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3.13. The economy is initially in equilibrium at point A, the triple intersection

of curves IS0, LM0 and BP0. Monetary expansion shifts the LM curve

from LM0 to LM1. Under fixed exchange rates this would result in a balance

of payments deficit. With flexible exchange rates the exchange rate depreciates

to maintain balance of payments equilibrium and both the BP and IS

curves shift to the right until a new equilibrium is established along the

curve LM1 to the right of point B, such as point C, the triple intersection of

curves IS1, LM1 and BP1. The effect of monetary expansion is reinforced by

exchange rate depreciation, leading to a higher level of income. In the

limiting case of perfect capital mobility illustrated in panel (b) monetary

expansion (which shifts the LM curve from LM0 to LM1) will put downward

pressure on the domestic interest rate. This incipient pressure results in

capital outflows and a depreciation of the exchange rate, causing the IS

curve to shift to the right (from IS0 to IS1) until a new equilibrium is

established at point C, the triple intersection of curves LM1, IS1 and BP at

the given world interest rate r* and a new income level Y1. In this limiting

case monetary policy is completely effective and contrasts with the position

of fiscal policy discussed above.

In summary, under a regime of fixed exchange rates with imperfect capital

mobility, while fiscal expansion will result in an increase in income, its

effects on the overall balance of payments (assuming sterilization takes place)

are ambiguous (depending on the relative slopes of the LM and BP curves).

In contrast, there is no ambiguity following a change in monetary policy.

Monetary expansion will result in an increase in income and always lead to a

deterioration in the balance of payments. However, in the absence of sterilization,

monetary policy is completely ineffective in influencing the level of

income. Furthermore, in the limiting case of perfect capital mobility fiscal

policy becomes all-powerful, while monetary policy will be impotent, having

no lasting effects on aggregate demand and the level of income. Under a

regime of flexible exchange rates, with imperfect capital mobility, while

fiscal expansion will result in an increase in income, it could (depending on

the relative slopes of the LM and BP curves) cause the exchange rate to

depreciate or appreciate, thereby reinforcing or partly offsetting the effect of

fiscal expansion on aggregate demand and income. In contrast, monetary

expansion results in an increase in income, with the effects of monetary

expansion on aggregate demand and income being reinforced by exchange

rate depreciation. In the limiting case of perfect capital mobility fiscal policy

becomes impotent and is unable to affect output and employment, while

monetary policy becomes all-powerful.

In concluding our discussion it is important to note that there are a number

of limitations of the above IS–LM model for an open economy. These limita134

Figure 3.13 Monetary expansion under (a) imperfect and (b) perfect

capital mobility

tions include: restrictive assumptions (for example fixed wages and prices,

and static expectations about exchange rate changes); specification of the

capital account (where net capital flows between countries depend solely on

the differential between domestic and foreign interest rates) which is inconsistent

with portfolio theory where perpetual capital flows require continuous

interest changes; the implicit assumption that a country is able to match a

continuous deficit on the current account with a surplus on the capital account

whereas, in reality, the nature of the balance of payments objective is

likely to be much more precise than just overall balance of payments equilibrium;

and adopting comparative statics rather than considering the dynamics

of adjustment following a disturbance (see Ugur, 2002). For a discussion of

the origin and subsequent refinements of the Mundell–Fleming model the

reader is referred to Frenkel and Razin (1987); Mundell (2001); Obstfeld

(2001); Rogoff (2002); Broughton (2003).

Having analysed the effectiveness of fiscal and monetary policy in the

context of the fixed-price Keynesian models of both a closed and open

economy we next discuss the original Phillips curve analysis and comment

on the importance of the curve to orthodox Keynesian economics.