Mundell Fleming model IS LM BP model
Mundell- Fleming model (IS-LM- BP model)
The balance of payments is a summary statement of all the transactions of the residents of a
nation with the residents of all other nations recorded during a particular period of time,
usually a calendar year.
The Mundell-Fleming model addresses how both
internal balance and external balance can be achieved with just expenditure-switching
policies. The conclusions of the Mundell-Fleming model can be developed using IS-LM-BP
analysis.
Determination of exchange rate
In the diagram, BOP equilibrium at
given exchange rate is maintained at
point A where IS,LM and BOP curves
are intersect with each other by
determining equilibrium income and
interest rate OY and OR respectively.
Policy under the fixed exchange rate: It is a nominal exchange rate that is set firmly by the
monetary authority or central bank with respect to a foreign currency or a basket of foreign
currencies. The central bank promises to always buy and sell currency at a particular price,
which guarantees that the exchange rate will always be the same.
1
A.
Expansionary
monetary
Policy:
Monetary policy is concerned with change with money supply, interest rate etc. Central bank
may increase money supply or decrease interest rate during this policy.
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where IS0, LM(Mo)
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose the monetary authority increases
the money supply from Mo to M 1, LM
curve shifts parallel towards the right from
LM(M0) to LM(M1). As a result,
equilibrium is reached to point B, with a
fall in interest rate to OR1 and income
increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
At point B, there is infinite outflow of money due to increase in import demand at higher
income and domestic investors seek to purchase higher returning foreign assets due to lower
domestic interest rate (i.e. higher foreign interest rate)
If economy wants to stay at point B in the long run, devaluation of domestic currency is
needed which shifts the BOP curve towards the right and finally BOP equilibrium is
maintained at point B.
2
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves
and buys excess domestic currency. It reduces the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve back to
the initial position LM(Mo) and income and interest rate also decreases to their initial position
OY0 and OR0 respectively.
B. Contractionary monetary Policy:
Thus, it can be concluded that monetary policy is ineffective for the objective of increasing
output level if a country adopts fixed exchange rate system.
C.
Expansionary Fiscal Policy: In this
policy, government may increase its expenditure or decrease tax rate to encourage economic
activities and to reduce unemployment. Effects of expansionary fiscal policy on exchange
rate determination can be analyzed in two ways.
1. When BOP curve is less elastic than LM curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose that government expenditure
increases from Go to G 1, IS0 curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B, with a rise in interest rate to
OR1 and income increases to OY1.
3
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
At point B, there is infinite outflow of money due to increase in import demand with the
increase income which makes the current account deficit. Similarly, foreign investors seek to
purchase higher returning domestic assets due to higher domestic interest rate (i.e. lower
foreign interest rate). It makes the capital account positive. Here, deficit current account is so
powerful that it outweighs the positive capital account ( i.e. direct effect Y 0Y1>induced effect
Y1Y2).Which shifts the LM curve towards the left.
If economy wants to stay at point B in the long run, devaluation of domestic currency is
needed which shifts the BOP curve towards the right and finally BOP equilibrium is
maintained at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves
and buys excess domestic currency. It reduces the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve
towards the left to the new position LM 1 (M1) and finally, BOP is in equilibrium at point c by
determining equilibrium income and interest rate OY 2 and OR2 respectively.
2. When BOP curve is more elastic than LM curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
4
Suppose that government expenditure
increases from Go to G1, IS curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B and interest rate and income
increases to OR1 and OY1 respectively.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP
curve.
At point B, there is outflow of money due to increase in import demand with the increase
income which makes the current account deficit. Similarly, foreign investors seek to purchase
higher returning domestic assets due to higher domestic interest rate (i.e. lower foreign interest
rate). It makes the capital account positive. Here, positive capital account is so powerful that it
outweighs the deficit current account ( i.e. direct effect Y 0Y1>induced effect Y1Y2). It shifts
the LM curve towards the right.
If economy wants to stay at point B in the long run, overvaluation of domestic currency is
needed which shifts the BOP curve towards the left and finally BOP equilibrium is maintained
at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It buys excess foreign exchange
reserves (i.e. increases the foreign currency reserves) and sells domestic currency (i.e.
increases the domestic money supply). It increases the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve
towards the right to the new position LM 1 (M1) and finally, BOP equilibrium is achieved at
point c
Expansionary fiscal policy with fixed exchange rates is powerful because it forces monetary
policy to be fully accommodating.
5
2. Flexible exchange rate: It is an
endogenous variable determined by market forces. It fluctuates with the change in economic
condition of country.
A. Expansionary monetary Policy:
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where IS0, LM0 and
BOP0 curves are intersect with each other
by determining equilibrium income and
interest rate OY0 and OR0 respectively at
given exchange rate.
Suppose the monetary authority increases
the money supply from Mo to M 1, LM
curve shifts parallel towards the right from
LM(M0) to LM(M1). As a result,
equilibrium is reached to point B, with a
fall in interest rate to OR1 and income
increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
Domestic investors seek to purchase higher returning foreign assets due to higher foreign
interest rate (i.e. lower domestic interest rate). For this, they need to sell their domestic
currency to buy foreign currency. This leads to a depreciation of domestic exchange rate. It
means that domestic products become cheaper in abroad and foreign products become more
expensive at home. In other words, depreciation makes the economy more internationally
competitiveness. As net export increases, IS curve shift towards the right from IS 0 to IS1 until
the domestic and international interest rates are equal i.e. OR 2. Since, net export increases,
6
balance of payment bettered i.e. BOP curve shift towards the right to BOP 1. Finally, the
system will be equilibrium at point C where IS 1, LM1 and BOP1 curves are intersect with each
other by determining the equilibrium income and interest rate OY 2 and OR2.
B. Expansionary Fiscal Policy: In this policy, government may increase its expenditure or
decrease tax rate to encourage economic activities and to reduce unemployment. Effects of
expansionary fiscal policy on exchange rate determination can be analyzed in two ways.
3.
When BOP curve is less elastic than LM
curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP0 curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose that government expenditure
increases from Go to G1, IS curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B, with a rise in interest rate to
OR1 and income increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP
curve.
Foreign investors seek to purchase higher returning domestic assets due to higher domestic
interest rate (i.e. lower foreign interest rate). For this, they need to sell their domestic currency
to buy foreign currency. As inflow of foreign currency increases, it leads to an appreciation of
domestic exchange rate. It means that domestic products become expensive in abroad and
7
foreign products become more cheaper at home. In other words, appreciation makes the
economy less internationally competitiveness. As net export decreases, IS curve shift towards
the left from IS 1 to IS2 until the domestic and international interest rates are equal i.e. OR 2.
Since, net export decreases, balance of payment worsened i.e. BOP curve shift towards the left
to BOP1. Finally, the system will be equilibrium at point C where IS 1, LM1 and BOP1 curves
are intersect with each other by determining the equilibrium income and interest rate OY 2 and
OR2.
8
The balance of payments is a summary statement of all the transactions of the residents of a
nation with the residents of all other nations recorded during a particular period of time,
usually a calendar year.
The Mundell-Fleming model addresses how both
internal balance and external balance can be achieved with just expenditure-switching
policies. The conclusions of the Mundell-Fleming model can be developed using IS-LM-BP
analysis.
Determination of exchange rate
In the diagram, BOP equilibrium at
given exchange rate is maintained at
point A where IS,LM and BOP curves
are intersect with each other by
determining equilibrium income and
interest rate OY and OR respectively.
Policy under the fixed exchange rate: It is a nominal exchange rate that is set firmly by the
monetary authority or central bank with respect to a foreign currency or a basket of foreign
currencies. The central bank promises to always buy and sell currency at a particular price,
which guarantees that the exchange rate will always be the same.
1
A.
Expansionary
monetary
Policy:
Monetary policy is concerned with change with money supply, interest rate etc. Central bank
may increase money supply or decrease interest rate during this policy.
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where IS0, LM(Mo)
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose the monetary authority increases
the money supply from Mo to M 1, LM
curve shifts parallel towards the right from
LM(M0) to LM(M1). As a result,
equilibrium is reached to point B, with a
fall in interest rate to OR1 and income
increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
At point B, there is infinite outflow of money due to increase in import demand at higher
income and domestic investors seek to purchase higher returning foreign assets due to lower
domestic interest rate (i.e. higher foreign interest rate)
If economy wants to stay at point B in the long run, devaluation of domestic currency is
needed which shifts the BOP curve towards the right and finally BOP equilibrium is
maintained at point B.
2
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves
and buys excess domestic currency. It reduces the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve back to
the initial position LM(Mo) and income and interest rate also decreases to their initial position
OY0 and OR0 respectively.
B. Contractionary monetary Policy:
Thus, it can be concluded that monetary policy is ineffective for the objective of increasing
output level if a country adopts fixed exchange rate system.
C.
Expansionary Fiscal Policy: In this
policy, government may increase its expenditure or decrease tax rate to encourage economic
activities and to reduce unemployment. Effects of expansionary fiscal policy on exchange
rate determination can be analyzed in two ways.
1. When BOP curve is less elastic than LM curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose that government expenditure
increases from Go to G 1, IS0 curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B, with a rise in interest rate to
OR1 and income increases to OY1.
3
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
At point B, there is infinite outflow of money due to increase in import demand with the
increase income which makes the current account deficit. Similarly, foreign investors seek to
purchase higher returning domestic assets due to higher domestic interest rate (i.e. lower
foreign interest rate). It makes the capital account positive. Here, deficit current account is so
powerful that it outweighs the positive capital account ( i.e. direct effect Y 0Y1>induced effect
Y1Y2).Which shifts the LM curve towards the left.
If economy wants to stay at point B in the long run, devaluation of domestic currency is
needed which shifts the BOP curve towards the right and finally BOP equilibrium is
maintained at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It sells foreign exchange reserves
and buys excess domestic currency. It reduces the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve
towards the left to the new position LM 1 (M1) and finally, BOP is in equilibrium at point c by
determining equilibrium income and interest rate OY 2 and OR2 respectively.
2. When BOP curve is more elastic than LM curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
4
Suppose that government expenditure
increases from Go to G1, IS curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B and interest rate and income
increases to OR1 and OY1 respectively.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP
curve.
At point B, there is outflow of money due to increase in import demand with the increase
income which makes the current account deficit. Similarly, foreign investors seek to purchase
higher returning domestic assets due to higher domestic interest rate (i.e. lower foreign interest
rate). It makes the capital account positive. Here, positive capital account is so powerful that it
outweighs the deficit current account ( i.e. direct effect Y 0Y1>induced effect Y1Y2). It shifts
the LM curve towards the right.
If economy wants to stay at point B in the long run, overvaluation of domestic currency is
needed which shifts the BOP curve towards the left and finally BOP equilibrium is maintained
at point B.
But the central bank cannot accept this as it has already committed to fixed exchange rate. For
this, central bank intervenes in foreign exchange market. It buys excess foreign exchange
reserves (i.e. increases the foreign currency reserves) and sells domestic currency (i.e.
increases the domestic money supply). It increases the high powered money as well as money
supply through money multiplier i.e. non-sterilized intervention. It shifts the LM curve
towards the right to the new position LM 1 (M1) and finally, BOP equilibrium is achieved at
point c
Expansionary fiscal policy with fixed exchange rates is powerful because it forces monetary
policy to be fully accommodating.
5
2. Flexible exchange rate: It is an
endogenous variable determined by market forces. It fluctuates with the change in economic
condition of country.
A. Expansionary monetary Policy:
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where IS0, LM0 and
BOP0 curves are intersect with each other
by determining equilibrium income and
interest rate OY0 and OR0 respectively at
given exchange rate.
Suppose the monetary authority increases
the money supply from Mo to M 1, LM
curve shifts parallel towards the right from
LM(M0) to LM(M1). As a result,
equilibrium is reached to point B, with a
fall in interest rate to OR1 and income
increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP deficit as it lies below the BOP
curve.
Domestic investors seek to purchase higher returning foreign assets due to higher foreign
interest rate (i.e. lower domestic interest rate). For this, they need to sell their domestic
currency to buy foreign currency. This leads to a depreciation of domestic exchange rate. It
means that domestic products become cheaper in abroad and foreign products become more
expensive at home. In other words, depreciation makes the economy more internationally
competitiveness. As net export increases, IS curve shift towards the right from IS 0 to IS1 until
the domestic and international interest rates are equal i.e. OR 2. Since, net export increases,
6
balance of payment bettered i.e. BOP curve shift towards the right to BOP 1. Finally, the
system will be equilibrium at point C where IS 1, LM1 and BOP1 curves are intersect with each
other by determining the equilibrium income and interest rate OY 2 and OR2.
B. Expansionary Fiscal Policy: In this policy, government may increase its expenditure or
decrease tax rate to encourage economic activities and to reduce unemployment. Effects of
expansionary fiscal policy on exchange rate determination can be analyzed in two ways.
3.
When BOP curve is less elastic than LM
curve
In the diagram, Initially, all markets ( i.e.
goods, money and foreign) are in
equilibrium at point A where ISo, LMo
and BOP0 curves are intersect with each
other by determining equilibrium income
and interest rate OY0 and OR0 respectively
at given exchange rate.
Suppose that government expenditure
increases from Go to G1, IS curve shifts
parallel towards the right from IS0(G0) to
IS1(G1). As a result, equilibrium is reached
to point B, with a rise in interest rate to
OR1 and income increases to OY1.
Here, point B is quasi equilibrium. It represents the BOP surplus as it lies above the BOP
curve.
Foreign investors seek to purchase higher returning domestic assets due to higher domestic
interest rate (i.e. lower foreign interest rate). For this, they need to sell their domestic currency
to buy foreign currency. As inflow of foreign currency increases, it leads to an appreciation of
domestic exchange rate. It means that domestic products become expensive in abroad and
7
foreign products become more cheaper at home. In other words, appreciation makes the
economy less internationally competitiveness. As net export decreases, IS curve shift towards
the left from IS 1 to IS2 until the domestic and international interest rates are equal i.e. OR 2.
Since, net export decreases, balance of payment worsened i.e. BOP curve shift towards the left
to BOP1. Finally, the system will be equilibrium at point C where IS 1, LM1 and BOP1 curves
are intersect with each other by determining the equilibrium income and interest rate OY 2 and
OR2.
8