Exchange Rate Economics: Theories and Evidence

The sticky-price monetary model 109
there is equilibrium in the goods market. It has an upward slope because a higher
level of output will,with a marginal propensity to spend of less than unity,lead to an
excess supply of goods which necessitates an exchange rate depreciation (a rise in s)
to maintain goods market equilibrium (the rising exchange rate improves the trade
balance – assuming that the Marshall–Lerner condition holds – diverting demand
towards domestic goods). The LL schedule represents the locus of s and y consistent
with money market equilibrium: for a given rate of interest,equation (5.1),there
will be only one income level at which the money market clears (bearing in mind
that the price level is constant).
In Figure 5.1 B the curve IS represents the locus of interest rates and income
along which there is equilibrium in the goods market. The curve LM is the locus
of i and y consistent with equilibrium in the money market. The slopes of the IS
and LM schedules in i − y space should be obvious to those familiar with the basic
IS–LM analysis.
The FF schedule represents combinations of s and y consistent with equilibrium
in the balance of payments. In quadrant B,the perfectly elastic external balance
schedule reflects the assumption of perfect capital mobility. Thus the balance of
payments can only be in equilibrium when the domestic interest rate, i,equals the
foreign interest rate, i ∗ ; if for some reason i was above i ∗ the net capital inflow
would be potentially infinite and swamp the current account (trade balance). The
FF schedule in s/y space is upward sloping since an increase in income,by causing
the current balance to deteriorate,requires an increase in s (depreciation),to
maintain equilibrium in the balance of payments. The FF curve in s/y space is
drawn for the initial rate of flow of capital imports.
That the XX schedule is drawn steeper than the FF schedule reflects the assumed
stability of the system. Thus if FF were drawn steeper than XX and the economy
was at a disequilibrium point such as X,movements in s and y would push the
system away from the equilibrium,A. Initially,equilibrium pertains at point A.
We shall now consider two types of shock: an increase in the money supply and
an expansionary fiscal policy.
5.1.1 Amonetary expansion in the MF model
An expansionary monetary policy,conducted by an open market purchase of bonds
by the central bank,shifts the money market equilibrium schedule in Figure 5.2
from LM to LM ′ . At the initial levels of income and interest rate the expansionary
monetary policy must imply an excess of domestic liquidity. With the domestic
interest rate effectively fixed at the world level (equation (5.1)) and prices assumed
constant the only way money market equilibrium can be restored is via an increase
in income,from y 1 to y 2 . The latter will occur because the expansionary monetary
policy leads to an incipient decline in the domestic interest rate which,in
turn,leads to a capital outflow and exchange rate depreciation. The rising price of
foreign exchange will,via the Marshall–Lerner condition,result in an improved
trade balance and have an expansionary effect on income as demand is switched
from foreign goods to home goods: income will continue rising,and IS will shift