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3.5.4 The complete model and the effects of a change in fiscal and monetary policy

We are now in a position to consider the full IS–LM model for a small open

economy. Equilibrium in the goods and money markets, and in the balance of

payments, occurs at the triple intersection of the IS, LM and BP curves

indicated in Figure 3.9. In what follows we analyse the effects of a change in

fiscal and monetary policy on: (i) the level of income and the balance of

payments in a fixed exchange rate regime, and (ii) the level of income and the

exchange rate in a flexible exchange rate regime.

Under a regime of fixed exchange rates, while fiscal expansion will result

in an increase in income, it may lead to either an improvement or a deterioration

in the overall balance of payments position, and vice versa. The effects

of fiscal expansion on the level of income and the balance of payments are

illustrated in the two panels of Figure 3.10. In panel (a) the LM curve is

steeper than the BP curve, while in panel (b) the converse is true. In both

panels of Figure 3.10 the economy is initially operating at point A, the triple

intersection of the three curves IS0, LM and BP with equilibrium in the goods

and money markets, and in the balance of payments, at r0Y0. Expansionary

fiscal policy shifts the IS curve outwards to the right from IS0 to IS1 and

results in an increase in the domestic rate of interest from r0 to r1 (improving

the capital account) and an increase in income from Y0 to Y1 (worsening the

Figure 3.9 The Mundell–Fleming/Keynesian model

current account). As can be seen from both panels of Figure 3.10, the net

outcome on the overall balance of payments position depends on the relative

slopes of the LM and BP curves (that is, the structural parameters underlying

the model). In panel (a) the net outcome is an overall balance of payments

surplus at point B (that is, the curves IS1 and LM intersect at a point above the

BP curve), while in panel (b) it is one of an overall balance of payments

deficit (that is, the curves IS1 and LM intersect at point B below the BP

curve). Expansionary fiscal policy is more likely to lead to an improvement in

the overall balance of payments position: (i) the smaller is the marginal

propensity to import and the more interest-elastic are capital flows (that is,

the flatter the slope of the BP curve) and (ii) the greater is the income

elasticity and the smaller is the interest elasticity of the demand for money

(that is, the steeper the slope of the LM curve), and vice versa. In practice the

LM curve is likely to be steeper than the BP curve due to the interest elasticity

of the demand for money being less than that for capital flows. This view

tends to be backed up by available empirical evidence and will be adopted in

the discussion that follows on long-run equilibrium.

At this point it is important to stress that in analysing the consequences for

the balance of payments of a change in fiscal policy under fixed exchange

Figure 3.10 Fiscal expansion under imperfect capital mobility

rates the Keynesian approach assumes that the authorities can, in the short

run, sterilize the effects of a balance of payments surplus or deficit on the

money stock. The results we have been analysing necessarily relate to the

short run because in the long run it becomes increasingly difficult to sterilize

the effects of a persistent surplus or deficit on the money stock. Long-run

equilibrium requires a zero balance on the balance of payments, otherwise

the domestic money supply changes in the manner discussed in section 3.5.2.

As such the balance of payments surplus at point B in panel (a) of Figure 3.10

will cause an expansion of the domestic money supply following intervention

by the authorities to maintain the fixed exchange rate. This causes the LM

curve to shift downwards to the right and long-run equilibrium will occur at

point C, where the balance of payments is zero and the goods and monetary

markets are in equilibrium.

In contrast to fiscal expansion under a regime of fixed exchange rates,

with imperfect capital mobility, monetary expansion will always lead to a

deterioration in the balance of payments, and vice versa, regardless of whether

or not the LM curve is steeper than the BP curve. This is illustrated in Figure

3.11, where the economy is initially operating at point A, the triple intersection

of the three curves IS, LM0 and BP, with equilibrium in the goods and

money markets, and in the balance of payments. Expansionary monetary

policy shifts the LM curve from LM0 to LM1 and results in a reduction in the

domestic rate of interest from r0 to r1 (worsening the capital account) and an

increase in the level of income from Y0 to Y1 (worsening the current account).

Figure 3.11 Monetary expansion under imperfect capital mobility

With adverse interest and income effects on the capital and current accounts

respectively, the overall balance of payments is unambiguously in deficit at

point B (that is, the curves IS and LM1 intersect at a point below the BP

curve).

In a similar manner to that discussed for expansionary fiscal policy, point B

cannot be a long-run equilibrium. The implied balance of payments deficit

causes a contraction in the money supply, shifting the LM curve backwards.

The long-run adjustment process will cease at point A where the LM curve

has returned to its original position. In other words, in the absence of sterilization,

monetary policy is completely ineffective as far as influencing the

level of income is concerned. This assumes that the domestic country is small

relative to the rest of the world so that expansion of its money supply has a

negligible effect on the world money supply.

Readers should verify for themselves that, for a small open economy

operating under a regime of fixed exchange rates, in the limiting case of

perfect capital mobility, the equilibrium level of domestic income is in the

long run established at the intersection of the IS and ‘horizontal’ BP curves.

In this situation fiscal policy becomes all-powerful (that is, fiscal expansion

results in the full multiplier effect of the simple Keynesian 45° or cross model

with no crowding out of private sector investment), while monetary policy

will be impotent, having no lasting effects on aggregate demand and income.

Before considering the effectiveness of fiscal and monetary policy under

flexible exchange rates it is interesting to note that Mundell (1962) also

considered the appropriate use of monetary and fiscal policy to successfully

secure the twin objectives of internal (output and employment at their full

employment levels) and external (a zero overall balance of payments position)

balance. Mundell’s solution to the so-called assignment problem follows

his principle of effective market classification (Mundell, 1960). This principle

requires that each policy instrument is paired with the objective on which

it has the most influence and involves the assignment of fiscal policy to

achieve internal balance and monetary policy to achieve external balance.

We now consider the effects of a change in fiscal and monetary policy on

income and the exchange rate under a regime of flexible exchange rates. The

effects of fiscal expansion on the level of income and the exchange rate again

depend on the relative slopes of the BP and LM curves. This is illustrated for

imperfect capital mobility in panels (a) and (b) of Figure 3.12, which are the

flexible counterparts of Figure 3.10 discussed above with respect to fixed

exchange rates.

In panel (a) of Figure 3.12 the BP curve is steeper than the LM curve. The

economy is initially in equilibrium at point A, the triple intersection of curves

IS0, LM0 and BP0. Expansionary fiscal policy shifts the IS curve from IS0 to

IS1. As we have discussed above, under fixed exchange rates fiscal expansion

131

Figure 3.12 Fiscal expansion under (a) and (b) imperfect and (c) perfect capital mobility

would result in a balance of payments deficit (that is, IS1 and LM0 intersect at

point B below BP0). With flexible exchange rates the exchange rate adjusts to

correct potential balance of payments disequilibria. An excess supply of

domestic currency in the foreign exchange market causes the exchange rate

to depreciate, shifting the IS1 and BP0 curves to the right until a new equilibrium

is reached along the LM0 curve to the right of point B, for example at

point C, the triple intersection of the curves IS2, LM0 and BP1 with an income

level of Y1. In this particular case the exchange rate depreciation reinforces

the effects of domestic fiscal expansion on aggregate demand, leading to a

higher level of output and employment.

Panel (b) of Figure 3.12 depicts the case where the LM curve is steeper than

the BP curve. The economy is initially in equilibrium at point A, the triple

intersection of curves IS0, LM0 and BP0. Fiscal expansion shifts the IS curve

outwards from IS0 to IS1 with the intersection of curves IS1 and LM0 at point B

above BP0. This is equivalent to a balance of payments surplus under fixed

exchange rates and causes the exchange rate to adjust to eliminate the excess

demand for domestic currency. In contrast to the situation where the BP curve

is steeper than the LM curve, the exchange rate appreciates, causing both the

IS1 and BP0 curves to shift to the left. Equilibrium will be established along the

LM curve to the left of point B, for example at point C. In this situation fiscal

policy will be less effective in influencing output and employment as exchange

rate appreciation will partly offset the effects of fiscal expansion on aggregate

demand. As noted above, panel (b) is more likely to represent the true situation.

In the limiting case of perfect capital mobility illustrated in panel (c) of

Figure 3.12, fiscal policy becomes completely ineffective and is unable to

affect output and employment. In the case of perfect capital mobility the BP

curve is horizontal; that is, the domestic rate of interest is tied to the rate

ruling in the rest of the world at r*. If the domestic rate of interest were to rise

above the given world rate there would be an infinite capital inflow, and vice

versa. Fiscal expansion (that is, a shift in the IS curve to the right from IS0 to

IS1) puts upward pressure on the domestic interest rate. This incipient pressure

results in an inflow of capital and leads to an appreciation of the exchange

rate. As the exchange rate appreciates net exports decrease, causing the IS

curve to move back to the left. Equilibrium will be re-established at point A

only when the capital inflows are large enough to appreciate the exchange

rate sufficiently to shift the IS curve back to its original position. In other

words fiscal expansion completely crowds out net exports and there is no

change in output and employment. At the original income level of Y0 the

current account deficit will have increased by exactly the same amount as the

government budget deficit.

Finally we consider the effects of monetary expansion on the level of

income and the exchange rate under imperfect and perfect capital mobility.

The case of imperfect capital mobility is illustrated in panel (a) of Figure