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3.5.3 The overall balance of payments and the BP curve

Early Keynesian analysis of the balance of payments (see Dimand, 2002c)

focused on the determination of the current account and how government

policy could improve the balance of payments on it (in particular the conditions

under which devaluation would be successful in doing just this). The

late 1950s/early 1960s witnessed a period of increasingly liberalized trade

and capital movements and, as noted earlier, Mundell and Fleming extended

the Keynesian model of an open economy to include capital flows. At the

onset of this discussion it is important to note that we assume we are dealing

with a small open economy in the sense that changes within the domestic

economy of that country and its macroeconomic policies have an insignificant

effect on the rest of the world.

Overall balance of payments equilibrium requires that the sum of the

current and capital accounts of the balance of payments is zero. As noted

earlier, imports are a function of domestic income and relative prices (of

domestic and foreign goods), while exports are a function of world income

and relative prices. Ceteris paribus, as domestic income rises, imports increase

and the balance of payments on the current account worsens. With

static expectations about exchange rate changes, net capital flows are a function

of the differential between domestic and foreign interest rates. Ceteris

paribus, as the domestic interest rate rises, domestic assets become more

attractive and the capital account of the balance of payments improves due to

the resulting inward flow of funds.

The BP curve (see Figure 3.9) traces out a locus of combinations of

domestic interest rates and income levels that yield an overall zero balance of

payments position on the combined current and capital accounts. The BP

curve is positively sloped because if balance of payments equilibrium is to be

maintained (that is, a zero overall balance) then increases (decreases) in the

level of domestic income which worsen (improve) the current account have

to be accompanied by increases (decreases) in the domestic rate of interest

which improve (worsen) the capital account. Points above and to the left of

the BP curve are associated with an overall balance of payments surplus

since, given the level of income, the domestic rate of interest is higher than

that necessary to produce an overall zero balance of payments position.

Conversely, points below and to the right of the BP curve indicate an overall

balance of payments deficit since, given the level of income, the domestic

rate of interest is lower than that necessary to produce an overall zero balance

of payments position.

The slope of the BP curve depends on the marginal propensity to import and

the interest elasticity of international capital flows. Ceteris paribus, the BP

curve will be flatter (steeper) the smaller (larger) is the marginal propensity to

import and the more (less) interest-elastic are capital flows. For example, the

more sensitive capital flows are to changes in domestic interest rates, the

smaller will be the rise in the domestic interest rate required to maintain a zero

overall balance of payments equilibrium for a given increase in income, and

hence the flatter will be the BP curve. The BP curve shown in Figure 3.9

represents a situation of imperfect capital mobility since the domestic rate of

interest can depart from that ruling in the rest of the world. With respect to the

interest elasticity of international capital movements it is important to note that

in the two limiting cases of perfect capital mobility and complete capital

immobility the BP curve would become horizontal and vertical respectively.

For example, in the case of perfect capital mobility the BP curve will be

horizontal; that is, the domestic rate of interest will be tied to the rate ruling in

the rest of the world. If the domestic rate of interest were to rise above the given

world rate there would be an infinite capital inflow, and vice versa.

The BP curve is drawn for given levels of the world income, interest rate

and price level; the exchange rate; and the domestic price level. If any of

these variables should change, then the BP curve would shift. For example,

anything that results in an increase in exports and/or a decrease in imports

(such as a rise in world income; a fall in the exchange rate; a rise in the

foreign price level; or a fall in the domestic price level) will cause the BP

curve to shift downwards to the right, and vice versa. In other words, at any

given level of domestic income an improvement in the current account will

require a lower domestic rate of interest to maintain a zero overall balance of

payments position via capital account effects.