Chapter 18

Open-Economy Macroeconomics:
Adjustment Policies
Since Keynes published The General Theory in 1936, it has been widely accepted that the
two fundamental propositions of a full employment policy are a) that incomes and
employment depend on the level of spending; and b) that there is no automatic mechanism to
keep spending near its full employment level, without conscious action by economic and
financial authorities. But the balance of payments equally depends on the level of spending.
Must it be only a happy chance if the 'internal balance' and 'external balance' levels of
spending coincide?
T.W. Swan, "Longer Run Problems of the Balance of Payments",
AEA Readings in International Economics, Irwin, 1968.

I. Chapter Outline
18.1 Introduction
18.2 Internal and External Balance with Expenditure-Changing and
Expenditure- Switching Policies
18.3 Equilibrium in the Goods Market, in the Money Market, and in the
Balance of Payments
18.4 Fiscal and Monetary Policies for Internal and External Balance with
Fixed Exchange Rates
18.4a Fiscal and Monetary Policies from External Balance and
Unemployment
18.4b Fiscal and Monetary Policies from External Deficit and Unemployment
18.4c Fiscal and Monetary Policies with Elastic Capital Flows
18.4d Fiscal and Monetary Policies with Perfect Capital Mobility
18.5 The IS-LM-BP Model with Flexible Exchange Rates
18.5a The IS-LM-BP Model with Flexible Exchange Rates and Imperfect
Capital Mobility
18.5b IS-LM-BP Model with Flexible Exchange Rates and Perfect Capital
Mobility
18.6 Policy Mix and Price Changes
18.6a Policy Mix and Internal and External Balance
18.6b Evaluation of the Policy Mix with Price Changes
18.6c Policy Mix in the Real World

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18.7 Direct Controls

18.7a Trade Controls
18.7b Exchange Controls
18.7c Other Direct Controls and International Cooperation

II. Chapter Summary and Review

Internal balance is defined as full employment. External balance is defined as
balance of payments equilibrium, which is defined as equality of autonomous
inflows and outflows. (Autonomous transactions will initially include those due to
exports and imports until capital flows are introduced). As the introductory quote
explains, internal balance and external balance may exist simultaneously and
continuously only by coincidence. In addition, we have seen that some of the
automatic adjustments in response to balance of payments disequilibria may be
costly. Consequently, governments may wish to adopt adjustment policies to
support or offset the automatic adjustments discussed in Chapters 16 and 17.
Government can use a number of policies to influence employment and the
balance of payments. These policies can be classified as expenditure-changing
policies, expenditure-switching policies, and direct controls.
Expenditure-changing polices are those that change the level of economic
activity, generally taken to be the price level and/or the level of real GDP, by
managing aggregate demand. Expenditure-changing policies include fiscal and
monetary policies. Fiscal policy is the use of the spending and taxing functions of
government. An expansionary fiscal policy is one that increases aggregate demand
by lowering taxes or increasing government spending. Similarly, a contractionary
fiscal policy is one that reduces aggregate demand by increasing taxes or
decreasing government spending.
Monetary policy is the management of the quantity of a nations money
supply by the nation's central bank. An expansionary monetary is one that increases
the money supply. An increase in the money supply will lower interest rates, which
increases borrowing for spending. The increased spending increases aggregate
demand and the equilibrium level of output. Contractionary monetary policy raises
the interest through reductions in the money supply. The higher interest rate lowers
spending, which lowers equilibrium income.

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Expenditure-changing policies affect the balance of payments primarily by

changing domestic income. An expansionary expenditure-changing policy increases
domestic income, and by increasing imports, moves the balance of payments
towards a deficit. A contractionary expenditure-changing policy, through the same
channels, moves the balance of payments towards surplus.
An expenditure-switching policy is a change in the exchange rate. Currency
depreciation switches spending by both domestics and foreigners from foreign
goods to domestic goods. By increasing domestic spending, currency depreciation
will also offset some of its own effects on the trade balance because some of the
increased spending goes to imports.
Direct controls include tariffs, quotas, and other trade barriers, as well as
exchange controls, and wage and price controls.
We begin with a very simple model, as demonstrated in the Swan Diagram in
Fig. 18.1. The Swan Diagram demonstrates how expenditure-switching and
expenditure-changing policies can be used to achieve simultaneous internal and
external balance. The Swan Diagram is named after its developer, T.W. Swan, the
author of the quote introducing this chapter of the study guide.

Figure 18.1
R=$/

Region II

Expenditure Switching Policy

EE

Surplus/Inflation

L
K

Region I

Surplus/Unemployment

Region III
Deficit/Inflation

H
Region IV
Deficit/Unemployment

YY

Domestic Expenditure (Absorption)

(Expenditure-Changing Policy

The EE line in Fig. 18.1 represents external balance. To see why it is upward
sloping, start at point F, which is assumed to be a point of external balance, and
imagine an increase in expenditures to point G. An increase in expenditures will
increase income and through the marginal propensity to import, will also increase
imports, producing a balance-of-payments deficit at point G. (We are still assuming

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that the balance of payments is made up of only exports and imports.) In order to
eliminate the deficit and restore external balance, R will have to increase from point
G to point H (a depreciation of the dollar) in order to increase exports and reduce
imports. Thus, for external balance to be maintained, an increase in domestic
expenditures must be matched by a devaluation of the dollar. Note that any point to
the right of EE indicates an external deficit, and any point to the left indicates an
external surplus.
The line YY indicates internal balance, or full employment with no inflation.
For simplicity, it is assumed that inflation only occurs if output is above full
employment. If point J is one point of full employment, then a decrease in R to point
K will, by increasing imports and decreasing exports (switching demand towards
foreign goods), cause unemployment. In order to restore full employment, domestic
expenditures must be increased from point K to point L. Note that any point to the
left of YY indicates unemployment and any point to the right of YY indicates
inflation.
Any point in Fig. 18.1 not on the EE and YY lines can be classified as a point
that produces inflation or unemployment, and surplus or deficit. The four possible
regions in Fig. 18.1 are labeled regions I, II, III and IV. Region I, for example, is
above the EE line and below the YY line so all points in Region I will produce
unemployment and a surplus.
There is only one point, point F, in Fig.18.1 where there is both internal and
external balance. Any other point will require an expenditure-changing and/or an
expenditureswitching policy to achieve simultaneous internal and external balance.
Consider point C. Point C is on the EE line, but below the YY line, so there is
external balance, but unemployment. In order to achieve point F, note that both
types of policies are necessary. If just fiscal policy is used to increase expenditure to
lower unemployment, then the increased income will cause more imports, producing
an external deficit. The expenditureincreasing policy must be accompanied by a
devaluation of the domestic currency (an increase in R) in order to achieve internal
and external balance.
Similarly, point H produces internal balance, but an external deficit. If the
external deficit is addressed with a devaluation, then the resulting increase in
expenditures on domestic goods will produce inflation. The devaluation must be
accompanied by a reduction in domestic expenditures; fiscal and or monetary policy
must be contractionary.

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An interesting case is one like point H'. This case is interesting because
intuition suggests that unemployment be addressed by domestic expansion, but
that's not what the Swan Diagram suggests. At H' there is a deficit and
unemployment. Notice that the size of the devaluation necessary to produce
external balance increases domestic spending by enough to be inflationary.
Domestic expenditures must be lowered in order to achieve internal-external
balance.
The Swan Diagram helps us understand how devaluation and expenditurechanging and switching policies can be used to achieve internal-external balance. If
policy makers, however, are reluctant to change the exchange rate, either because
they have committed to a fixed exchange rate system, or they fear the costs of
changing the exchange rate, then the above analysis suggests that both internal
and external balance may be impossible to achieve.
The Mundell-Fleming model, however, addresses how both internal
balance and external balance can be achieved with just expenditure-switching
policies. The conclusions of the Mundell-Fleming model can be developed using ISLM-BP analysis. It will be assumed that the student is reasonably familiar with IS-LM
analysis, so only the BP line of the analysis will be summarized. See Salvatore,
including the Appendices to Chapter 18, for a review of the IS curve, the LM curve
and the BP curve.
In the Mundell-Fleming model, external balance is determined not only by
imports and exports, but also by capital flows. The BP line shows the combinations
of income (Y) and the interest rate (i) for which there is external balance. Suppose
an economy is in internal balance at point A in Fig. 18.2. If Y increases, moving
horizontally to the right of point A, then there will be an external deficit due to the
increase in imports that will accompany the increase in Y. In order to restore
external balance at this higher level of income, the interest rate will have to increase
in order to attract enough financial capital to make up for the increased imports.
Thus, although there are indeed more outflows associated with the higher imports at
point D than at point A, there are more financial inflows. Points below and to the
right of the BP line entail higher Y, and so higher imports, or a lower interest rate, so
points below the BP line will produce an external deficit. Points above the line will
produce an external surplus.
Although the intent of the Mundell-Fleming model is to determine how
simultaneous internal and external balance can be achieved with fixed exchange
rates, it can incorporate the effects of devaluation (or depreciation). If there is a

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depreciation of the domestic currency, then what was formerly external balance will
now be a surplus. External balance could now be achieved with higher income or
lower interest rates. That is, devaluation (or depreciation) will cause the BP line to
shift down, as shown in Fig. 18.2.

Figure 18.2
i
D

devaluation

external surplus

A
external deficit

Assume simultaneous equilibrium in all three markets, so that i and Y are

currently at the intersection of the IS, LM and BP curves. This is shown at point E in
Fig. 18.3. At point E there is external balance, but there is unemployment because
the equilibrium level of output, YE, is less than the full employment level of output,
YF. Notice that full employment and external balance can be produced if LM shifts to
LM' and IS shifts to IS'. LM will shift to LM' if the money supply is reduced by the
appropriate amount, and IS will shift to IS' if fiscal policy is expansionary by the
appropriate amount. Thus, it is possible to achieve internal-external balance through
the use of just expenditure-changing policies. Given any initial situation, it is
possible to shift the IS and LM curves to produce an intersection with BP at full
employment.
In the above situation, where there was initially unemployment and external
balance, it was necessary for fiscal policy to be expansionary and monetary policy
to be contractionary in order to produce internal-external balance. This assignment
of policies may change depending upon the shape of the BP curve. The BP curve is
upward sloping because an increase in income increases imports, requiring an
increase in interest rates to attract flows of financial capital. If financial capital flows
are highly responsive to interest rateshigh capital mobilitythen only small
increases in interest rates are necessary to attract the requisite amount of financial
capital, so the BP curve will be flatter. In the extreme case of perfect capital mobility,

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infinitesimally small increases in the interest rate are all that is necessary to attract
the requisite amount of financial capital, and the BP curve will be flat. From another
perspective, a flat BP curve means that countries cannot charge an interest rate
different than the rest of the world because it will set off financial flows that will
equate it to the rest of the world. Equality of interest rates throughout the world is
the law of one price applied to interest rates. If interest rates are higher in the United
Kingdom than in the United States, then funds will flow to the United Kingdom,
lowering the interest rate until it equals the U.S. interest rate.

Figure 18.3
i

BP

LM
LM

IS

IS

YE

YF

Now take the same initial situation as in Fig. 18.3, but assume a very flat BP
curve. This is shown in Fig. 18.4. In order to reach full employment and external
balance, the IS, LM, and BP curves have to intersect at point G, which requires both
expansionary fiscal policy (shifting the IS curve to the right) and expansionary
monetary policy (shifting the LM curve to the right.)

Figure 18.4
i
LM

BP
G

IS
YE

Y
YF

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If there is perfect capital mobility, then we get the interesting result that in a
fixed exchange rate system, monetary policy, by itself, becomes completely
ineffective. The case of perfect capital mobility is shown in Fig. 18.5. Equilibrium is
assumed to be initially at point J, at which there is external balance but
unemployment.

Figure 18.5
i
LM
LM
S
J

LM
R
BP
K

IS
IS

YE

YF

If monetary authorities attempt to promote full employment by increasing the

money supply, say through open market operations, then the LM curve will shift to
LM'. The IS and LM curves now intersect at point K, which is below the BP line. The
low interest rate produces financial outflows and downward pressure on the
domestic currency's exchange rate. To maintain a fixed exchange rate, the
monetary authorities must buy their own currency, which reduces the money supply,
shifting the LM curve back to its original position. Monetary policy becomes
completely ineffective because the money supply cannot be controlled. (Recall that
the same conclusion about monetary control with fixed exchange rates was reached
in Chapter 15, although the analysis was the monetary approach to exchange
rates.)
Fiscal policy, however, does become effective in a fixed exchange rate
system. If the IS curve is shifted to IS' (less than what is necessary to reach full
employment), then IS and LM intersect at point S, at an interest rate above the BP
line. The higher interest rate will attract financial flows, putting upward pressure on
the country's exchange rate. In order to maintain a fixed exchange rate, the
monetary authorities must sell their own currency, which increases the money
supply, shifting the LM curve to the right to LM''. This will occur until interest rates
reach the BP line, which occurs at point R.

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With floating exchange rates and perfect capital mobility, the role of fiscal
and monetary policy reverses. In a floating exchange rate system, fiscal policy
becomes ineffective and monetary policy becomes effective. If we start, as above,
with external balance and unemployment, then expansionary fiscal policy will shift
the IS curve to the right so that the IS and LM curves intersect above the flat BP
line. (Draw this.) The equilibrium interest rate is now above the flat BP line, causing
financial inflows, which will cause an appreciation of the exchange rate. An
appreciated exchange rate will cause exports to decrease and imports to increase,
which are reductions in spending on domestic goods. This decreased spending
shifts the IS curve back until the interest rate reaches the flat BP line, which is at the
original equilibrium. Essentially, increased government spending (or lower taxes)
causes decreased exports and increased imports by the same total amount, leaving
total spending unchanged.
Monetary policy, though, is effective with floating exchange rates. An
increase in the money supply shifts the LM curve to the right, producing an
intersection with the IS curve at an interest rate below the flat BP line. The low
interest rate produces capital outflows and a depreciation of the domestic currency.
The currency depreciation increases exports and decreases imports, shifting the IS
curve to the right until it intersects the LM curve on the flat BP line, which is at a
higher level of output. An increased money supply works not by the usual
mechanism of lowering interest rates, but by changing the currency value, which
stimulates exports and discourages imports.
There is an interesting analysis that suggests that monetary policy should be
directed towards external balance problems and that fiscal policy should be directed
towards internal balance problems. This is Mundell's principle of effective market
classification, in which a policy should be directed at that target on which it has the
most effect. The key to understanding why monetary policy should be used for
external balance problems is recognizing that monetary policy will have a greater
effect on the external balance than will fiscal policy.
The Salvatore text presents Mundells principle of effective market
classification graphically; it will be summarized here intuitively. If fiscal policy is
expansionary, then it will increase domestic income and imports, causing an
external deficit. If, on the other hand, monetary policy is expansionary, increasing
domestic income by the same amount as in the expansionary fiscal case, then
imports will also increase. But expansionary monetary policy works by reducing
interest rates, so in addition to increasing imports, there will be capital outflows.

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Thus, expansionary monetary policy will cause a greater external deficit than an
equivalent fiscal policy, as measured by the effect on income. Similarly,
contractionary monetary policy will cause a greater external surplus than will fiscal
policy. If policy is directed towards that goal (internal balance versus external
balance) on which it has the larger effect, then monetary policy should be used for
external balance problems, leaving fiscal policy to be used for internal balance
problems.
There are a number of problems with this analysis, including the assumption
that fiscal policy has little effect on interest rates (or that monetary policy is always
used to offset the effect of fiscal policy on interest rates), as well as the fact that
nations often have more than two objectives. Additional objectives include price
stability and adequate long-run growth, so fiscal and monetary policy would have to
be supplemented by other policies such as exchange rate changes and direct
controls, the latter being summarized in the Salvatore text.

III. Questions
1. a) Suppose that a nation has an external surplus and inflation. Is it necessarily
the case that expenditures should be reduced, along with the appropriate
expenditure-switching policy, in order to reach internal and external balance? Along
with your explanation, demonstrate your answer with the Swan Diagram. (Assume
throughout this question that the Marshall-Lerner condition is met.)
b) Suppose a nation has a deficit and inflation. Is it necessarily the case that
expenditures should be reduced, along with the appropriate expenditure-switching
policy, in order to reach internal and external balance? Along with your explanation,
demonstrate your answer with the Swan Diagram.
c) Is it possible to for a nation to eliminate a deficit and inflation with just an
expenditure-switching policy? Along with your explanation, demonstrate your
answer with the Swan Diagram.

2. Suppose that the Marshall-Lerner condition is not met, i.e., a deprecation (or
devaluation) of a currency actually causes a larger deficit. Draw the EE and YY
schedules of the Swan Diagram.

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3. Assuming perfect capital mobility and fixed exchange rates, use IS-LM-BP
analysis to determine the effect of the following changes on a nation's
i) interest rate
ii) domestic income
iii) trade balance (the trade balance is only part of external balance when
there are capital flows)
a) An increase in foreign incomes, leading to greater imports by foreigners
b) An increase in a nation's budget deficit
c) The central bank conducts open market purchases designed to increase the
money supply

4. Assuming perfect capital mobility and a floating exchange rate, use IS-LM-BP
analysis to determine the effect of each of the following (a-c) on a nation's
i) Interest rate
ii) Domestic income
iii) Trade balance
iv) Exchange rate
a) An increase in foreign incomes, leading to greater imports by foreigners
b) An increase in a nation's budget deficit
c) The central bank conducts open market purchases designed to increase the
money supply

5. Suppose events lead international investors to become concerned about the

safety of their investments in a small nation. A small nation will tend to have a flat
BP line because they can have little influence on world interest rates. If international
investors perceive greater risk, they will require higher interest rates. This has the
effect of shifting the BP line up. Assume the small nation pursues a fixed exchange
rate and was originally at full employment.
a) Will this fear by international investors cause domestic incomes to fall or
increase? Use IS-LM-BP analysis.

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b) What policy should the small nation pursue to restore full employment?

6. a) What important component of the balance of payments is assumed away by

the Swan Diagram, but is an important part of the IS-LM-BP analysis?
b) Why could the Swan Diagram be considered appropriate for very long-run
analysis?

7. Using IS-LM-BP analysis, determine the direction (expansionary or

contractionary) of fiscal policy and monetary policy necessary to correct the
following situations. Assume that capital is not perfectly mobile, but the BP line is
flatter than the LM curve. Assume that exchange rates are fixed.
a) Full employment and external surplus
b) Full employment and external deficit
c) Inflation (production above full employment) and external deficit
b) Unemployment and external deficit

8. According to the principle of effective market classification, determine the

direction of fiscal policy and monetary policy necessary to correct the following
situations:
a) External deficit and inflation
b) External deficit and unemployment
c) External surplus and inflation
d) External surplus and unemployment

9. a) Using the IB-EB lines developed in the Salvatore text (but not in the above
Summary and Review), explain why the IB line is steeper than the EB line. Here's a
way to proceed: Begin at the intersection of IB and EB and then increase

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government spending. Now, will interest rates have to be increased more or less to
reach internal balance versus external balance? Whichever balance requires the
greater increase in interest rates has the steeper line.
b) What do the IB-EB lines look like if international flows of capital are not
responsive to interest rate changes?
c) Assume external surplus and inflation. Using the IB-EB model, show and explain
what would happen if policy makers begin by decreasing the money supply,
followed by increasing government spending.

10. Explain how IS-LM-BP analysis differs from that used in effective market
classification? (Hint: Consider how fiscal policy is treated in the two models.)

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