International-Economics-by-Salvatore.pdf

A18.4 Mathematical Summary 611
An increase in the supply of money as a result of easy monetary policy will shift the MS
curve down in panel III and shift the LM curve to the right in panel I until equilibrium in
the money market is reestablished. On the other hand, a depreciation or devaluation of the
nation’s currency will increase domestic prices and the transaction demand for money (i.e.,
MT shifts down in panel II) and shift the LM curve to the left in panel I until equilibrium
in the money market is reestablished.
Problem Starting from point E on the LM curve in panel I, trace (i.e., pencil in) in each
of the four panels of Figure 18.14 the effect of (a) an easy monetary policy that increases
the nation’s money supply by 100, on the assumption that the entire increase in the money
supply will be held for transaction purposes, and (b) a depreciation that shifts the MT
function down by 200 in panel II, on the assumption that monetary authorities keep MS at
800. (c) What happens if instead monetary authorities increase MS by 200 to MS = 1000
in part (b)?
A18.3 Derivation of the BP Curve
The four panels of Figure 18.14 are used to derive the BP curve in panel I. The BP curve
shows the various combinations of interest rates and national income at which the nation’s
balance of payments is in equilibrium.
In panel II, the trade balance (X − M ) from the bottom panel of Figure 17.3 is plotted
as a decreasing function of national income. The 45 ◦ line in panel III shows the external
equilibrium condition that a balance-of-trade deficit be matched by an equal net short-term
capital inflow, or a balance-of-trade surplus be equal to a net short-term capital outflow.
Panel IV shows net short-term capital inflows (SC ) as an increasing function of the interest
rate in the nation (and interest differential in favor of the nation on the assumption of constant
interest rates abroad). For example, at Y E = 1000, X − M = 0 = SC at i = 5.0%.
This defines point E in panel I. Similarly, at Y F = 1500, X − M =−75 and SC =+75 (so
that X − M + SC = 0) at i = 8.0%. This defines point F in panel I. By joining points E and
F, we derive the BP curve in panel I and in Figure 18.2. Note that at Y < Y E , X − M > 0 and
SC < 0 (i.e., there is a net capital outflow from the nation), so that X − M + SC = 0 and we
get another point on the FE curve below point E.
The BP curve is drawn on the assumption that the exchange rate is fixed. A depreciation
or devaluation from a condition of less than full employment in the nation shifts the X − M
function up and improves the nation’s trade balance at each level of income so that a smaller
net short-term capital inflow (or an even greater outflow) is needed at a lower i to keep the
balance of payments in equilibrium (i.e., the BP curve shifts down in panel I).
Problem Starting from point E on the BP curve in panel I, trace (i.e., pencil in) in each
of the four panels of Figure 18.14 the effect of a depreciation or devaluation that shifts the
X − M function up by 50 in panel II.
A18.4 Mathematical Summary
The preceding discussion can be summarized mathematically in terms of the following
three equations, respectively, the equilibrium condition in the goods market, in the money