1

What is Balance of Payments Accounting?

o Accounting system for international trade

o Kept by various government agencies

Measures the flow and balance of payments between customers and vendors in various countries e.g.
Imports/Exports, Tourism, Military Aid, Foreign Investment

The balance of payments is not the same as the balance of trade. The balance of trade is only one of two
major components in the balance of payments. The first component is the "current account." The "current
account" is roughly the same as the balance of trade, and includes all short-term imports and exports of
goods and services. The second component is the "capital account", which includes long-term investments
and loans between the United States and foreign economies.

Before 1933 the United States and most of the industrialized world was on the gold standard. Applying
this standard meant that all international currencies were valued in terms of how much gold they
represented. Because of the Great Depression, Great Britain abandoned the gold standard in the early
1930s, but it was not until the Bretton Woods Agreement of 1944 that a new system based on the U.S.
dollar instead of gold was implemented. Under this system a country could always "devalue" its currency
relative to other countries' currencies if its balance-of-payments deficit became dangerously large. This
would wipe out much of the deficit. The United States was the only country that could not devalue its
currency to lower its balance-of-payments deficit. That restriction was applied because the Bretton Woods
system valued all currencies against the U.S. dollar. President Richard Nixon (1913–94) abandoned the
Bretton Woods Agreement in 1973, which enabled the United States to devalue the dollar when necessary.
Since then all world currencies including the dollar may be exchanged freely on the world market at
whatever rate the market will bear. The United States continues to accumulate balance-of payment
deficits, when the value of the dollar is strong compared to other currencies. Foreign goods and services
are inexpensive relative to U.S. goods and services. The U.S. government offsets these deficits by selling
U.S. government bonds to foreign investors attracted to the stable dollar.

Balance: By definition it must balance. When one sends money to another country the money is held as
reserves or invested or used to buy something else in peso. A flow out of one country is always balance by
a flow back into that country or by an increase in the value of another account.

When we pay money to a foreigner it is 99.9% in the form of a check or a wire transfer. The recipient can
then :

Buy something in p balancing current account

o Convert Y at a bank giving the bank a claim in dollars

o The bank can then invest in peso or loan to someone to invest in peso. This results in a
capital account transaction.

In any case the money does not just sit around in peso in another country unused. All current account
transactions are either offset by other current account transactions or are used in a capital transaction.

Balance of Payments Accounts

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An open economy engages in international trade and international borrowing and lending. A country's
spending need not equal its production in every period. By importing more than it exports and borrowing
from abroad to make up the difference, a nation can temporarily spend more than it produces.

The balance of payments is a record of a country's trade in goods, services, and financial assets with the
rest of the world.

Any international transaction involves two opposite flows of equal value:

1. credit - flow for which the country is paid, e.g. exports, sale of assets
2. debit - flow for which the country must pay, e.g. imports, purchase of assets

Each transaction is recorded twice in the balance of payments: once as a credit and once as a debit. This
is called double-entry bookkeeping. As a result, the balance of payments must balance.

These economic transactions under Balance of Payments can be subdivided into three main categories. The two
categories to focus on are:

current account

capital account – which records trade between countries in existing assets.

current account records:

a record of all international transactions for goods and services. The current account combines the
transactions of the trade account and the services account.

Shows all the money flows to and from a country arising from exports and imports or Goods and Services, plus
transfers of income and other net transfers.

If X > M, SURPLUS in Current Account

If X < M, DEFICIT in Current Account

1. Net Exports of goods and services which include:

a) Merchandise Trade Balance is balance on net exports of physical goods e.g. food,
clothes etc.
b) Balance on invisibles which include balance on net exports of services e.g.
insurance.

2. Income balance refers to investment income received less investment income paid.

3. Balance on current transfers refers to remittances coming in the country and going
out of the country.
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The current account balance = exports of goods, services, and investment income
- imports of goods, services, and investment income
+ net unilateral transfers

Services include transportation, tourism, insurance, education, and financial services. Investment income
includes interest payments and dividends people receive from assets owned outside of their own country.
A unilateral transfer occurs when one party gives something but receives nothing in return, e.g. foreign
aid.

Current Account

Net exports Current transfers balance

Income balance

Merchandise Balance on invisibles

Trade Balance

CURRENT ACCOUNT

Trade Balance:
Show the sum of visible export revenue minus the sum of visible Import expenditure.

A negative value is a Trade Deficit. (+ M) Imports are more than Exports

A positive value is a Trade Surplus (+X) Exports are more than Imports

INVISIBLE BALANCE: (Intangible goods)

Net flows in Services: (TOURISM, PROFESSIONAL SERVICES, TRANSPORT, etc.)

Net Flows in Income: (Wages, Returns of Investment, Profits of Firms, Interest payment)

Net transfers: (Subsidies from other Governments to locals, Transfers from donations and remittances
(presents, gifts to families, prizes, etc.), and Government transfers (received and sent)...

CURRENT ACCOUNT BALANCE:

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Is the sum of visible and invisible trade balances. If credit is more than debit, then there is surplus in current
account. If debits are more than credits, there is a deficit in current account.

capital account records:

Records international transactions consisting of short-term and long-term capital movements into and out
of the country.

Short term consists of private and official flows of money in search of higher interest rates and
safety of capital.

Long term consists of private and official flows of money for investment purposes and long term
loans.

Private refers to private companies and official refers to government transactions.

Records international borrow, lending, investment, and other transactions. Shows how capital transfers flow to
and from other countries.

A current account deficit means that there must be a net inflow in capital account.

Balance of Payments = balance on current account + balance on capital account = 0.

The balance on current account will offset the balance on capital account. For example, if there is a
surplus on the current account, that would mean a deficit on the capital account.

Since current account will not exactly offset the capital account by the same amount, the difference known
as balancing item.

A deficit balance on the current account is unfavorable since it indicates exports are less than imports and
more income or remittances are going out of the country than coming in the country. However major
cause of current account deficit is that a country is importing more than exporting.

While deficit maybe a problem, a current account surplus may also indicate problems especially if it
continues.

- One country’s surplus is another country’s deficit therefore countries with deficits may reduce trade to
correct their BOP.
- A current account surplus may cause a country’s currency to appreciate therefore encouraging imports
while reducing exports.
- Therefore income from surplus may be used to finance imports.
- Surplus on the current account may lead to demand pull inflation since economy is generating more
income leading to greater demand for goods and services.

Due to the above reasons, a persistent surplus may not be good for an economy in the long run.
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Terms of trade: is a ratio of export prices to import prices. It measures changes in the domestic country’s
competitiveness with its overseas trading partners. A riser in the ratio is favorable for the country whereas
a decrease in the ratio indicates deterioration in the terms of trade.

A capital inflow occurs when the home country sells an asset to another country, e.g. Rockefeller Center
is sold to a Japanese company.

A capital outflow occurs when the home country buys an asset from abroad, e.g. an American obtains a
Swiss bank account.

The capital account balance = capital inflows - capital outflows

A country has a capital account surplus when its residents sell more assets to foreigners than they buy
from foreigners.

Current Account balance + Capital Account balance = Zero

When a country runs a current account deficit, it means that it received fewer funds from its exports than
the funds paid for imports. To finance this deficit, it must sell its assets to the foreigners. So, a current
account deficit must be accompanied by a capital account surplus. The balance of payments must balance.

Included in the capital account is the official settlements balance. The official settlements balance
records transactions conducted by central banks. It measures the net increase in a country's official
reserve assets, assets that can be used in making international payments. The official settlements balance
is called the balance of payments.

CURRENT ACCOUNT CAPITAL ACCOUNT

EXPORTS: produce INFLOWS = CREDIT. Investment Abroad
IMPORTS: produce OUTFLOWS = DEBIT. Investment from Abroad
Change in Official Reserves
NET VISIBLE TRADE: Services Sold abroad
NET TRANSFERS: Foreign Aid Payments.

CAPITAL ACCOUNT BALANCE:

The sum of all investment and financial flows to and from a country during a time period.

A + Value shows a K account Surplus

A – Value shows a K account Deficit.

NOTE: THAT BALANCE OF PAYMENTS SHOULD BE ALWAYS IN EQUILIBRIUM:

If Capital Account is positive (+), assets of the country decrease.

If Capital Account is negative (-), assets of the country increase.

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Direct Investment: A foreign firm building a plant or buying an existing factory in local economy is FDI
(Foreign Direct Investment). Credit in K account.
E.g.: if a foreigner buys land for raising cattle in local country, the capital account of the local economy
increases, due to the decrease of the asset: land.

Portfolio Investment: Buying stocks, shares, bills or bonds abroad or foreigners buying local bonds, stocks,
shares, bills, bonds, etc…
E.g. if a person buys bonds from a foreign country: The capital account of the local economy decreases, but
the assets increase (due to the bonds now in property of the local citizen.)

Other financial flows: Savings Abroad. (Outflow of foreign currency $). Loans to foreigners mean that K
account is decreasing but there is an asset that is going to be recovered in the future.

Foreign Reserves: are the foreign currency deposits held by Central Banks and monetary authorities. These
are assets of the central banks which are held in different reserve currencies, such as the dollar, euro
and yen, and which are used to back its liabilities. E.g. the local currency issued.

Balancing item (or statistical error)

Parallel Markets
Illegal trade (not reported flow of capital, illegal trade, smuggling, etc.)

Forces Behind Exchange Rates

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Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of
a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is
critical to most every free market economy in the world. For this reason, exchange rates are among the most
watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller
scale as well: they impact the real return of an investor's portfolio. Here we look at some of the major forces behind
exchange rate movements.

Overview

Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading
relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in
foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign
markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate
would increase it.

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship between two countries.
Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The
following are some of the principal determinants of the exchange rate between two countries. Note that these factors
are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much
debate.

1. Differentials in inflation: As a rule of thumb, a country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth
century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in
relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2. Differentials in interest rates: Interest rates, inflation and exchange rates are all highly correlated. By
manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing
interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if
additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates -
that is, lower interest rates tend to decrease exchange rates.

3. Current-account deficits: The current account is the balance of trade between a country and its trading
partners (see Understanding The Current Account In The Balance Of Payments), reflecting all payments between
countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending
more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies
more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the
country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too
expensive to generate sales for domestic interests.

4. Public debt: Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and
debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high,
the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably
causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds,
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increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices.
Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will
be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating
(as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of trade: A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its
terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports.
This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency
(and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the
currency's value will decrease in relation to its trading partners.

6. Political stability and economic performance: Foreign investors inevitably seek out stable countries with strong
economic performance in which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can
cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A
declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover,
the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities.
While exchange rates are determined by numerous complex factors that often leave even the most experienced economists
flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the
rate of return on their investments.
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Exchange Rates

Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In
fact, more than $3 trillion is traded in the currency markets on a daily basis as of 2009. This article is certainly
not a primer for currency trading, but it will help you understand exchange rates and why some fluctuate
while others do not.

Foreign exchange is the money of another country. The exchange rate is the price of one country's currency in terms
of another country's money. For example, say, $1 = 5.6415 French francs.

The foreign exchange is the currency of another country required to carry out international transactions.

Foreign exchange rate is one of factors that affects exports and imports of a country hence current
account is also affected by the exchange rate.

All exchange operations are carried out in the foreign exchange market which functions due to buying and
selling of currencies.

Suppose the exchange rate becomes $1 = 5.7 French francs. Then the value of the dollar has appreciated or gone up.
The price in dollars of French goods has fallen while the price of U.S. goods has increased for the French. So, our
exports will fall and imports will rise.

If the exchange rate, instead, became $1 = 5.4 French francs, the value of the dollar has fallen or depreciated. Now,
American goods are cheaper in terms of the French franc while French products are more expensive for U.S.
consumers. Exports will rise and imports will fall.

The real exchange rate, R, takes price levels into account. It measures the price of foreign goods relative to domestic
goods, measured in the same currency.

Floating exchange rate: also known as flexible exchange rate. The floating exchange rate is determined
by the intersection of market forces (demand and supply of foreign currencies). Therefore the floating rate
fluctuations quite frequently since the demand and supply of currency are constantly changing.

A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be
corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease,
thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will
generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in
the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black
market", which is more reflective of actual supply and demand, may develop. A central bank will often then be forced
to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of
the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid
inflation; however, it is less often that the central bank of a floating regime will interfere.

Depreciation of a currency is an increase in the amount of domestic currency required purchase one unit
of foreign currency.
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Appreciation of a currency is a decrease in the amount of domestic currency required purchase one unit of
foreign currency.

Fixed exchange rate: is a rate between two currencies set in terms of a stable value of the currency.

What Does Fixed Exchange Rate Mean?

A country's exchange rate regime under which the government or central bank ties the official exchange rate to another country's
currency (or the price of gold). The purpose of a fixed exchange rate system is to maintain a country's currency value within a very
narrow band. Also known as pegged exchange rate.

What Does Central Bank Mean?

The entity responsible for overseeing the monetary system for a nation (or group of nations). Central banks have a wide range of
responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full
employment. Central banks also generally issue currency, function as the bank of the government, regulate the credit system,
oversee commercial banks, manage exchange reserves and act as a lender of last resort.

What Does Reserve Currency Mean?

A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations,
or to influence their domestic exchange rate.

Pegged exchange rate: is where one currency is pegged to a stable currency or to a basket of
currencies.

The World Once Pegged

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the
value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This
allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of
World War I, the gold standard was abandoned.

What Does Gold Standard Mean?

A monetary system in which a country's government allows its currency unit to be freely converted into fixed amounts
of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic
difference for an ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914
and also during the interwar years.

At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and
increase global trade, established the basic rules and regulations governing international exchange. As such, an
international monetary system, embodied in the International Monetary Fund (IMF), was established to promote
foreign trade and to maintain the monetary stability of countries and therefore that of the global economy. (For
further reading on the IMF, see What Is The International Monetary Fund?)

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was
pegged to gold at US$35 per ounce. What this meant was that the value of a currency was directly linked with the
value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S.
dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its
currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971,
when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were
eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a
peg has been completely abandoned.
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Why Peg?
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to
peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what
his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can
also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the
currency.

Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run.
This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high
value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the
governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged
rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency
before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In
Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had
to allow the currency to float, and by the end of 1997, the Thai bhat had lost 50% of its as the market's demand and
supply readjusted the value of the local currency. (For more insight, see What Causes A Currency Crisis?)

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions.
The peg is therefore there to help create stability in such an environment. It takes a stronger system as well as a
mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with
some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial
institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value
of the peg periodically and then changes the peg rate accordingly. Usually this causes devaluation, but it is controlled
to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the
government to "save face" by not being forced to devalue in an uncontrollable crisis.

What Does Asian Financial Crisis Mean?

Also called the "Asian Contagion", this was a series of currency devaluations and other events that spread
through many Asian markets beginning in the summer of 1997. The currency markets first failed in Thailand as the
result of the government's decision to no longer peg the local currency to the U.S. dollar. Currency declines spread
rapidly throughout South Asia, in turn causing stock market declines, reduced import revenues and even government
upheaval.

The Asian Financial Crisis was stemmed somewhat by financial intervention from the International Monetary Fund and
the World Bank. However, market declines were also felt in the United States, Europe and Russia as the Asian
economies slumped.

What Does Contagion Mean?

The likelihood of significant economic changes in one country spreading to other countries. This can refer to either
economic booms or economic crises.

An infamous example is the "Asian Contagion" that occurred in 1997 and started in Thailand. The economic crisis in
Thailand spread to bordering southeast Asian countries and then eventually spilled over to Latin America.

Asian Financial Crisis

As a result of the crisis, many nations adopted protectionist measures to ensure the stability of their own currency.
Often this led to heavy buying of U.S. Treasuries, which are used as a global investment by most of the world's
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sovereignties.

The Asian crisis led to some needed financial and government reforms in countries like Thailand, South Korea, Japan
and Indonesia. It also serves as a valuable case study for economists who try to understand the interwoven markets
of today, especially as it relates to currency trading and national accounts management.

What Does Crawling Peg Mean?

A system of exchange rate adjustment in which a currency with a fixed exchange rate is allowed to fluctuate within a
band of rates. The par value of the stated currency is also adjusted frequently due to market factors such as inflation.
This gradual shift of the currency's par value is done as an alternative to a sudden and significant devaluation of the
currency.

Some of the issues under fixed or pegged exchange rate:

The Central Bank may intervene in the foreign exchange market based on the Balance of Payment account records.
The Central bank tries to keep the exchange rate in the foreign exchange market fixed or pegged to maintain
consistency and for the benefit of trade interactions etc, the performance of the balance of payment accounts will
indicate if the country has enough reserves to meet the deficits. If the central bank runs out of reserves of foreign
exchange, it may decide to devalue the currency. Devaluation is the decrease of a country’s currency value against
other currencies in the fixed /pegged exchange market. When a country devalues its currency, its exports become
cheaper and imports become expensive.

Revaluation is when the value of a currency rises in comparison to other currencies in the fixed/pegged exchange
market. The exports become expensive and imports become cheaper for a country.

The BP Line

There are two policy problems under fixed exchange rates:

1. external balance - maintaining the BOP so the exchange rate can remain fixed because a BOP
deficit puts downward pressure on the value of the dollar while a BOP surplus puts upward
pressure
2. internal balance - control AD to maintain full-employment without inflation

With fixed exchange rates, the BOP reflects private trading between the domestic and foreign currency. A
BOP surplus causes a net inflow of money from abroad while a BOP deficit causes a net outflow.

Influences on BOP

1. current account balance = NX(Y, R)

2. financial capital flows = F(r)

The BP line shows combinations of Y and r that allow equilibrium in the foreign exchange market. Point to
the left of the BP line represent a BOP surplus while points to the right of the line represent a BOP deficit.
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In the short run (meaning we are ignoring the FE line), the economy is in equilibrium at the intersection of
the IS and LM curves. Equilibrium can be at any BOP position: surplus, deficit, or balanced.

Fixed Exchange Rates and Economic Policy

monetary policy

An expansionary monetary
policy worsens the balance
of payments. An increase in
the money supply has three
effects:

1. the real interest rate

falls causing an outflow
of capital, so the BOP
worsens
2. real income rises, so
imports go up and the
BOP worsens

3. the price level rises

causing imports to rise
and exports to fall, so
the BOP worsens
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Fiscal policy

Expansionary fiscal policy

worsens the balance of
payments in the long run. A rise
in government spending, for
example, causes

1. Y to rise so imports go up,

worsening the BOP

2. r to rise, leading to an
inflow of money which
improves the BOP, but only
in the short run

Fiscal policy is more effective than monetary policy when exchange rates are fixed.

Perfect Capital Mobility

Perfect capital mobility means that money is free to move between countries in search of the highest interest rate. So,
the interest rate all over the world is fixed at rw.
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monetary policy

An increase in the money supply

pushes the domestic interest rate
below rw. This causes an outflow of
money and the money supply
shrinks. A contractionary monetary
policy has the opposite effect. So,
the LM curve is horizontal at rw and
monetary policy has no effect on
the LM curve. Monetary policy is
ineffective under fixed
exchange rates and perfect
capital mobility.

fiscal policy

A rise in government spending causes

the interest rate to rise. With r above
rw, money flows into the economy
from abroad. The inflow causes the
money supply to rise until r falls back
to rw. Fiscal policy is effective
under fixed exchange rates and
perfect capital mobility.