Open Economy IS:LM BP Revision PDF

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Topic 3 – Open Economy - IS/LM BP The Balance of Payments The balance of payments is divided into two sets of accounts:  the current account (CA)  the capital account (KA) The current account is a record of the international transactions in goods and services. The capital account is a record of international direct and indirect investment. Exports of goods are an injection into the goods market and are seen as a function of overseas incomes, the price level and the exchange rate all of which we assume are fixed. Exports are therefore given and shift the goods market injections function. Imports are seen as a leakage from the goods market and are a function of domestic income, overseas price levels and the exchange rate with the last two assumed fixed. As a leakage imports will pivot the leakage function. The current account (CA) is therefore a function of the domestic level of income (Y). As income increases imports rise and with a given volume of exports the current account will deteriorate. The IS curve in an open economy will therefore be steeper. Capital account (KA) transactions are seen as function of the rate of interest (i/r). As domestic interest rates rise relative to international rates the capital surplus increases. There will be various combinations of domestic levels of income and rates of interest that generates an overall balance of payments – the BP curve. As income increases the current account deficit increases requiring a higher rate of interest to generate a big capital account surplus to offset it. The BP curve will therefore be upward sloping with the slope depending on the propensity to import and interest elasticity of capital flows (capital mobility). Deriving the BP Curve Derive the BP curve using the four-quadrant approach. Examine the implications for the BP curve of different degrees of capital mobility. Open Economy Equilibrium There will now be a unique combination of income and rate of interest that will simultaneously generate an equilibrium in all three markets – goods, money and trade.

point A will either generate a surplus or deficit in the balance of payments. point B will either be above or below the BP curve. if it is above then there is a balance of payments surplus, which causes an increase in the money supply, LM curve shifts to the right. if it is below then there is a balance of payments deficit, which causes a decrease in the money supply, LM curve shifts to the left.

Example Exam Question Derive the IS, LM and BP curves and using the framework assuming fixed prices, fixed exchange rates and with the BP curve steeper than the LM curve illustrate and explain the impact on the equilibrium level of income and rate of interest of: a) A decrease in private sector investment b) An increase in the transactions demand for money

Info Fixed exchange rate – it is the LM curve that adjusts and shifts – change in the money supply The level of capital mobility is the determinate of the slope of the BP curve When deriving BP make sure if it says steep to draw it steep as well as in the equilibrium graph

TD  i/r Transactions demand for money rises and with a given money supply interest rates rise Rise in interest rates crowd out interest sensitive expenditure, therefore private sector investment decreases At B MS Money supply rises, people have more money so buy bonds, bond prices rise, interest rates fall, reduces hot money flows, increase in investment, increase in income

Macroeconomics: theory and policy in the UK - Shaw, Greenway & McCrostie...