David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 25 Open economy macroeconomics
Capital controls are
regulations preventing private
sector capital flows be1ween
different currencies.
Most economies had capital controls during the period of fixed exchange rates
from 1945 to 1973. Subsequent integration of global financial markets made these
controls less effective and now they have been scrapped.
With a fixed exchange rate but no private capital flows, suppose the economy has
a balance of payments deficit (because it has a current account deficit). To finance
the deficit, the forex reserves must fall. The central bank sells foreign exchange and buys domestic currency,
demanding the domestic currency that nobody else wants. In consequence, domestic money in circulation
falls as pounds disappear back into the Bank of England. The balance of payments deficit reduces the
domestic money supply. A balance of payments surplus would increase the money supply.
Under fixed exchange rates, the money supply is not determined exclusively by the original decision about
how much domestic money to create. It also depends on the balance of payments surplus or deficit. When
there is a payments surplus (deficit), cash flows into (out of) the country, directly changing narrow money,
which in turn affects bank deposits and broad money.
Unsterilized intervention
uses the forex reserves to offset
balance of payments surpluses
or deficits. Since foreign
reserves are exchanged for
domestic cash, this alters the
cash in circulation and the
domestic money supply.
Sterilization is an open
market operation be1ween
domestic money and domestic
bonds, to offset the change in
domestic money supply that
a balance of payments surplus
or deficit otherwise induces.
IS
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II)
G.I
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G.I
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c
Output
I
· ·
I
I
I
I
I
I
Figure 25.1 A balance of payments deficit
reduces the money supply and raises interest rates
Allowing the balance of payments to change the money supply is called unsterilized
intervention in the forex market. For a given money demand schedule, allowing
changes in the money supply means then having to change interest rates to make
this an equilibrium.
Figure 25.1 illustrates using the IS-LM model. Initially, the economy faces the IS
curve shown, and its monetary policy is reflected in LM. Short-run equilibrium is
therefore at point A. However, the economy has a current account deficit and
balance of payments deficit. If it allows this to deplete its domestic money supply,
the LM curve will shift to LM', causing a rise in interest rates and a domestic
recession. The economy moves to point B. The recession reduces import demand
and eliminates the current account deficit.
Alternatively, the central bank may create additional domestic money to prevent
the balance of payments deficit reducing the money supply. The LM curve remains
in its original position and the economy remains at
point A.
Although the total money supply is not changing,
something important is happening to the balance
sheet of the central bank. On the liability side, money
supplied is constant. On the asset side, the central
bank holds foreign exchange reserves and government
bonds.
M=R+B
To keep M constant while R is falling, the central
bank is effectively selling foreign exchange and buying
domestic government bonds. It can keep doing so
until R becomes zero, at which point it runs out of
foreign exchange reserves and can no longer keep
financing the balance of payments deficit. If the exchange
rate is not to be devalued, thereafter it requires a
domestic recession to get imports down. This can
be achieved either by allowing the shift in the LM
schedule shown in Figure 25. l or by fiscal action,
for example higher taxes, that shifts the IS schedule
to the left. Higher taxes reduce disposable incomes,
reduce aggregate demand, and thereby reduce imports.
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