidity
trap monetary policy cannot lower the rate of interest beyond i * and hence it
cannot affect real variables like s. An increase in money supply (from (M s/P)0
to(Ms/P)1) has no impact on the interest rate which remains unchanged at i *. Once
you learn about monetary and fiscal policies, you will see that conventional
monetary policy becomes ineffective when the economy is in a liquidity trap
whereas fiscal policy is very effective in this case.
The concept of liquidity trap became important in policy circles during the global
financial crisis of 2007-08, when in advanced economies like USA and Japan
interest rates hit a floor and became zero (USA) or almost zero (Japan). In this
case conventional monetary policy could not be used to reduce the rate of interest
on government bonds any further and policy experiments involving the use of
unconventional monetary policy measures had to be explored. Fiscal policy
measures were also employed, but increase in public debt levels raised concerns
regarding debt sustainability. In the next section we will explore the role of fiscal
policy in the Keynesian model and touch on some of these policy issues.
2. What is speculative demand for money? How does it affect the slope of
the money demand function?
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50
3. What is meant by ‘liquidity trap’? What are its implications? The Keynesian Model
.......................................................................................................................
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.......................................................................................................................
.......................................................................................................................
4. Discuss the role of the government in an economy that is facing a
prolonged recession.
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.......................................................................................................................
5. Give any three reasons why policy makers tend to be concerned about
mounting budget deficits.
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(ii) An increase in MPC will increase the slope of the consumption function.
4) As interest rate decreases the cost of borrowing decreases. Thus, some of the
projects which were unviable earlier become profitable. Therefore, more
investment takes place with decrease in interest rate.
c) 4
d) In the case of lump sum tax, the multiplier will be the same as
autonomous expenditure multiplier given in (b). In the case of proportional
tax at the rate of 0.1, the multiplier will be reduce to = 3.08
. × .
53
UNIT 3 THE NEOCLASSICAL SYNTHESIS
Structure
3.0 Objectives
3.1 Introduction
3.2 Equilibrium in the Real Sector
3.2.1 Derivation of the IS Curve
3.2.2 Shift in the IS Curve
3.3 Equilibrium in the Monetary Sector
3.3.1 Derivation of the LM Curve
3.3.2 Shift in the LM Curve
3.4 Simultaneous Equilibrium of Real and Monetary Sectors
3.4.1 Shocks in the IS-LM Model
3.4.2 Adjustment Process in the Economy
3.4.3 Impact of Supply Shocks
3.5 AD-AS Model
3.5.1 Derivation of the AD Curve
3.5.2 Aggregate Supply Curve
3.0 OBJECTIVES
After going through this unit, you should be in a position to
explain the equilibrium in the real sector and the monetary sector in an
economy;
explain the underlying ideas behind the IS curve;
explain the underlying ideas behind the LM curve;
explain how the IS and LM curves interact;
identify factors that influence the position and slope of the IS and the LM
curves;
derive aggregate demand (AD) curve from the IS-LM model; and
find out the factors that influence the AD curve.
3.1 INTRODUCTION
In Unit 2 we discussed how the equilibrium level of output is determined in the
Keynesian model. Recall that Keynes came up with his analysis in the aftermath
of the Great Depression. He considered an economy with underutilization of
resources (i.e., presence of idle capacity) with an objective of correcting the
Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi
economy immediately. Thus, he focused on the short-run. He reasoned that an The Neoclassical
Synthesis
increase in aggregate expenditure (which represents aggregate demand) leads to an
increase in output; it does not lead to rise in prices till full employment is reached.
In view of above, price level is kept fixed in the simple Keynesian model. An
implication of fixed prices is that nominal values and real values are the same.
In this Unit we deal with a closed economy; there is no external trade. We begin
with the derivation of IS and LM curves. Subsequently, we derive the AD curve
from the equilibrium points of the IS-LM model.
AD
AE1
b AE0
Y0 Y1 Y
Panel (b)
i
i0 a
i1 b
IS
O Y0 Y1 Y
Fig. 3.1: Derivation of the IS Curve
Suppose, there is a decrease in the rate of interest from 𝑖 to 𝑖 . As a result of this,
the level of investment in the economy increases and the new aggregate
expenditure level rises to AE1. The aggregate expenditure curve (AE1) intersects
the 45 line at point-b. Due to the increase in the aggregate expenditure, there is
an increase in the equilibrium level of output from Y0 to Y1. We plot point-b in
Fig. 3.1(b) corresponding to output level Y1 and intertest rate 𝑖 . When we combine
points ‘a’ and ‘b’ we obtain a downward-sloping curve, called the IS curve. A point
on the IS curve denotes equilibrium in the real sector (also called the goods sector)
of the economy and there is equality between investment (I) and saving (S). Note
56 that the real sector of the economy is at equilibrium on each and every point of the
IS curve. An implication of the above is that any point outside the IS curve shows The Neoclassical
Synthesis
disequilibrium in the real sector. In Fig. 3.2 we consider two such points ‘c’ and
‘d’ which are not on the IS curve, and find out their implications.
57
Traditional Approaches A change in the value of a parameter leads to a shift in the IS curve. An increase
to Macroeconomics
in autonomous consumption (the coefficient ‘a’ in equation (3.4)) or autonomous
investment (the coefficient ‘c’ in equation (3.4)) will lead to a parallel shift of the
IS curve upward to the right. A change in the marginal propensity to consume,
however, will affect the slope of the IS curve.
Check Your Progress 1
1) What will be the nature of change in the IS curve if there is a decrease in the
propensity to consume?
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
2) What is the implication of the following on the position of the IS curve?
(i) Decrease in autonomous government expenditure
(ii) Decrease in tax rate
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
………………………………………………………………………………
𝐿 = 𝑘𝑌 − ℎ𝑖 … (3.5)
where k > 0, h > 0; L is the demand for real balances (liquidity), Y is aggregate
income and 𝑖 is the rate of interest. You should remember three issues about the
monetary sector: (i) A person would like to deposit his money in bank and earn
interest on it. The alternative is to hold on to the cash, where no interest income is
earned. Thus, the opportunity cost of holding money is the interest foregone. If
there is an increase in the rate of interest, the interest foregone increases.
Conversely, if the rate of interest decreases, the interest income foregone
decreases. Therefore, the demand for money is a downward-sloping curve, if we
measure rate of interest on the y-axis and quantity of money on the x-axis. You
may be familiar with the concept of liquidity trap; a situation where the rate of
interest is very low, and people prefer to keep all their money in the form of liquid
cash as the interest income foregone is negligible. (ii) The demand for real balances
is described for a given level of income. We consider the money demand function
58
while keeping the level of income fixed (say, 𝐿(𝑌 )). If there is an increase in the The Neoclassical
Synthesis
level of income, there is an increase in the level of transactions and wealth in the
economy, which in turn increases the demand for money. Thus, there will be a
parallel shift in the money demand function. (iii) The supply of money is
determined by the central bank and it is constant. Thus, the supply of money is a
vertical straight line. If the supply of money is increased by the central bank, the
vertical straight line will shift to the right. When we deal with the short-run, we
assume that money supply does not change.
3.3.1 Derivation of the LM Curve
The supply of money in real terms is given by . Equilibrium in the money market
is achieved when 𝐿 = 𝑀 = 𝑀 . Thus, equilibrium in the money market is given by
= 𝑘𝑌 − ℎ𝑖 … (3.6)
𝑌=− + 𝑖 … (3.6a)
60
The Neoclassical
Synthesis
In the IS-LM model we assumed that price level is constant. Let us relax that
assumption and look into the impact of prices on equilibrium output in the
economy. First, we derive the aggregate demand (AD) curve. Subsequently, we
juxtapose the AD curve with the aggregate supply (AS) curve and find out the
equilibrium level of output.
3.5.1 Derivation of the AD Curve
A change in the price level changes the real money supply ( ) in the economy.
This will result in a shift in the LM curve if money supply (M) is assumed to be
constant. Thus, there will be a change in the equilibrium rate of interest and output.
If we assume that the price level keeps changing over time, we will obtain a series
of equilibrium levels of output corresponding to different price levels. If we plot
such combinations of prices and output, we obtain the aggregate demand (AD)
curve.
The derivation of the AD curve from IS-LM curves is shown in Fig. 3.8. In panel
(a) of Fig. 3.8 we juxtapose 𝐼𝑆 and 𝐿𝑀 curves intersecting at point E with an
equilibrium income level of 𝑌 and interest rate 𝑖 . The 𝐿𝑀 curve is based on real
money stock of 𝑀 /𝑃 . Thus, we describe the combination 𝑃 and 𝑌 as point ‘a’
on the AD curve in panel (b) of Fig.3.8.
68
2) Since the AD curve is derived from the IS-LM model, it depends on the factors The Neoclassical
Synthesis
that influence the IS and LM curves. Explain the impact of these factors on
the AD curve.
69
UNIT 4 OPEN ECONOMY
MACROECONOMICS -I
Structure
4.0 Objectives
4.1 Introduction
4.2 National Income Identity in an Open Economy
4.3 Balance of Payments and Exchange Rate
4.3.1 Balance of Payments
4.3.2 Exchange Rate
4.4 Let Us Sum Up
4.5 Answer/Hints to Check Your Progress Exercises
4.0 OBJECTIVES
After going through this Unit you should be in a position to
explain the national income identities in an open economy;
assess the relation between aggregate expenditure and income in an open
economy;
explain the relation between private savings-investment gap, fiscal deficit and
current account deficit;
explain the concept of Balance of Payments (BOP);
explain current and Capital accounts of BOP;
explain the concepts of nominal and real exchange rates; and
explain fixed and flexible exchange rate regimes.
4.1 INTRODUCTION
In this Unit we will examine the national income identities, with a view to
identifying certain fundamental differences between open and closed economies.
Thereafter we examine certain basic concepts relating to Balance of Payments
(BOP) and exchange rates. The BOP accounts record the transactions of an
economy with the ‘rest of the world’ and provide important insights into the
pattern of international trade and capital flows. The exchange rate is also an
important variable in an open economy with important implications for
international trade and competitiveness.
Prof. Ananya Ghosh Dastidar, Department of Finance and Economics, University of Delhi
government) given by [C + I + G], includes expenditure on domestic as well as Open Economy
Macroeconomics-I
imported goods. Aggregate spending on domestic goods by domestic agents is
given by [C + I + G – M]. To this we add expenditure on domestic goods by
foreigners or exports, to obtain total final expenditure on domestically produced
goods, i.e., [C + I + G + X –M].
From the equivalence between the expenditure, income and product approaches
to measurement of aggregate output, we can say that aggregate final expenditure
is equal to aggregate output produced in the economy or GDP (Y).
So the national income identity for an open economy can be written as:
Y=C+I+G+X–M
or, Y = C + I + G + NX (where NX = X – M) (4.1)
Note that (X – M) is also referred to as net exports (NX) or balance of trade.
When exports exceed imports, NX is positive and there is a trade surplus; when
imports exceed exports, NX is negative and there is a trade deficit.
In an open economy we draw a distinction between GDP and GNP (Gross
National Product). While GDP refers to aggregate incomes earned (by domestic
residents and foreigners) within the geographical boundaries of the country, GNP
is defined as the aggregate income of citizens of the country, irrespective of
whether they are located within the country or abroad. E.g., the salary of a
German consultant located in New Delhi would be a part of German GNP and
India’s GDP; the salary of an Indian worker in Singapore would be a part of
Singapore’s GDP and India’s GNP.
So we define net factor income from abroad (NFIA) as follows:
NFIA = Income earned abroad by domestic factors of production minus income
earned by foreign factors of production in the domestic economy.
To obtain GNP, NFIA is added to GDP (denoted often as Y in macroeconomics):
i.e., GNP = Y + NFIA (4.2)
Note that NFIA can be positive or negative and the difference between GDP and
GNP can often bequite large.For example, GDP may exceed GNP (NFIA < 0) in
countries where mostproduction units are owned by foreign multinationals (so
that a large share of the incomes generated within the economy, accrue to
foreigners) or which have a sizeable migrant population employed abroad.
Using the national income identity we can show in an open economy aggregate
expenditure (C+I+G) can exceedaggregate income (GNP) and that this imbalance
is reflected in a current account deficit.
We can also write (4.2) as:
GNP = C+I+G+NX +NFIA
or, GNP = C+I+G+ CA, (where CA = NX + NFIA)
or, GNP – (C+I+G) = CA (4.3)
71
Traditional Approches Note that CA represents the ‘current account balance’ of a country, which may be
to Macroeconomics
positive (current account surplus) or negative (current account deficit).
The identity (4.3) indicates that aggregate domestic absorption (C+I+G) exceeds
aggregate income (GNP) in a country that has a current account deficit (CA < 0).
Such a country is a net debtor (or, borrower) as it has to borrow to bridge the gap
between income and expenditure whereas aggregate income exceeds expenditure
in a country running a current account surplus (CA > 0) and it is a net lender.
A current account deficit may be financed by borrowing from the rest of the
world or by sale of foreign assets held by domestic agents. We will have more to
say on this in the next section on balance of payments.
The national income identity can be further used to understand whether the real
sector imbalance reflected in a current account deficit, stems mainly from the
private sector, or the government sector, or both.
From the income side, we know that aggregate income is either consumed (C), or
saved (S) or paid out in taxes (T), so that,
C + S + T = GNP (4.4)
Combining (4.3) and (4.4), we can write,
C + S + T = GNP = C+I+G+CA
or, C + S + T = C+I+G+CA,
or, S + T = I+G+CA
or, (S – I) + (T – G) = CA (4.5)
From identity (4.5) it is clear that a current account deficit (CA <0) reflects either
an excess of private investments over private savings (i.e., (S – I) < 0 ) or, a
budget deficit (i.e., (T–G) < 0) or, both. Also, if (S – I) > 0 but, (T–G) < 0 and
absolute value of (T–G) is larger than that of (S – I), there would be a current
account deficit. The identity (4.5) represents the ‘twin deficits’, where an external
deficit (CA < 0) is reflected as a deficit in the private sector (i.e., (S – I) < 0), or
in the government sector (i.e., (T–G) < 0), or in both.
The national income identities clearly indicate that an imbalance in the current
account reflects an imbalance in the real economy.That is, whenever a country
runs a current account deficit, there is an excess of aggregate expenditure over
income; this may occur because, private savings are too low, or there is aprivate
investment boom, or, the government is running a budget deficit or some
combination of these factors. Conversely, aggregate income exceeds expenditure
in a country that runs a current account surplus and either its private savings
would exceed investments (i.e. (S – I) > 0) or, public savings would be positive
(i.e., (T – G) > 0) or, both.
The main difference between closed and open economies should be evident from
the above discussion. In a closed economy, by definition, there are no
transactions with the ‘rest of the world’and CA is zero. Thus aggregate
72
expenditure cannot exceed aggregate income. It means, an excess of private Open Economy
Macroeconomics-I
investments over savings (S – I < 0) needs to be compensated by public savings
(T–G > 0). However, open economies can borrow from the rest of the world.
Thus it can sustain excess of expenditure over income and excess of investments
(I) over private (S) and public savings (T – G). International trade and capital
flows allow countries running current account deficits to draw on the savings of
other countries running current account surpluses.
73
Traditional Approches exchange (e.g. exports) are a credit and those involving outflows of foreign
to Macroeconomics
exchange (e.g., imports) are a debit entry. The current account comprises two
main components: the balance of trade and the balance on invisibles.
Transactions involving trade in services, factor incomes and transfers are also
referred to as ‘invisibles’ in the current account. These are further explained
below.
The balance of trade or merchandise trade balance is the difference between
exports and imports of goods by a country and it may be positive, negative or
zero. A negative balance of trade or a trade deficit indicates that the country’s
imports of goods exceed exports; a positive trade balance indicates the country
has a trade surplus, with exports of goods exceeding imports.
Trade in services (e.g., India’s software exports) is a part of invisibles in the
current account. The balance of trade in services captures the difference between
a country’s service exports and imports and it may also be positive or negative,
depending on whether the country is a net exporter or net importer of services.
Factor incomes include net investment incomefrom abroad which measures
investment earnings from abroad earned by Indians minus foreigners’ earnings
from their Indian assets. Indian residents may receive investment income, such as
dividends and interest, on the foreign assets they hold while foreign residents
receive investment income on the Indian assets they possess. The former is a
credit (inflow of foreign exchange) while the latter is a debit entry (outflow of
foreign exchange) in the current account.
Unilateral Transfers, that are overseas payments made without any quid pro quo,
are also recorded in the current account. These include assistance by foreign
governments during war or natural calamity (foreign aid), workers’ remittances
(e.g., money sent by overseas Indians to their families in India), personal gifts,
donations etc. The net unilateral transfers are transfers received by Indians from
abroad minus similar transfers sent to foreigners from India. For many
developing countries workers’ remittances are an important source of foreign
exchange earnings.
The current account balance is the sum of (i) the balance on merchandise trade
and (ii) the balance on invisibles (which comprises balance on services trade, net
investment income and net transfers). When total foreign exchange receipts on
account of all the transactions recorded in the current account are greater than
total payments, the country has a current account surplus. In case the foreign
exchange payments exceed the receipts, the country has a current account deficit.
Note that even if a country has a trade deficit it could have a current account
surplus, if it has a positive and very high net invisibles balance. This can be seen
in many countries that are net recipients of large unilateral transfers and
remittances. For example, remittances received from Indian workers employed
abroad are an important source of foreign exchange earnings for India. India is
the largest recipient of remittances in absolute figure ($87 billion in 2021) while
74
in terms of percentage of GDP Lebanon is the largest recipient that contributed Open Economy
Macroeconomics-I
54 per cent of GDP in 2021.
Capital Account: The capital account of the BOP includes transactions involving
cross-border purchase and sale of real and financial assets. The asset in question
could be physical assets like land, factories, houses or financial assets like stocks
and bonds. In the capital account each transaction is recorded twice, once as a
credit and once as a debit entry, thereby capturing the two aspects of each
transaction. E.g., purchase of a foreign financial asset such as foreign government
bond or shares of a foreign firm by a domestic resident involves an asset import
and a capital outflow (payment made by the domestic resident for the foreign
asset).
Broadly two types of capital flows are recorded in the capital account – debt
creating and non-debt creating flows. For example, when domestic agents borrow
from foreign financial institutions, the country experiences a debt creating capital
inflow, as this loan has to be repaid at a future date. However, foreign firms
investing in the domestic country (e.g., foreign direct investment or FDI), involve
a non-debt creating capital inflow, as this does not create any commitment for
repayment for the recipient nation. Capital flows can also be classified on the
basis of the duration involved. For example, foreign institutional investors (FIIs)
purchasing shares of domestic firms, involves a short term capital inflow (also
known as foreign portfolio investment or FPI). The FIIs may sell the equity and
withdraw their funds at a short notice. Such withdrawal of foreign funds would
involve a capital outflow. Typically, investment by foreign firms in country’s
production sector (e.g., Greenfield FDI) involves longer term capital inflows that
are not likely to be withdrawn at short notice unlike investment in the financial
sector (e.g., FPI).
When capital inflows exceed capital outflows, the country has a capital account
surplus. In the opposite case, when outflows exceed inflows it has a capital
account deficit.
In the current account, in general, transactions involving the inflow of foreign
exchange are recorded as a credit entry, with the corresponding debit entry
appearing in the capital account. Therefore a surplus (or deficit) in current
account is mirrored in a corresponding deficit (or surplus) in the capital account.
If a country has a current account deficit, this must be financed either by selling
assets or by borrowing, so there must be a corresponding surplus in the capital
account. So a current account deficit is financed by net capital inflows, either on
account of the private sector or the government sector or both.
Overall BOP Balance: Every transaction is recorded twice in the BOP account,
once as a debit and once as credit, as per the principles of double entry
bookkeeping. Therefore in an accounting sense the BOP is always balanced.
However, in practice, this is not observed, primarily because of problems related
to data collection. There are time lags involved in the international transactions;
e.g., data on exports is collected from customs, at the time goods are shipped,
75
Traditional Approches whereas payments for the same may be received six months later and hence may
to Macroeconomics
not be recorded in BOP of that year. Therefore, in order to balance the BOP
account an entry for errors and omissions is included.
Even though the BOP always balances, we can talk about an overall BOP surplus
or deficit. Overall BOP balance is obtained by adding the current and capital
account balances. A country has a BOP surplus in the following cases: (i) there is
current account surplus as well as capital account surplus; (ii) there is a current
account deficit but a capital account surplus that is larger in magnitude; (iii) there
is a current account surplus and a relatively smaller capital account deficit. There
would be a BOP deficit, either when there is a deficit on both current and capital
accounts or when there is a relatively large deficit in either one of the current or
capital accounts.
In the case of a BOP surplus there is an increase in the foreign exchange reserves
of the country. In the case of a deficit, the stock of foreign exchange reserves is
depleted. Let us discuss this issue in details.
Change in Foreign Exchange Reserves
Apart from transactions made by private and government agents, the capital
account of the BOP also includes official reserve transactions that involve
change in the stock of foreign exchange reserves held by the central bank. When
there is a BOP surplus, the country experiences a net inflow of foreign exchange,
leading to a correspondingincrease in foreign exchange reserves. In the case of a
BOP deficit, there is net outflow of foreign exchange and a corresponding
reduction in foreign exchange reserves. Thus,
BOP Balance = Current Account + Capital Account (including errors and
omissions) + Official Reserve Transactions = 0
In case a country has a current account deficit (of say, – $15,000), but a capital
account surplus that is smaller in magnitude (say, $12,000), then it has a BOP
deficit (of –$3000) that leads to a decrease in foreign exchange reserves (by
$3000).
Note that a BOP surplus is recorded with a positive sign in the BOP, while the
corresponding increase in reserves has a negative sign, so that the two add up to
zero. Therefore in BOP accounts an increase in foreign exchange reserves
appears with a negative sign whereas a decrease in reserves has a positive sign.
4.3.2 Exchange Rate
The exchange rate is an important concept in an open economysuch as India, that
has transactions involving foreign goods, services and assets, whose prices are
denominated in terms of foreign currencies. Throughout the following discussion
we assume that the domestic country is India and the foreign country is the USA.
Demand for foreign exchange arises whenever domestic agents purchase foreign
goods, services or assets (i.e., imports and capital outflows); whereas, sale of
domestic goods, services and assets to foreigners (i.e., exports and capital
76
inflows) constitutes the primary source of supply of foreign exchange. The Open Economy
Macroeconomics-I
market value of the exchange rate is determined by demand and supply in the
foreign exchange market. However, often the official exchange rate may differ
from its market value as you will see from our discussion on alternate exchange
rate regimes. First we shall learn about various exchange rate concepts.
Nominal Exchange Rates
The nominal exchange rate ‘e’ can be defined as the number of units of domestic
currency (Rupee) required forpurchasing one unit of foreign currency (dollar).
For example, if Rs. 80 is required to buy one dollar, then the exchange rate e =
Rs. 80 per dollar. Similarly, the exchange rate of the Indian rupee can also be
defined in terms of other currencies, e.g., yen, euro, pound, etc.
When the exchange rate ‘e’ rises (say, from Rs. 80 to Rs.82 per dollar), there is
an increase in the price of dollars in terms of rupees and there is nominal
depreciation of the rupee vis-à-vis dollar (and nominal appreciation of the dollar
vis-à-vis rupee). When ‘e’ falls (e.g., from Rs. 80 to Rs. 78 per dollar), the dollar
becomes cheaper in terms of rupees and there is a nominal appreciation of the
rupee (and nominal depreciation of the dollar vis-à-vis rupee).
Real Exchange Rate
While nominal exchange rates measure the rate of exchange between domestic
and foreign currencies, the real exchange rate captures the rate at which domestic
goods are exchanged for foreign goods. It isthe price of foreign goods in terms of
domestic goods and is computed using the nominal exchange rate and prices of a
comparable basket of domestic and foreign goods as bellow:
r = (e pf) / pd (4.6)
where‘e’ is the nominal exchange rate (rupees per dollar), pd denotes the
domestic price level (in rupees) and pfdenotes the foreign price level (in dollars).
‘e pf’ is the price in rupees of a foreign basket of goods and ‘pd’ is the price (in
Rupees) of a comparable domestic basket.
The real exchange rate between rupee and dollar reflects the price of goods
produced in the USA relative to those produced in India. A rise in r means
American goods become relatively more expensive vis a vis Indian goods and
there is real depreciation of the rupee; whereas a reduction in r makes Indian
goods relatively more expensive and there isreal appreciation of the rupee. The
real exchange rate is often used as an index of a country’s international price
competitiveness. In case a country faces real appreciation of its currency,
domestic goods become more expensive and this can lead to a reduction in
demand for exports. In contrast, a real depreciation of the currency can boost
export demand.
When domestic and foreign prices remain unchanged (that is, is constant), a
nominal depreciation (‘e’ rises) of the domestic currency causes a corresponding
real depreciation (‘r’ rises). In this case the nominal and real exchange rates
77
Traditional Approches move in the same direction. However, prices may change simultaneously with
to Macroeconomics
exchange rates; e.g., an appreciation in nominal exchange rates (‘e’ falls), along
with a large fall in domestic prices (𝑝 falls) may lead to a real depreciation (r
rises). So, ‘e’ and ‘r’ may also move in opposite directions.
Exchange Rate Regimes
The exchange rate regime of a country determines how its exchange rate is
determined.
Under a flexible (or floating) exchange rate regime, the value of ‘e’ is
determined by the demand and supply of foreign exchange, without any
government intervention. In this case the currency is on a clean float or pure
float. That means the exchange rate is fully flexible and adjusts continuously to
equate market demand and supply of foreign exchange, so there is no role for
intervention by the central bank and hence no need of foreign exchange reserves.
In this case BOP balance is attained via exchange rate fluctuations. That is, in
case there is a BOP surplus (supply of foreign currency exceeds demand), the
exchange rate appreciates (e falls, so that given prices, r falls, so foreign goods
are relatively cheaper), X falls, M rises and NX falls (the current account deficit
widens and BOP surplus is reduced), till BOP equilibrium is restored. Floating
exchange rates lead to considerable volatility in exchange rates that may be
unfavorable for exporters and importers and may have adverse impacts on
domestic production, investment and employment. As such, ‘pure floats’ are
rarely observed in practice.
In most countries central banks maintain a stock of foreign exchange reserves
and intervene and try to maintain the value of exchange rate within a certain
band. Such exchange rate arrangements, widely prevalent across countries, are
called a ‘managed float’ or dirty float. Intervention refers to the central bank
buying or selling foreign exchange in an attempt to influence the exchange rate.
In a managed float, the currency is allowed to float within a certain ‘target zone’
and the central bank stands ready to intervene (e.g., buy or sell dollars against
rupees) whenever the exchange rate appears to breach the limits of this band.
At the other extreme we have the system of fixed exchange rate, wherein the
exchange rate is not freely floating, but is fixed by the government. An
important function of central banks in a fixed exchange rate system is to
intervene in foreign exchange markets to keep the price of foreign exchange
fixed at the pre-announced level. For this, central banks have to maintain
adequate stock of foreign exchange reserves.
Under a fixed exchange rate system, the fixed parity announced by the central
bank may be revised at times; in this case a decrease in ‘e’ due to official
intervention is called revaluation while an increase in ‘e’ by official intervention
is called devaluation. In a world with few restrictions on international
transactions in goods and assets, maintaining a fixed exchange rate poses an
78
immense challenge for a country’s government. We will discuss a few aspects of Open Economy
Macroeconomics-I
policy dilemmas under a fixed exchange rate regime in the next section.
1) State whether the following statements are ‘True’ or ‘False’, giving reasons
for your answer in each case:
(a) A country can have a current account surplus, even when it has a negative
trade balance (or merchandise trade deficit).
(b) When Indian firms invest in foreign firms (‘outward FDI’), there would
be a corresponding capital inflow in the current account of India’s BOP.
(c) A country can have an overall BOP deficit even when it has a current
account surplus.
(d) When a country has a current account deficit (of say –$20,000) and a
capital account surplus (of say $8000), its foreign exchange reserves
would increase.
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2) Suppose that domestic currency depreciates by 2 percent and simultaneously
domestic prices rise by 5 percent, while foreign prices remain unchanged.
(i) What would be the impact on (a) real exchange rate; and (b) net
exports?
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(ii) How would your answer in (b) above wouldchange if domestic prices
remained constant following the nominal currency depreciation?
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3) Suppose a country experiences a sudden surge in capital inflows (e.g., FPI
inflows) that create an excess supply of foreign exchange (say dollars). How
would this affect the following?
79
Traditional Approches (a) the exchange rate and net exports under a flexible exchange rate regime
to Macroeconomics
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(b) the exchange rate and foreign exchange reserves under a fixed exchange rate
regime ?
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5.0 OBJECTIVES
After going through this Unit you should be in a position to
analyse short run macroeconomic equilibrium using the open economy IS-
LM model; and
discuss the limits to monetary and fiscal policies under fixed vis-à-vis flexible
exchange rate regimes.
5.1 INTRODUCTION
In this Unit we will introduce the open economy IS-LM framework and use it to
understand the complications involved in framing monetary and fiscal policy
under alternate exchange rate regimes. In particular we consider two different
exchange rate regimes, viz., fixed and flexible rate systems and explore the
implications for conduct of monetary and fiscal policies under the assumption of
unrestricted international capital mobility.
Apart from the above, we use the open economy IS-LM framework with perfect
capital mobility to study the conduct of monetary and fiscal policy under
alternate exchange rate regimes. First we examine the conduct of policy making
under flexible exchange rates, followed by the case of a fixed exchange rate
regime. This is known as the ‘Mundell-Fleming model’, named after economists
Robert Mundell and Marcus Fleming, who developed this framework and
analysed policymaking in open economies in the early 1960s.
Prof. Ananya Ghosh Dastidar, Department of Finance and Economics, University of Delhi
Traditional Approches
to Macroeconomics
5.2 THE OPEN ECONOMY IS-LM FRAMEWORK
After our discussion above on certain basic concepts and accounting tools
pertaining to open economies (see Unit 4), we will now examine output market
equilibrium in the short run Keynesian framework using the open economy IS-
LM model.
As in case of the closed economy IS-LM model, here also we assume that prices
are given and there is ‘excess capacity’, so that output is demand determined.
5.2.1 The IS Curve
You are familiar with the IS curve in a closed economy (see Unit 3). In an open
economy, aggregate demand (AD) is given by:
AD = C + I + G + X – M = C + I + G + NX, (5.1)
where, C = C (Yd), is aggregate consumption expenditure which is a function of
disposable income, Yd= Y – T ;
I [= I (i)] is private investments, an inverse function of the rate of interest i;
G represents exogenous government expenditure;
X [= X (Yf, r)] is exports, the demand for domestic goods by foreigners, which is
a function of foreign GDP (Yf) and the real exchange rate r;
M [= M (Y, r)[ is imports, the demand for foreign goods by domestic agents,
which is a function of domestic GDP (Y) and the real exchange rate r;
NX [= (X – M) = NX (Yf, Y, r)] stands for the net exports that depend on the
factors underlying demand for imports and exports, i.e., Y f, Y and r.
Clearly imports are a leakage from the domestic economy as it is the expenditure
ofdomestic agents on output that is produced in a different economy (hence part
of their GDP) while exports are an addition to the total expenditure on domestic
goods. Exports depend on Yf, ceteris paribus, the higher is Yf, higher would be
export demand. Similarly, the higher is Y, higher would be the demand for
imports. Both exports and imports depend on the real exchange rate which
represents the relative price of foreign vis-à-vis domestic goods as discussed in
equation (6). With an increase in r (a real depreciation), foreign goods become
relatively more expensive. Thus, there is a decline in imports, while exports
increase as domestic goods become relatively cheaper. So a rise in r would lead
to a rise in X and a fall in M and net exports would be higher. Note that
economists Alfred Marshall and Abba Lerner gave certain conditions under
which a real devaluation or depreciation leads to an improvement in the trade
balance (increase in NX), known as the Marshall- Lerner condition. According to
the Marshall-Lerner condition, depreciation will lead to an improvement in the
balance of trade of a country only if the sum of the price-elasticities of exports
and imports of the country is greater than one. Throughout our discussion we
assume that the Marshall-Lerner condition is satisfied.
82
Note that one of the assumptions in the IS-LM framework is that of given prices. Open Economy
Macroeconomics-II
Therefore, with given foreign (pf) and domestic prices (pd), a nominal
depreciation or appreciation (rise or fall in e) brings about a real depreciation or
appreciation (rise or fall in r).
i.e., Y = AD
However, compared to the closed economy case, now there are two new
determinants of aggregate demand, viz., foreign GDP and the real exchange rate.
These two factors affect net exports and hence demand and output in an open
economy. If Yf increases (decreases) or r increases (decreases), NX would also
increase (decrease) and the IS curve would shift to the right (left).
Let us assume that there is perfect capital mobility, i.e., there are no restrictions
on international capital inflows and outflows and cross-border capital movements
involve zero transaction costs. This is a simplifying assumption that captures the
83
Traditional Approches reality of large-scale international capital mobility observed in the era of
to Macroeconomics
globalization, with advances in technology greatly reducing the cost of moving
capital across international borders.
The assumption of perfect capital mobility has certain implications for the
determination of interest rates in an open economy. It means that the domestic
and foreign bonds are perfect substitutes, so that therate of intereston domestic
bonds (i)has to be in line withthe rate of interest on foreign bonds (if), i.e., i = if
must hold. Here we assume that the foreign interest rate is given and not
influenced by domestic economic policy.
Another point you should note regarding the money market in open economies
relating to the supply of money and the role of foreign exchange reserves. Note
that the stock of foreign exchange reserves is an asset of the central bank. When
the central bank buys foreign currency, adding to its assets, it issues domestic
currency so there is matching rise in its liability. As such, any change in foreign
exchange reserves affects the monetary base or high powered money (liabilities
of the central bank) and hence money supply in the economy, via the money
multiplier.
Therefore, when a country experiences capital inflows and has a BOP surplus,
this increasesforeign exchange reserves and leads to an increase in money supply.
Similarly, a capital outflow can result in a BOP deficit and a fall in money supply
via a reduction in the stock of foreign exchange reserves.
In this context you should note that the central bank often uses a policy of
sterilization to offset the impact of a change in foreign exchange reserves on the
money supply. This can be done by using open market operations. In particular,
central banks often use foreign exchange reserves for intervention in the foreign
exchange market. Suppose the RBI intervenes to buy dollars (in order to absorb
an excess supply of dollars) against rupees. This would add to its foreign
exchange reserves and hence increase money supply. However, the RBI can carry
out a sterilized intervention, by simultaneously selling bonds, in an open market
operation, to reduce money supply. Thereby the RBI can either fully or partially
84
offset the impact of the increase in foreign exchange reserves on the money Open Economy
Macroeconomics-II
supply.
LM M p
E
i0 = if BP
IS
Y
Y0
Fig. 5.1: “Macroeconomic Equilibrium in Open Economy IS-LM Model
Note that at the equilibrium E,the rate of interest, i0 = if, owing to the assumption
of perfect capital mobility. The point E represents macroeconomic equilibrium in
the sense that there is both internal balance (goods and money market
equilibrium) and external balance (BOP equilibrium).
The horizontal line BP that passes through the equilibrium rate of interest
represents BOP equilibrium, in the sense that it represents interest rate – income
combinations for which the current account surplus (deficit) is exactly offset by a
capital account deficit (surplus). Note that here NX represents the current account
balance.
With perfect capital mobility, the BP curve is horizontal, as the slightest
deviation of i from if, would create BOP disequilibrium and trigger either infinite
capital inflows or outflows. If i> if, there will be a surge in capital inflows and a
BOP surplus, since inflows would be higher than required for BOP balance, at
any given level of income. Whereas, or any i < if, there will be unlimited capital
outflows and a BOP deficit. That is, for any Y (say Y0), there is BOP surplus at
all points above BP and a BOP deficit at all points below BP.
With imperfect capital mobility the BP curve would be upward sloping. As Y
increases, M would rise, NX would fall and the current account deficit would
widen. To maintain BOP balance therefore, i would have to increase to attract
capital inflows and create a matching capital account surplus. With imperfect
85
Traditional Approches capital mobility, which occurs when there are restrictions on cross-border capital
to Macroeconomics
flows or when domestic and foreign bonds are imperfect substitutes, there can be
a difference between iand if. However, here we will only consider the case of
perfect capital mobility.
LM M p
i E1
i1
i2 E0
BP
i0 = if
IS2 IS1
IS0
Y
Y0 Y1
Initially the economy is at E1 (see Fig. 5.2), where goods and money markets are
in equilibrium and there is BOP equilibrium as well, with i 0= if. With fiscal
expansion (or fall in tax rate t), there is an increase in G. The IS curve shifts from
IS0 to IS1 and the interest rises from i0 to i1 as the economy moves to the new
equilibrium E1. However, with if remaining the same, the rise in domestic interest
rate makes domestic bonds relatively more attractive and there is a surge in
capital inflows, that leads to a BOP surplus (excess supply of foreign exchange),
causing a currency appreciation (e falls). With given prices (implying prices
remaining constant), a nominal appreciation leads to a real appreciation (r falls),
reducing X, raising M and worsening the trade balance (NX falls). As a result
aggregate demand falls and the IS curve shifts to the left. It shifts back all the
way to IS0, where once again i = i0 = if and output is back to Y0.Note that at any
other IS curve, e.g., IS2, the domestic interest rate is still above if (i2> if), so e, r
86
and NX would fall and IS would shift further to the left. Therefore, we see that Open Economy
Macroeconomics-II
with flexible exchange rates, fiscal expansion is ineffective. It fails to raise output
(the increase in output from Y0 to Y1 is only temporary), the trade balance
worsens because of appreciation in the exchange rate (NX is lower) and the fiscal
position deteriorates (G has increased or tax rate t has fallen).
5.3.2 Monetary Policy under Flexible Exchange Rates
We now examine the impact of expansionary monetary policy under a flexible
exchange rate regime.
i LM
M
p
M
LM p
E0
i0 = if BP
E
i2
E IS3
i1 E
IS0 IS2
Y
Y0 Y1 Y3
[Fig. 5.3: Expansionary Monetary Policy under Flexible Exchange Rates]
In Fig. 5.3 an increase in nominal money supply (from M0 to M1) shifts the LM
curve outward from LM0 to LM1 and the economy moves from E0 to E1, as
domestic interest rate falls from i0 to i1.At i1 there is internal balance (output and
money markets are in equilibrium) but there is external imbalance (BOP
disequilibrium) that triggers capital flows. Since i 1< if, this triggers a capital
outflow, leading to a BOP deficit (excess demand for dollars) and causing a
depreciation of the nominal (e rises) and real exchange rates (r rises). As a result
domestic goods become relatively cheaper, X rises, M falls and NX increases,
and with higher external demand, the IS curve shifts to the right. This process
continues till the IS curve shifts all the way to IS3 and the economy is at E3,
where once again i = if and both internal and external balance are restored. At any
other point (e.g., E2 on IS2, i2< if, so e and r would rise, NX would fall, moving
the IS curve further to the right).
This shows, that in complete contrast to fiscal policy, monetary expansion is an
extremely effective policy tool in an open economy with flexible exchange rates
87
Traditional Approches and perfect capital mobility. It brings about currency depreciation that improves
to Macroeconomics
the trade balance, so that output increases from Y0 all the way to Y3.
Check Your Progress 1
1. What is the effect of monetary expansion on output and interest rates in an
open economy with perfect capital mobility under flexible exchange rate?
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3. What is the effect of fiscal contraction (cut in tax rate) on output and interest
rates in an open economy with perfect capital mobility under flexible
exchange rates?
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88
We first consider the impact of expansionary fiscal policy under a fixed exchange Open Economy
Macroeconomics-II
rate system, where e = e* is the official parity (Fig. 5.4).
M
i LM p
M
LM p
i1
E0 E1
i0 = if BP
IS1
IS0
Y
Y0 Y1
Fig. 5.4: Expansionary Fiscal Policy under Fixed Exchange Rates
89
Traditional Approches 5.4.2 Monetary Policy under Fixed Exchange Rates
to Macroeconomics
Now we consider the case of a monetary expansion under a system of fixed
exchange rates (Fig. 5.5).
M
LM p
i
M
LM p
E0
i0 = if BP
i1 E1
IS0
Y
Y0
Suppose the central bank engages in an open market purchase of bonds in a bid to
increase domestic money supply. This shifts the LM curve from LM0 to
LM1(since money supply increases from M0 to M1) and the economy moves to
E1, where the interest rate i1< if (see Fig. 5.5). Due to lower domestic rates of
interest, investors would move to foreign bonds, triggering capital outflows and
giving rise to a BOP deficit and excess demand for dollars. This creates pressure
for currency depreciation, but the central bank is committed to maintain a fixed
parity. Therefore it intervenes to sell dollars against rupees, leading to a fall in
foreign exchange reserves and contraction in money supply. As money supply
falls, the LM curve shifts to the left of LM1 and this process continues as long as
i< if. Ultimately the economy is back to E0, with money supply falling back to its
initial level (M0), so that i = if and output is back to its initial level Y0.
Clearly with fixed exchange rates and perfect capital mobility, money supply
becomes ineffective as a policy tool as monetary expansion has no effect on
output in the short run.
90
In fact the above discussion indicatesthat money supply becomes endogenous Open Economy
Macroeconomics-II
with fixed exchange rates and perfect capital mobility, in the sense that it
passively adjusts to changes in the foreign exchange reserves as the central bank
intervenes in foreign currency markets to defend the fixed parity. That is, since
the central bank wants to hold the exchange rate constant, it has to intervene to
keep the exchange rate from depreciating or appreciating, so foreign exchange
reserves and hence money supply adjusts accordingly.
Our discussion also highlights the fact that it is impossible to simultaneously
have the following three features in a single policy regime, viz.: (a) perfect
capital mobility; (b) independent monetary policy; and (c) fixed exchange rates.
This is also known as the ‘policy trilemma’. In the presence of perfect capital
mobilityand fixed exchange rates, money supply becomes endogenous and the
Central Bank’s attempt to pursue an independent monetary policy isnot
effectiveasthe Central Bank is committed to maintaining a fixed parity. Whereas,
in the case of flexible exchange rates, perfect capital mobility and independent
monetary policy do indeed go together, as we saw that monetary policy is very
effective in this case. Countries may adopt fixed exchange rates and yet retain
monetary policy independence only with restrictions on international capital
flows, i.e., in the absence of perfect capital mobility. In this case, interest rate
differentials between countries would persist owing to restrictions on capital
mobility.
Check Your Progress 2
1. What is the effect of fiscal contraction (cut in tax rate) on output and interest
rates in an open economy with perfect capital mobility under fixed
exchange rate?
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91
Traditional Approches 3. (a) What is the effect of monetary contraction (sale of bonds by central bank)
to Macroeconomics
on output and interest rate in an open economy with perfect capital
mobility under (i) fixed exchange rates, and (ii) flexible exchange rates?
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4. Use the open economy IS-LM model to explain the concept of ‘policy
trilemma’.
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93