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Equilibrium in the Goods Market, in the Money Market, and in the Balance of Payments

We now introduce the Mundell–Fleming model to show how a nation can use fiscal and monetary policies to achieve both internal and external balance without any change in the exchange rate. The new tools of analysis take the form of three curves: the IS curve, showing all points at which the goods market is in equilibrium; the LM curve, showing equilibrium in the money market; and the BP curve, showing equilibrium in the balance of payments. Short-term capital is now assumed to be responsive to international interest rate differentials. Indeed, it is this response that allows us to separate fiscal from monetary policies and direct fiscal policy to achieve internal balance and monetary policy to achieve external balance.

The IS, LM, and BP curves are shown in Figure .

The IS curve shows the various combinations of interest rates (i) and national income (Y) that result in equilibrium in the goods market. The goods market is in equilibrium whenever the quantity of goods and services demanded equals the quantity supplied, or when injections into the system equal leakages, as shown by Equation (18-2). The level of investment (I) is now taken to be inversely related to the rate of interest (i). That is, the lower the rate of interest (to borrow funds for investment purposes), the higher is the level of investment (and national income, through the multiplier process).

 Saving (S) and imports (M) are a positive function of, or increase in, the level of income of the nation (Y), while the nation’s exports (X), government expenditures (G), and taxes (T) are taken to be exogenous, or independent, of Y. With this in mind, let’s see why the IS curve is negatively sloped.

The interest rate of i = 5.0% and national income of YE = 1000 define one equilibrium point in the goods market (point E on the IS curve). The IS curve is negatively inclined because at lower interest rates, the level of investment is higher so that the level of national income will also have to be higher to induce a higher level of saving and imports to once again be equal to the higher level of investment. At that point, the nation’s goods market is once again in equilibrium. Exports, government expenditures, and taxes are not affected by the increase in the level of national income because they are exogenous. Thus, equilibrium in the nation’s goods market is reestablished when I = S + M. For example, at i = 2.5%, the level of investment will be higher than at i = 5.0%, and the level of national income will have to be YF = 1500 (the full-employment level of income) to maintain equilibrium in the goods market (point U on the IS curve). At Y < 1500 (with i = 2.5%), there is unemployment, and at Y > 1500 there is inflation.

The LM curve shows the various combinations of interest rates (i) and national income (Y) at which the demand for money is equal to the given and fixed supply of money, so that the money market is in equilibrium. Money is demanded for transactions and speculative purposes. The transaction demand for money consists of the active working balances held for the purpose of making business payments as they become due. The transaction demand for money is positively related to the level of national income. That is, as the level of national income rises, the quantity demanded of active money balances increases (usually in the same proportion) because the volume of transactions is greater. The speculative demand for money arises from the desire to hold money balances instead of interest-bearing securities. The reason for the preference for money balances is to avoid the risk of falling security prices. Furthermore, money balances will allow the holder to take advantage of possible future (financial)investment opportunities. However, the higher the rate of interest, the smaller is the quantity of money demanded for speculative or liquidity purposes because the cost (interest foregone) of holding inactive money balances is greater.

At i = 5.0% and YE = 1000, the quantity of money demanded for transaction purposes plus the quantity demanded for speculative purposes equals the given supply of money so that the money market is in equilibrium (point E on the LM curve). The LM curve is positively inclined because the higher the rate of interest (i), the smaller the quantity of money demanded for speculative purposes. The remaining larger supply of money available for transaction purposes will be held only at higher levels of national income. For example, at r = 7.0%, the level of national income will have to be YF = 1500 (point Z on the LM curve) for the money market to remain in equilibrium. At Y < 1500 (and r = 7.0%), the demand for money falls short of the supply of money, while at Y > 1500, there is an excess demand for money. To be noted is that the LM curve is derived on the assumption that the monetary authorities keep the nation’s money supply fixed.

The BP curve shows the various combinations of interest rates (i) and national income (Y) at which the nation’s balance of payments is in equilibrium at a given exchange rate. The balance of payments is in equilibrium when a trade deficit is matched by an equal net capital inflow, a trade surplus is matched by an equal net capital outflow, or a zero trade balance is associated with a zero net international capital flow. One point of external balance is given by point E on the BP curve at i = 5.0% and YE = 1000. The BP curve is positively inclined because higher rates of interest lead to greater capital inflows (or smaller outflows) and must be balanced with higher levels of national income and imports for the balance of payments to remain in equilibrium.

For example, at i = 8.0%, the level of national income will have to be YF = 1500 for the nation’s balance of payments to remain in equilibrium (point F on the BP curve). To the left of the FE curve, the nation has a balance-of-payments surplus and to the right a balance-of-payments defificit. The more responsive international short-term capital flflows are to changes in interest rates, the flflatter is the BP curve. The BP curve is drawn on the assumption of a constant exchange rate. A devaluation or depreciation of the nation’s currency shifts the BP curve down since the nation’s trade balance improves, and so a lower interest rate and smaller capital inflows (or greater capital outflows) are required to keep the balance of payments in equilibrium. On the other hand, a revaluation or appreciation of the nation’s currency shifts the BP curve upward. Since we are here assuming that the exchange rate is fixed, the BP curve does not shift.

In Figure , the only point at which the nation is simultaneously in equilibrium in the goods market, in the money market, and in the balance of payments is at point E, where the IS , LM , and BP curves cross. Note that this equilibrium point is associated with an income level of YE = 1000, which is below the full-employment level of national income of YF = 1500. Also to be noted is that the BP curve need not cross at the IS−LM intersection. In that case, the goods and money markets, but not the balance of payments, would be in equilibrium. However, a point such as E, where the nation is simultaneously in equilibrium in all three markets, is a convenient starting point to examine how the nation, by the appropriate combination of fiscal and monetary policies, can reach the full-employment level of national income (and remain in external balance) while keeping the exchange rate fixed.

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