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3.5.2 The money market and the LM curve

The open economy LM curve is exactly the same as in the case of a closed

economy with one important extension. In an open economy operating a

fixed exchange rate the domestic money supply will be altered by balance of

payments deficits/surpluses (that is, the net balance on the combined current

and capital accounts) unless the authorities are able to sterilize or neutralize

the effects of the balance of payments deficits/surpluses on the domestic

money supply. Under a regime of fixed exchange rates the authorities are

committed to buy and sell foreign exchange for the home currency at a fixed

price. For example, in the case of a balance of payments surplus residents

will sell foreign currency to the authorities for domestic currency at a fixed

exchange rate. Ceteris paribus, a balance of payments surplus will result in

an increase in both the authorities’ foreign exchange reserves and the domestic

money supply, thereby shifting the LM curve downwards to the right.

Conversely, a balance of payments deficit will result in a fall in both the

authorities’ foreign exchange reserves and the domestic money supply, thereby

shifting the LM curve upwards to the left. In contrast, under a regime of

flexible exchange rates the exchange rate adjusts to clear the foreign exchange

market (that is, the central monetary authorities do not intervene in

the foreign exchange market) so that the sum of the current and capital

accounts is always zero. In consequence the LM curve is independent of

external factors and the determinants of the position of the LM curve are the

same as those discussed earlier in section 3.3.2.

To complete the IS–LM model for an open economy we next turn to

consider overall balance of payments equilibrium and the BP curve.