module 4 bop adjustment

________________________________________________________Module 4: BOP Adjustment

TOPIC 1: Foreign Trade MultiplierQ.1 Explain the working of foreign trade multiplier and bring out its effect on the economy

in the presence of foreign repercussions.OR

Explain the foreign trade multiplier and bring out its global implications.OR

What is foreign trade multiplier ? Discuss its international repercussions.

Ans. Working of foreign Trade Multiplier:

The foreign trade multiplier is also known as the export multiplier. It operates like the investment multiplier of Keynes. It may be defined as “the amount by which the NI of a country will be raised by a unit increase in domestic investment or exports.”

As export increase, there is an increase in the income of all persons associated with export industries. These, in turn create demand for goods. However, it is depend upon their marginal propensity to save (MPS) and the marginal propensity to import (MPM). The smaller these two marginal propensities are, the larger will be the value of the multiplier, and vice versa.

Process of foreign trade multiplier:

Suppose the exports of the country increase. To begin with, the exporters will sell their products to foreign countries and receive more income. In order to meet the foreign demand, they will engage more factors of production to produce more. This will raise the income of the owners of factors of production. This process will continue and the NI increases by the value of the multiplier. The value of the multiplier depends on the value of MPS and MPM, there being an inverse relation between the two propensities and the export multiplier.

Derivation of foreign trade multiplier:

The NI identity in an open economy is

Y = C + I + X - M

Where, Y = National Income

C = National Consumption

I = Total Investment

X = Exports

M = Imports.

The above relationships can be solved as:

Y - C= I + X – M

S = I + X – M

S + M= I + X

Thus at equilibrium levels of income the sum of savings and imports (S + M) must equal the sum of investment and export (I + X).

In an open economy the investment (I) component is divided into domestic investment (Id) and foreign investment (If)

____________ (1)

Foreign Investment (If) is the difference between exports and imports of goods and services

____________ (2)

M.COM – SEM II: ECONOMICS OF GLOBAL TRADE AND FINANCE

S = Y - C

I = S

Id + If = S

If = X- M

1


Substituting (2) into (1), we have

Id + X = S + M

This is an equilibrium condition of NI in an open economy. The foreign multiplier coefficient (kf) is equal to

kf =Y

X

and

[DId = 0]

Dividing both sides by Y, we get

X=

S + M

Y Y

Or

kf =

1

S + M

Y Y

kf =1

MPS + MPM

M.COM – SEM II: ECONOMICS OF GLOBAL TRADE AND FINANCE

Id + X- M = S

X = S + M

Y=

Y

X S + Mkf =

Y

X

2


(S + M) Y (S + M) Y (S + M) Y E Id + X E1 Id + X1 E

E E1 Id + X Id + X Id + X1

S(Y) S(Y) S d

Id d Id S

Y 0 Y Y 1 0 Y 1

Y National Income

In the above diagram, S(Y) is the saving function and (S + M) Y is the saving plus import function. Id represents domestic investment and Id + X the exports plus domestic investment. The (S + M) Y and Id + X functions determine the equilibrium level of NI ‘OY’ at point E, where S = Id and X = M.

If there is a shift in the Id + X function due to increase in X, the NI will increase from OY to OY1. This increase in income due to the multiplier effect i.e. Y = kf * X. The exports will exceed imports by Sd, the amount by which S Id.

If there is a fall in exports, the export function will shift downward to Id + X1. In this case M X and Id S by dS. This is the reverse operation of the foreign trade multiplier.

Foreign Repercussion or Backwash or Feedback Effect

A country’s exports or imports affect the national income of the other country which, in turn, affects the foreign trade and NI of the first country. This is known as the Foreign Repercussion or Backwash or Feedback Effect.

The smaller the country is in relation to other trading partner, the negligible is the foreign repercussion. But the foreign repercussion will be high in the case of the large country because a change in the NI of such a country will have significant foreign repercussion or backwash effect.

Assuming two large countries A and B where A’s imports are B’s exports and vice versa. An increase in A’s domestic investment will cause a multiplier increase in its income. This will increase its imports. This increase in A’s imports will be increase in B’s exports which will increase income in B through B’s foreign trade multiplier. Now the increase in B’s income will bring an increase in its imports from country A’s which will induce a second round increase in A’s income and so on.

M.COM – SEM II: ECONOMICS OF GLOBAL TRADE AND FINANCE 3

COUNTRY A COUNTRY B

+Id X+ +Y Y+ +M M+

X+ X+ Y+ Y+ M+ M+

and so on


When autonomous domestic investment (Id) increases in country A, its NI increases (Y). It induces country A to import more from country B. this increase the demand for country B’s exports (X). As a result, the NI in country B’s increases (Y). Now this country imports more (M) from country A. As the demand for country A’s exports increases (X), its NI (Y) increases further and this country import (M) more from B country. This process will continue in smaller rounds. These are the foreign repercussions or the backwash effects for country A which will reduce the effects of increase in the original autonomous domestic investment (Id) in country A.

kf =1 + MPMB/MPSB

MPSA + MPMB + MPMB (MPSA/MPSB)

Country A (Panel I) Country B (Panel II) Country A (Panel III)

(S + M) Y (S + M) Y (S + M) Y (S + M) Y E1 Id1 + X E1 Id + X1 E2

E E E1 Id1 + X1

Id + X Id + X Id1 + X

Id1 Id

Id Id

Y Y1 0 Y 0 Y1 0 Y 1

Y2

National Income

Stage I: Domestic investment in country A increase from Id to Id1 in Panel I. This leads to an upward shift in the Id + X curve to Id1 + X. As a result, the new equilibrium point is at E1, which show an increase in the NI form OY to OY1.

Stage II: As the NI increases, the demand for imports from country A also increases. This means increase in the exports of country B. This is shown in Panel II when the I d + X schedule of country



B shift upwards as Id + X1. As a result, the NI in country B increases from OY0 to OY1 at the higher equilibrium level E1.

Stage III: As country B’s income increases, its demand for imports from country A also increases. This, in turn, leads to the backwash effect in the form of increase in the demand for exports of country A. This shown in Panel III where the Id1 + X curve (of Panel I) further shift upwards to Id1 + X1 and consequently the NI increases further from OY1 to OY2.

Implications of Foreign Repercussion:

1. The foreign repercussion effects suggest a mechanism for the transmission of income disturbances between trading countries. If a country is small, it will be affected by changes in income of other countries that will change the demand for its exports. But it will not be able to transmit its own income disturbances to the later. If a country is large, it may transmit its own income disturbances to other countries and in, turn; be affected by income disturbances in them. It implies that a boom or depression in one country has repercussion on the incomes of other countries.

2. The repercussion effects also suggest that since the backwash effects ultimately peter out, automatic income changes cannot remove completely the current account BOP deficit or surplus produced by an automatic disturbance.

3. The policy implications of the backwash effects suggest that export promotion policies raise NI in the trading partners at a lower rate than by an increase in domestic investment. The export promotion measures raise NI via the simple foreign trade multiplier, whereas increase in domestic investment policies raise NI may many times in multiplier rounds via the repercussion effect.

TOPIC 2: Balance of Payments Policies: Internal and External Balance

Q.1 How can fiscal and monetary policies be used to achieve full employment and external balance in a country?

OR

Explain the role of monetary and fiscal policies in correcting the disequilibrium in the balance of payments.

OR

Discuss the expenditure switching and expenditure adjusting policy measures to correct disequilibrium in the balance of payments.

Ans: The policy measures are used by every government in order to correct BOP disequilibrium. They are:

a) internal balance which refers to full employment with price stability, and

b) the external balance or BOP equilibrium.

It was Meade who pointed out that to maintain both internal and external balance; a country must control both its aggregate expenditure and the exchange rate.

It was, however, Johnson who pointed towards the expenditure changing and expenditure switching policy instruments for bringing about both internal and external balance.

Expenditure Changing Monetary and Fiscal Policies

Expenditure changing policies are meant to change the aggregate expenditure in the economy through appropriate monetary and fiscal policies in order to affect its BOP disequilibrium.

A) Expenditure Changing Monetary Policy:



An expenditure changing monetary policy affects the economy through changes in money supply and interest rates. A contractionary monetary policy leads to a BOP surplus and expansionary monetary policy to a BOP deficit.

Assumptions:

a) there is fixed exchange rate

b) there is relative capital mobility and

c) there is no change in government expenditure i.e. the IS curve remains unchanged.

1) Expenditure Reducing Monetary Policy:

Suppose there is a BOP deficit in the country. This implies expenditure is more than income. To correct it, the monetary policy reduces the money supply which increases interest rates thereby reducing investment and output. The reduction in investment and output, in turn, reduces income and aggregate demand for imported goods. There is also a reduction in the domestic price level which may lead to switching of expenditure from foreign to domestic goods. As a result, the country’s imports are reduced and exports are increased. Thus the current account trade deficit is reduced. Simultaneously, there is reduced outflow of short – term capital with reduction in imports which cuts down the BOP deficit. On the other hand, rises in domestic interest rates increase the inflow of capital, thereby completely removing the BOP deficit.

Expenditure reducing monetary policy and its effects on BOP situation are explained in the below figure and diagram.

Tight Monetary Policy Decrease in Rise in Interest rates Capital Inflow

Money Supply

Expenditure and Imports Falls BOT ImprovesIncome fall

Price Level Decreases Exports Rises

BP LM1

E1 LM Interest R1 E Rate R

IS

0 Y1 Y National IncomeIn the above diagram, the economy is in equilibrium with OR interest rate and OY income level at point E of the intersection of IS-LM-BP curves. Suppose the domestic money supply reduced. This will shift the LM curve upward to the left to LM1 and the economy moves to new equilibrium is point E1. There is increase in interest rate from OR to OR1

which brings capital inflow. On the other hand, the reduction in income from OY to OY1



will leads to BOT surplus due to fall in imports. Thus a contractionary policy leads to a BOP surplus. However, E1 does not represent a permanent equilibrium. The BOP surplus will increase the domestic money supply and gradually shift the LM1 curve to the right towards the LM curve so that E1 begins to move down along the IS curve to point E where the economy is again in BOP equilibrium.2) Expenditure Increasing Monetary Policy:

On the other hand, an expansionary monetary policy leads to a BOP deficit is explained in the above fig. and diagram.

EasyMonetary Policy Increase in Fall in Interest rates Capital Outflow

Money Supply

Expenditure and Imports Rise BOT WorsensIncome Rise

Price Level Rises Exports Fall

BP LM

E LM2

Interest R Rate R2 E2

IS

0 Y Y2 National Income

In the above diagram, the initially the economy is in equilibrium at point E. Suppose the monetary authority increase the money supply. This will shift the LM curve downward to the right to LM2 and the economy moves to new equilibrium point E2. There is fall in interest rate from OR to OR2 which tend to generate a capital account deficit and capital outflow. On the other hand, the increase in income form OY to OY2 will tend to generate a current account deficit with increase in imports. Thus an expansionary monetary policy leads to a BOP deficit. However, E2 does not represent a permanent equilibrium. The BOP deficit will reduce the domestic money supply and gradually shift the LM2 curve to the left towards the LM curve so that E2 begins to move along the IS curve to point E and the economy is again in BOP equilibrium.

B) Expenditure Changing Fiscal Policy: Fiscal policy means change in government expenditure or taxes. An expansionary fiscal policy tends to increase government expenditure and reduce taxes. On the other hand, a contractionary fiscal policy related to cut in government expenditure and increase in taxes.1) Expenditure Reducing Fiscal Policy: The effects of an expenditure reducing policy to correct BOP deficit are explained in below fig. and diagram.



Assumptions:a) the exchange rate is fixedb) there is relative capital mobilityc) there is no change in monetary policy so that the LM curve remains unchanged.

ContractionaryFiscal Policy Fall in Govts. Fall in Interest rates Capital Outflow Expenditure or Rise in Tax Rates BOP may worsen

first, but Improves eventually

Expenditure and Imports Falls BOT ImprovesIncome Falls

Price Level Falls Exports Rises

BP1

LM

BPInterest E

Rate R R2 E2

ISIS2

0 Y2 YNational Income

In the above diagram, the economy is in equilibrium at point E with OR interest and OY income level where IS-LM-BP curves intersect. Suppose the government adopts a contractionary fiscal policy whereby it reduces its expenditure and increase taxes. This shifts the IS curve downward to the left to IS2 which cuts the LM curve at point E2. This point shows fall in interest rate from OR to OR2 which leads to an outflow of capital and to capital account deficit. The income level also fall from OY to OY2 which reduces imports, thereby leading to current account surplus.However, the effects of a contractionary fiscal policy on BOP will depend upon the elasticity of the BP curve. In the above case, the BP curve is elastic. If the BP curve is less elastic such as BP1, a contractionary fiscal policy will lead to a BOP surplus. This is because point E2 is above and to the left of the BP1 curve.

2) Expenditure Increasing Fiscal Policy:



ExpansionaryFiscal Policy Rise in Govts. Rises in Interest rates Capital Inflow Expenditure or Fall in Tax Rates BOP may Improve

first, but worsens eventually

Expenditure and Imports Rise BOT WorsensIncome Rises

Price Level Rises Exports Falls

BP1

LM

Interest Rate

R1 E1 BP E R

IS IS1

0 Y Y1

National IncomeWhen the government increases its expenditure and reduces taxes. As a result, the IS curve shifts upwards to the right as the IS1 curve which cuts the LM curve at E1. This new equilibrium shows increase in interest rate from OR to OR1 and rise in income from OY to OY1. The increase in interest rate leads to capital inflow thereby creating short run BOP surplus on capital account. On the other hand, the rise in income increases imports thereby leading to BOP deficit on current account. The net overall effect on BOP will depend upon the elasticity of the BP curve. If the BP curve is elastic, equilibrium point E1 is above and to the left of the curve BP curve; there will be overall BOP surplus in an expansionary fiscal policy. In case the BP curve is less elastic, shown as the BP1 curve, the equilibrium point E1 being below and to the right of BP1 curve, there will be overall BOP deficit. Thus the above analysis shows that a contractionary monetary policy is effective in correcting a BOP deficit. But an expansionary fiscal policy can either improve or worsen a Bop deficit. Note: Any point above and to the left of the BP curve represents BOP surplus, and appoint below and the right of the BP curve shows a BOP deficit.

TOPIC 3: Monetary – Fiscal Policy under Fixed and Flexible Exchange rates for Internal and External BalanceQ.1 Discuss the efficiency of fiscal and monetary policies to achieve internal and external

balance under fixed and flexible exchange rates. OR



Examine the use of fiscal and monetary policies to achieve internal and external balance in the IS-LM framework.

OR

Explain how a country can use monetary and fiscal policy for internal and external stability.

Ans: The use of monetary – fiscal mix policies to achieve internal and external balance under fixed and flexible exchange rate with perfect and relative capital mobility and their effects on balance of payments of a country is explained below.

1) Fixed Exchange Rates with Perfect Capital Mobility : When capital is perfectly mobile, a small change in the domestic interest rate brings large flow of capital.

Interest Rate Capital Flow BOP Positionid = if Stable Equilibriumid < if Outflow Deficitid > if Inflow Surplus

LM

LM1

Interest R E E2 BPRate

R1 E1

IS

0 Y Y1 YF

National Income

In the above diagram, the policy implication of perfect capital mobility is shown where the BP curve is drawn horizontally. E is the initial equilibrium point through which IS-LM-BP curves pass, where national income is OY and interest rate OR. At point E, BOP is zero but the economy is not in full employment equilibrium. Suppose OYF is the full employment income level in which the economy wants to attain.

Expansionary Monetary PolicyThe monetary authority starts an expansionary monetary policy to achieve full employment level of income OYF. This shifts the LM curve to LM1 which intersects the IS curve at E1 so that the interest rate falls to OR1. It, in turn, leads to an outflow of capital. Since the price of foreign exchange is fixed, the monetary authority will finance the capital outflow by selling foreign exchange which will decrease the money supply. As a result, the LM1 curve shifts upwards to the left to its original position of the LM curve. Thus monetary policy is totally ineffective under fixed exchange rates and perfect capital mobility in maintaining internal balance. This is because the economy cannot attain the full employment equilibrium point E2. A contractionary money supply would also be ineffective.

Expansionary Fiscal PolicySuppose the government expenditure is increased to achieve full employment level of income OYF. This shifts the IS curve to right to IS1 which intersects the LM curve at E1. This causes the interest rate to rise to OR1 and the income level rise to OY1. The rise in interest rate leads



to large capital inflows from abroad. This increases the money supply with the rise in foreign reserves, thereby shifting the LM curve to the right to LM1. This LM1 curve intersects the IS1

curve at point E2 where at fixed exchange rate full employment income level OYF is reached. Thus fiscal policy by increasing money supply raises the aggregate demand, income and employment.

LM E1 LM1

Interest R1 Rate E E2 BP

RIS1

IS

0 Y Y1 YF National Income

Thus under perfect capital mobility and fixed exchange rates, fiscal policy is effective in maintaining internal balance and monetary policy is ineffective. So far as the external balance is concerned, it is maintained itself because of perfect capital mobility.2) Flexible Exchange Rates with Perfect Capital Mobility

LMInterest LM1

Rate E E2

R BPR1 E1

IS

0 Y Y1 Y2 National Income

Expansionary Monetary PolicyStarting from E an expansionary monetary policy shifts the LM curve to the right to LM 1 curve, given the IS curve. The LM1 curve intersects the IS curve at E1 which lowers the interest rate to OR1

and raises income to OY1. These lead to capital outflows and the consequent deficit in the BOP and depreciation of the exchange rate. Depreciation increases the demand for domestic goods in the foreign country, thereby increasing output and income. This moves the economy upward along the LM1 curve till it reaches point E2 when income rises to OY2 and the interest rate rises to the old level OR. Equilibrium in the BOP is restores at E2 where the increase in imports through rise in income is offset by surplus in trade balance due to depreciation.Expansionary Fiscal Policy

LM Interest Rate R1 E E1

R BP



IS1

IS 0 Y Y1

National IncomeAn expansionary fiscal policy which shifts the IS curve to IS1, given the LM curve. This brings the economy into equilibrium at E1 where the IS1 curve intersects the LM curve with OR1 interest rate and OY1 income level. Since point E1 is above the BP line, there is BOP surplus. This surplus leads to the appreciation of the exchange rate which, in turn, reduces the demand for domestic output. Appreciation will continue to reduce the demand for goods and offset the expansionary effect of fiscal policy till the IS1 curve shift back to the IS curve and the equilibrium is re-established at E where the interest rate and income are back to their original levels of OR and OY. At E the BOP is in equilibrium but there is trade deficit due to exchange appreciation which increases the prices of domestic goods for foreigners and reduces the price of imports. As a result, exports will decline and imports will increase, thereby creating a trade deficit. The equilibrium in BOP is being maintained at E1 by financing the trade deficit through capital inflows with expansionary fiscal policy. So fiscal policy has no effect on income and employment under perfect capital mobility.Thus under flexible exchange rate with perfect capital mobility monetary policy is effective in maintaining internal and external balance and fiscal policy is ineffective.

3) Fixed Exchange Rates with Relative Capital Mobility

BPLM1

Interest E1

Rate R1 LM R2 E E2 LM2

R E’ R’ IS1

IS 0 Y Y’ Y1 Y2

National IncomeIn the above diagram, initial equilibrium is at point E where the curve IS=LM=BP curves with OR interest rate and OY income level. Expansionary Fiscal PolicyAn expansionary fiscal policy shifts the IS curve to IS1 which intersects the LM curve at E2. The interest rate rises from OR to OR2 and the level of income increases from OY to OY2. There will be a deficit in the BOP because E2 is below and to right of the BP curve. This deficit will bring a decline in the money supply as the monetary authority starts selling foreign exchange. Thus the LM curve shifts upward to the left to LM1, where it intersects the IS1 and BP curves at E1. As a result, the economy is at internal & external balance with OR1 interest rate and OY1 income level. Thus fiscal policy is effective.

Expansionary Monetary Policy An expansionary monetary policy will always lead to a deficit in the BOP. With this policy, the LM curve shifts to the right to LM2, the interest rate will fall from OR to OR’ and the income will increase from OY to OY’. The fall in interest rate will lead to a capital account deficit with capital outflow and increase in income to current account deficit with rise in imports. These deficits will force the monetary authority to sell foreign exchange which will reduce the money supply and thus



shits the LM2 curve to its original position of LM curve. As a result, the equilibrium position remains at point E with OR interest rate and OY income level. Thus monetary policy is ineffective.However, fiscal – monetary policy mix can lead the economy to both internal and external balance. This can be achieved by combining an expansionary fiscal policy with a restrictive monetary policy. When an expansionary fiscal policy shifts the IS curve to the right to IS1 and a restrictive monetary policy shifts the LM curve to the left to LM1, both intersect the BP curve at point E1. Thus the economy attains full employment as well as BOP equilibrium with OR1 interest rate and OY1

income level which is higher than the original level at point E.

4) Flexible Exchange Rates with Relative Capital Mobility

BPBP1

LM LM1

Interest R3 E3 Rate R E R2 E2 E1 IS1

IS 0 Y Y2 Y3 Y1

National IncomeExpansionary Monetary PolicyAn expansionary monetary policy shifts the LM curve to the right LM1 and intersect the IS curve at E2. This leads to short run BOP deficit because point E2 is below and to the right of the BP curve. With fall in interest rate to OR2, there is capital outflow. This leads to increase in the demand for foreign currency and the country’s exchange rate depreciates. This increases exports and decreases imports. This causes the IS curve to shift to the right to IS1. BOP improves so that the curve shifts to the right to BP1. The new equilibrium is established at E1 where the curve IS1=LM1=BP1 curve and both external and internal balance are attained at a higher OY1 income level than OY. Thus monetary policy is effective under flexible exchange rates.

Expansionary Fiscal PolicyStarting from the equilibrium point E, with an increase in government expenditure or/and cut in taxes, the IS curve will shift to the right to IS1 which cuts the LM curve at E3. This raises the interest rate to OR3. There is capital inflow which causes currency appreciation. This, in turn, raises imports and reduces exports and leads to depreciation of the currency, and the IS1 curve is shifted back to the IS curve. The original equilibrium point E is reached. Thus fiscal policy is ineffective under flexible exchange rates with relative capital mobility.However, an expansionary monetary policy combined with a contractionary fiscal policy under flexible exchange rates and capital movements is effective in attaining internal and external balance.

Sr. No. Exchange Rates and Capital Mobility Monetary Policy Fiscal Policy1. Fixed Exchange Rates with Perfect Capital Mobility Ineffective Effective

2.Flexible Exchange Rates with Perfect Capital Mobility

Effective Ineffective

3. Fixed Exchange with Relative Capital Mobility Ineffective Effective4. Flexible Exchange with Relative Capital Mobility Effective Ineffective



Monetary – Fiscal Policy Mix ((The Mundellian Model)

Q.2 Explain and evaluate the monetary and fiscal policy alternatives as instruments of BOP adjustments.

OR “Internal stability and external balance are conflicting objectives which can be reconciled

only with a suitable mix of monetary and fiscal tools.” Do you agree? Justify.OR

Explain the monetary fiscal policy mix in converting the disequilibrium in balance of payments.

Ans: The Assignment Problem:The theory of economic policy has concentrated on two distinct problems.

1) the relation between the number of policy objectives and the number of policy instruments;

2) the assignment of policy instruments to the realisation of targets.

Jan Tinbergen was the first economist to lay down that the number of policy instruments must be equal to the number of objectives. If there are more objectives than policy instruments it means that there are enough tools to achieve the policy objectives. The system is underdetermined. On the other hand, if the number of policy instruments is more than the number of objectives, then there is not one combination of tools and objectives that will solve the problem, but any number. The system is over-determined. Thus the number of policy tools must equal the number of targets for economic policy to be successful. This has come to be known as the Tinbergen Principle or the fixed targets approach.



In order to achieve given objectives with the same number of policy instruments, the second problem of the assignment of instruments to targets arises. The formulation of the assignments problem will eventually lead to equilibrium values of the objectives, despite lack of co-ordination between them. Thus the assignment problem relates to the assignment of instruments to targets. The solution to the assignment problem has been suggested by Robert Mundell by the Principle of Effective Market Classification.

The Mundellian Model Mundell discusses the case of relationship between two instruments and two targets.

The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure. The two objectives or targets are full employment (internal balance) and balance of payments equilibrium (external balance). The assignment rule is to assign monetary policy to the objective of external balance and fiscal policy to internal balance.

Assumptions:1. Monetary policy is related to changes in interest rate.2. Fiscal policy is related to deficit or surplus budget.3. Exports are exogenously given.4. Imports are a positive function of income.5. International capital movements respond to domestic rate changes.

The ModelGiven these assumptions, Mundell states that “in countries where employment and BOP policies are restricted to monetary and fiscal instruments, monetary policy should be reserved for attaining the desired level of the BOPs, and fiscal policy for preserving internal stability under the conditions assumed here.”

M IRecession

Deficit Budget Surplus L K II

A B Recession S C D Surplus E IV Inflation Deficit III

IV Inflation IB Surplus

EB 0

R Interest Rate

In the above diagram, the X axis measures interest rate (monetary policy) and the Y axis budget surplus (fiscal policy). IB is the internal balance line and EB the external balance line. The IB line represents full employment. It is negatively sloped because a reduction in budget surplus must be balanced by an increase in interest rate in order to maintain full employment. There is inflation below this line IB (Zone III and IV), and recession above it (Zone I and II).



On the other hand, line EB gives all points of equilibrium in the BOPs. It is also negatively sloped because a reduction in the budget surplus must be counteracted by increase in interest rate. There is deficit in the BOPs below this line (Zone I and IV). And surplus above this line (Zone II and III). The EB line is steeper than the IB line because an increase in interest rate in order to balance an expansionary fiscal policy (increase in budget deficit or reduction in budget surplus) induces a short term capital flow for an external balance. The above diagram explains external and internal balance and the role played by monetary and fiscal policy in maintaining equilibrium between the two at point E with OR interest rate and OS budget surplus. The two policy measures will take the economy to the equilibrium point E in inflation-deficit and recession-surplus situations. But there are policy conflicts in inflation-surplus (Zone III) and recession-deficit (Zone I).Suppose the economy is at point A in Zone I where there is full employment within the economy and BOPs deficit. To remove BOPs deficit, the monetary authority acts by increasing the interest rate by AB in order to reduce money supply. The reduction in money supply will reduce demand for goods and this will, in turn, decrease imports, and restore equilibrium in the BOP at B. But here the economy is having recession and unemployment. To correct these and to have internal balance, budget surplus will have to be reduce by BC. But at C, there is again BOPs deficit which necessitates further increase in interest rate by CD for reducing money supply. At D the internal balance is again disturbed leading to a further reduction in budget surplus. This process of reduction in money supply followed by reduction in budget surplus will ultimately lead the economy to the equilibrium point E where there is simultaneous internal and external balance. Thus the use of monetary policy for external balance and fiscal policy for internal balance will lead to equilibrium in Zone II and IV.On the other hand, if budget surplus is used to remedy the BOPs deficit and monetary policy to correct recession and unemployment, there would be neither external balance nor internal balance. Starting form point A, an increase in budget surplus would move the economy to K where the external balance is achieved but there is recession and unemployment in the economy. To remedy it, the interest rate is reduced by KL for increasing the money supply. But at L BOPs deficit rises over its previous level. This will require a still greater budget surplus by LM. This will necessitate still larger reduction in interest rate to remove recession and unemployment. In this way, the economy would move further and further away from point E and there would not be simultaneous internal and external balance.

The following policy measures are suggested for specific imbalances:

Zone Problem Monetary Policy Fiscal PolicyI Recession & BOP Deficit Contractionary ExpansionaryII Recession & BOP Surplus Expansionary ExpansionaryIII Inflation & BOP Deficit Contractionary ContractionaryIV Inflation & BOP Surplus Expansionary Contractionary

Expenditure Switching Policies

Q.3 Discuss the expenditure switching policy measures to correct disequilibrium in the balance of payments.

ORHow can the disequilibrium in the balance of payments are corrected by expenditure switching policy.

Ans: Expenditure switching policies refer to devaluation or revaluation of a country’s currency in order to switch its expenditure from foreign to domestic goods or vice versa. They aim at



correcting BOP disequilibrium. But Johnson distinguishes between two types of expenditure switching policies.1) Devaluation2) Direct Controls to restrict imports and to correct BOP deficit.

1) Devaluation: Devaluation means a reduction in the external value of a currency in terms of other currencies. When a country with BOP deficit devalues its currency, the domestic price of its imports increases and the foreign price of its exports fall. This makes its exports cheaper and imports dearer. This encourages exports. This causes expenditure to be switched from foreign to domestic goods as the country’s exports increase and the country produces more to meet the domestic and the foreign demand for goods. On the other hand, with imports becoming dearer than before, they decline. Thus with the rise in exports and fall in imports, BOP deficit is corrected.

Assumptions:1) The elasticity of demand for exports and imports is elastic.2) The supply of exports is sufficient to meet the increased demand for exports after

devaluation.3) The internal price level remains constant after devaluation.4) The other country does not adopt such counter-deviation measures as levying tariff

duties on the exports of the devaluing country.

(A) (B)

Sx Px1 E1

Price Px E Pm in Rs. Dx1

Dx

0 X X1 Exports 0 Imports

The above figures A and B explains the effects of devaluation on exports and imports respectively where Dx and Sx are the demand and supply curves of exports and Dm and Sm are the demand and supply curves of imports. Suppose the Indian Rupee is devalued in relation to the US dollar ($) and the price movements before and after devaluation are taken in Rupee. Both the demand and supply curves of exports and imports are taken as elastic. First, take exports and Panel (A) of the figure. Before devaluation, Indian exports OX quantity at OPx price to the U.S. Devaluation of rupee has no effect on the supply of exports in Rupee. Therefore, the supply curve of exports Sx does not change. But to the U.S. consumers of Indian goods, devaluation of rupee means cheaper goods than before. As a result, the demand for exports increases and the demand curve for exports Dx shifts to the right to Dx1. The pre-devaluation price



of OX exports is OPx. After devaluation of the rupee, the export price rises to OPx1 and the volume of exports increases to OX1.Now take the effect of devaluation on imports. Before devaluation, India imports OM quantity at OPm price from the U.S. With devaluation, imports become dearer in rupee and their volume is reduced than before devaluation. Therefore, the supply curve of imports Sm shifts to Sm1 in Panel (B) of the figure. But the demand curve for imports Dm being elastic, the increase in the price of imports from OPm to OPm1 reduces the quantity bought from OM to OM1.Thus by increasing exports by XX1 and decreasing imports by M1M, devaluation in terms of the currency of the devaluing country brings equilibrium in the balance of payments.

Limitations:1. Less Elastic Demand : In reality, the demand for exports and imports is never more than

unity. Rather, it is always less than unity. As a result, the effect of devaluation on BOP will be unfavourable.

2. Supply Shortages : It also assumes an adequate supply of exports to meet the increased demand for exports after devaluation. But it is not possible for a devaluing country to increase the supply of exports due to the scarcity of domestic raw materials, lack of incentives to manufacturers and exporters of exportable goods, reduction in export duties, etc.

3. Price Rise : This is unrealistic because when the demand for increases, there is a shortage of such goods in the domestic market which raises their prices. Similarly, the devaluation, price of imported goods increase. Thus, the rises in the prices of goods nullify the favourable effects of devaluation.

4. Other Countries Devalue : It is assumed that other country does not devalue its currency. But there is every possibility that the other country, whose exports are adversely affected, may react and devalue its currency. As a result, the favourable effects will be neutralised.

5. Counter-Devaluation Measures : If other countries adopt trade restriction measures like rising of tariff duties and other direct controls, devaluation will fail to reduce BOP deficit.

2) Direct Control: The second type of expenditure switching policy is the use of direct controls to restrict imports in order to correct a BOP deficit.Direct controls can be broadly divided into two groups i.e.a) Commercial Controlsb) Financial Controls

a) Commercial Controls : To improve the BOP, commercial controls can be used to increase exports and discourage imports. Exports can be encouraged by reducing or abolishing export duties, providing export subsidy, encouraging production of export items, and export marketing.

The volume of imports may be controlled by imposing or increasing import duties, restricting imports through quotas, licensing and even by prohibiting altogether the import of certain items.

b) Financial Controls : They take the form of exchange control and use of multiple exchange rates. Under the exchange control, a government tries to have complete control over all dealings in foreign exchange. The recipients of foreign exchange like exporters are required to surrender their foreign exchange to a central board/bank in exchange for domestic currency and those who need foreign exchange, like importers, have to buy their foreign exchange from the same board/bank.


module 4 bop adjustment

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