M.COM. - I ECONOMICS OF GLOBAL TRADE AND FINANCE Semester IIModule I: Balance of Payments Adjustment:Foreign Trade Multiplier and Global Repercussions BOP and Policy Mix: Role of Monetary and Fiscal Policy in BOP Trade-off between Internal and External Balance (Mundell and Flemming Model) (15 Lectures)Module II: Foreign Exchange Market:Flexible Exchange Rate, Currency convertibility, Significance of foreign exchange reserves, Exchange risks, Global linkage of foreign exchange markets, Open and Closed: Interest Parity Conditions - Euro Currency Markets , Euro Equity and Euro Bonds Markets Nature and Characteristics. (15 Lectures)

Module III: International Factor Movements:Movement of labour between countries Trends in Migration, International capital movements Role and impact of foreign capital, Types and factors, Role of MNCs, Changing role of the IMF in the emerging international scenario. (15 Lectures)

MODULE - 1 : BOP ADJUSTMENTS

Topic:1 FOREIGN TRADE MULTIPLIER AND GLOBAL REPERCUSSIONS

Introduction:The foreign trade multiplier also known as export multiplier operates like the investment multiplier of Keynes. The investment multiplier of Keynes explains how a small change in investment generates multiple change in income in the closed economy. Where as, the foreign trade multiplier explains how a rise in net exports result in an increase in income of the exporting coutry in an open economy. In very simple terms we can say that foreign trade multiplier is a concept that states that net exports (exports minus imports) may magnify the impact on nation's income.Statement of the theory:

The foreign trade multiplier may be defined as the amount by which national income of a nation will be raised by a unit increase in domestic investment on exports. As exports increase there is an increase in the income of all persons associated with the exports industries. These in turn create demand for goods. But this is depends on their marginal propensity to save (MPS) and marginal propensity to import (MPM). The smaller these two propensities are, the larger will be the value of multiplier and vice versa.

Assumptions:

The foreign trade multiplier is based on the following assumptions:1. There is full employment in the domestic economy2. There is direct link between the domestic and the foreign country in exporting and importing goods.3. The country is small with no foreign repercussion effects.4. It is on a fixed exchange rate system.5. The multiplier is based on instantious process without time lags.6. There is no accelerator.7. There are no tariff barriers and exchange controls.8. Domestic investment (Id ) remains constant.9. Government expenditure is constant.10 The analysis is applicable to only two countries.

Explanation;The foreign trade multiplier process can be explained like this. Suppose the exports of the country increase. The exporters will sell their products to foreign countries and receive more income. In order to meet the foreign countries demand more factors of production to be hired to produce more. This will raise the income. The income increases by the value of MPS and MPM, there being an inverse relation between the two propensities and the export multiplier.

The foreign trade multiplier can be derived algebraically as follows:The national income identity in an open economy is

Y= C + I + X M

Where Y is national income, C is national consumption, I is total investment, X is exports and M is imports.

The above relationship can be solved as:

Y C = I + X M S = I + X M (:. S = Y C)S + M = I + X

Thus at equilibrium levels of income the sum of savings and imports (S + M) must equal the sum of investment and export (I + X).

In an open economy the investment (I) component is divided into domestic investment (Id) and foreign investment (I). I = S Id + I = S.(1)Foreign investment (I ) is the difference between exports and imports of goods and services. I = X M.(2)Subsisting (2) into (I), we have Id + X M = S or Id + X = S + M

Which is the equilibrium condition of national income in an open economy. The foreign trade multiplier coefficient (K ) is equal to

Diagrammatic ExplanationFigure 1: Equilibrium of the economy Given these assumptions, the equilibrium level in the economy is shown in Figure 1, where S(Y) is the saving function and (S + M) Y is the saving plus important function. Id represents domestic investment and Id + X the exports plus domestic investment. The (S+M) Y and Id + X functions determine the equilibrium level of national income OY at point E, where savings equal domestic investment and exports equal imports.

Figure 2: Increase in income thrugh increase in exports

If there is a shift in the Id + X function due to an increase in exports, the national income will increase from OY to OY1. As shown in figure 2. This increase in income is due to the multiplier effect i.e. Y = K X. The exports will exceed imports by sd, the amount by which savings will exceed domestic investment. The new equilibrium level of income will be OY1. It is a case of positive foreign investment.

Figure 3: Decrease in income through decrease in exports

If there is a fall in exports, the export function will shift downward to Id + X1 as shown in figure 3.

In this case imports would exceed exports and domestic investment would exceed savings by ds. The level of national income is reduced from OY to OY1. This is the reverse operation of the foreign trade multiplier.

Criticisms of Foreign Trade Multiplier

1.Exports and investment not Independent: The analysis of simple foreign trade multiplier is based on the assumption that exports and investment (both domestic and foreign) are independent of changes in the level of national income. But, in reality this is not so.

2. Lagless Analysis: The foreign trade multiplier is assumed to be an instantaneous process whereby it supplies the final results. Thus it involves no lags and is unrealistic.

3. Full Employment not realistic: The analysis is based on the assumption of a fully employed economy. But there is less than full employment in every economy.

4. Not applicable to more than two countries : The whole analysis is applicable to a two-countries, it becomes complicated to analyze and interpret the foreign repercussions of this theory.

5. Neglects trade restriction: The foreign trade multiplier assumes that there are no tariff barriers and exchange controls. In reality, such trade restrictions exists which restrict the operations of the foreign trade multiplier.

6. Neglects Monetary- fiscal measures: This analysis is based on the unrealistic assumption that the government expenditure is constant. But governments always interfere through monetary and fiscal policies which affect exports, imports and national income.

Despite these shortcomings, the foreign trade multiplier is a powerful tool of economic analysis which helps in formulating policy measures.

Applications of Foreign Trade Multiplier to under-developed countries (UDCS).

The foreign trade multiplier has important implications for UDCs. The value of this multiplier helps in implementing various policies. It is particularly important in those economies where the contribution of foreign trade in national income is high.

1. Basis for export promotion policies: The foreign trade multiplier supports export related policies in UDCs. It is through the export multiplier that a country can increase its national income may times. 2. Improvement in balance of payment: UDCs are always faced with the BOP deficit. Under such a situation, the current BOP can be improved by increasing exports.3. Incentive for domestic industries: By providing incentives to domestic industries for exports, the government can increase income by multiplier times through the export multiplier.4. Encouragement to foreign investment: Mostly goods are imported from abroad in UDCs.

Foreign Repercussion or Backwash Effect

The above analysis of the simple foreign trade multiplier has been studied in the case of one small country. But, in reality, countries are linked to each other directly also. A countrys exports or imports affect the national income of the first country. This is known as the foreign Repercussion or Backwash or feedback Effect. The smaller the country is in relation to other trading partner, the negligible is the foreign repercussion. But the foreign repercussion will be high in the case of a large country because a change in the national income of such a country will have significant foreign repercussion or backwash effect.

In large open economies the foreign repercussions are likely to be significant. A countrys imports are the exports of the rest of the world. Similarly, a countrys exports are imports of the rest of the world. Thus, an open economy is economically interdependent with rest of the world.

In a large economy economic events, such as investment booms or recessions, influence the economies of other nations, and such events occurring in the rest of the world exert influence on an open economy.

The foreign repercussions effect is explained by assuming the world consists of two countries. Country 1 is the home country and country 2 is the foreign country. Then the equilibrium condition S+M=I+X can be written as

S1+M1=I1+M2

S2+M2=I2+M1 Where1= Country 1, 2= Country 2, S= Savings, I=investments, M=imports.

Here each of the equations are corresponding to equilibrium conditions with only difference that each countrys exports are now given as other countrys imports. i.e,

X1= M2 and X2 = M1

The foreign repercussions effect can be shown with the help of following chart

Increase in exports in home countryIncrease in demand for imports in foreign country

Increase in income in Home country

Increase in income in foreign countryIncrease in imports in home country

It shows that an increase in income in home country increases its imports. This in turn will increase income in the foreign country leading to an increase in its demand for imports. This in turn increases exports of home country leading to an increase in home countrys income. These effects have further effects on each others exports, imports and income.

An increase in autonomous exports in country 1 (i.e. country 2's imports) will increase income through the multiplier in the country 1. The increase in imports in country 2 will cause country 2's income to fall which will in turn induce a decline in country 2' imports (i.e., country 1's exports). This.will dampen the rise in country 1's income. In country 2 the fall in its income due to increase in its imports from country 1 will be dampened by an increase in its exports to country 1 which is induced by a rise in country l's income. This shows that the income in country 1 is a function of income in country 2 and income in country 2 is a function of income in country 1.

Y Y2(Y1) Y1(Y2) National income in country1 E

x O National income in country 2

In the above figure,Y I (Y 2) shows the national income in country 1 as the function of income in country 2. The curve Y 2(Y 1) shows the income in country 2 as a function of income in country 1. Simultaneous equilibrium occurs at the point E where the two curves intersect. The slope of country 1s income, that is, Y I(Y 2)' depends upon the marginal propensities to save and import in country 1and the marginal propensity to import in country 2. Similarly, the slope of Y2(Y 1) depends upon the marginal propensities to save and import in country 2 and the marginal propensity to import in country1. A change in the marginal propensities will alter the slopes of these curves. But there will be a new equilibrium so long as the two curves continue to intersect.

Implications of Foreign Repercussion

The analysis of foreign trade multiplier and the foreign repercussions has shown that an open economy is economically interdependent with the rest of the world. We cannot ignore this interdependence; especially when the open economy is large. In a large country economic events, such as investment booms and recessions, influence the economies of other nations. Similarly, such events occurring in the rest of the world exert an influence on an open economy.The existence of foreign income repercussions explains how business cycles are propagated internationally. The existence of such foreign income repercussions helps to account for the parallelism in business cycles that has been observed among the major industrial economies. The Great Depression of the 1930s and 2008 is a great example of foreign repercussions on the global economy which contributed to the spread of depression to the entire world. The sharp fall in US economic activity that started in the early 1930s and 2008 had-reduced substantially the demand for imports in the US. The sharp reduction in US imports had a serious deflationary effect on foreign countries. This had reduced their imports from the US causing further fall in national income in US. Foreign repercussions were an important contributor to the spread of Great Depression to the entire world.

Thus, the economic crisis in some large country or economic area can easily spread to other countries and areas through trade linkages and will have significant impact on them.

The following are the implications of foreign repercussion effects.

1. The foreign repercussion effects suggest a mechanism for the transmission of income disturbances between trading countries.

2. The repercussion effect also suggest that since the backwash effects ultimately peter out, automatic income changes cannot eliminate completely the current account BOP deficit or surplus produced by an automatic disturbance.

3. The policy implications of the backwash effects suggest that export promotion policies raise national income in the trading partners at a lower rate than by an increase in domestic investment. The export promotion measures raise national income via the simple foreign trade multiplier, whereas increase in domestic investment policies raise national income many times in multiplier rounds ia the repercussion effect.

4. It shows that the effect of economic boom or recession in one country will be transmitted to its major trading partners.

5. The economic development of the developing countries will also benefit the developed countries .through trade effects. Thus, developed countries should contribute to the economic development of developing countries.

6. Large trade restrictions may not produce the expected benefits in the long run because they destroy the beneficial repercussions effect of foreign trade.

7. The foreign trade multiplier and its foreign' repercussions effect bring out 'the importance of export led growth.

Topic:2

BOP AND POLICY MIX: ROLE OF MONETARY AND FISCAL POLICY IN BOP

Introduction: Government tries to pursue to correct disequilibrium in the balance of payments through policy measures. They are: a) internal balance which refers to full employment with price stability, and (b) the external balance or balance of payments equilibrium. It was Meade who in his The Balance of payments pointed out that to maintain both internal and external balance, a country must control both its aggregate expenditure and the exchange rate. It was, however Johnson who pointed towards the range of policy instruments for bringing about both internal and external balance. He called them expenditure changing and expenditure switching policies. These policies are discussed below.

EXPENDITURE CHANGING MONETARY AND FISCAL POLICIES.Expenditure changing policies are intended to change the aggregate expenditure in the economy through appropriate monetary and fiscal policies in order to affect its BOP disequilibrium. This can be explained with IS-LM-BP technique.

Expenditure Changing Monetary PolicyAn expenditure changing monetary policy affects the economy through changes in money supply and interest rates. A Contractionary monetary policy leads to BOP surplus and an expansionary monetary policy to a BOP deficit.

Assumptions: a) There is fixed exchange rate;b) There is relative capital mobility; and c) There is no change in government expenditure i.e. the IS curve

Expenditure reducing Monetary Policy Suppose there is a BOP deficit in the country. This implies an excess of expenditure over income. To correct it, the monetary policy reduces the money supply which increases interest rates thereby reducing investment and output.

The reduction in investment (expenditure) and output, in turn, reduces income and aggregate demand or imported goods. There is also a reduction in the domestic price level which may lead to switching of expenditure from foreign to domestic goods. Consequently, the countrys imports are reduced and exports are increased. Thus the current account trade deficit is reduced. Simultaneously there is reduced outflow of short-term capital with the BOP deficit.

On the other hand, rise in domestic interests rates increase the inflow of capital, thereby completely eliminating the BOP deficit.

The adjustment process will be just the opposite of the above when the monetary authority adopts an expansionary monetary policy to correct a BOP surplus. Expenditure reducing monetary policy and its effects on BOP situations are illustrated in fig 1.

Given this assumptions we begin with a situation where the economy is in complete equilibrium with OR interest rate and OY income level at point E of the intersection of IS-LM-BP curves. Suppose the domestic money supply is reduced. This will shift the LM curve upward to the left to LM1. The new equilibrium is at E1. Since E1 is above and to the left of the BP curve, there BOP surplus. There is increase in interest rate from OR to OR1 which generates a BOP account surplus with capital inflow. On the other hand, the reduction in income from OY to OY1 will tend to generate current account surplus because of the reduction in imports. Thus a contractionary monetary policy leads to a BOP surplus. However, E1 does not represent a permanent equilibrium. The BOP surplus will increase the domestic money supply and gradually shift the LM1 curve to the right towards the LM curve so that E1 begins to move down along the IS curve to point E when the economy is again in BOP equilibrium.

Expenditure increasing monetary policyOn the other hand, an expansionary monetary policy leads to a BOP deficit, as illustrated in Fig.2 Starting from the complete equilibrium point E in the figure, the monetary authority increase the money supply. This will shift the LM curve downward to the right to LM2. The new equilibrium is set at E2. Since point E2 is below and to the right of the BP curve, there is BOP deficit. There is reduction in interest rate from OR to OR2 which generates a capital account deficit with capital outflow. On the other hand, the increase in income from OY to OY2 will tend to generate a current account deficit with increase in imports.

Thus an expansionary monetary policy leads to BOP deficit. However, E2 does not represent a permanent equilibrium. The BOP deficit will reduce the domestic money supply and gradually shift the LM2 curve to the left towards the LM curve so that E2 begins to move up along the IS curve to point E and the economy is again in BOP equilibrium.

Expenditure Changing Fiscal PolicyBy fiscal policy we mean changing government expenditure or / and taxation. An expansionary fiscal policy tends to increase government expenditure or / and reduce taxes. On the other hand, a contractionary fiscal policy relates to cut in government expenditure or / and increase in taxes.

Expenditure Reducing Fiscal policy The effects of an expenditure reducing fiscal policy in correcting a BOP deficit are illustrated in Figure 3.

Assumptiona) The exchange rate if fixed.b) There is relative capital mobility.c) There is no change in monetary policy so that the LM curve remains unchanged.

Given these assumptions, we start with the equilibrium situation E with OR interest rate and OY income level where IS LM-BP curves intersect in Fig. 3. Suppose the government adopts a contractionary fiscal policy whereby it reduces its expenditure or and increases taxes. This shifts the IS curve downward to the left to IS2. Which cuts the LM curve at point E2.

This point shows fall in interest rate from OR to OR2 which leads to outflow of capital and to capital account deficit. The income level also falls from OY to OY2 which reduces imports, thereby leading to current account deficit.

Thus the overall effect of a contractionary fiscal policy is to have a BOP deficit because point E2 is below and to the right of the BP curve.

However, the effects of a contractionary fiscal policy on BOP will depend upon the elasticity of the BP curve. In the above case, the BP curve is elastic. If the BP curve is less elastic such as the BP1 curve in the figure, a contractionary fiscal policy will lead to a BOP surplus. This is because point E2 is above and to the left of the BP1 curve.

Expenditure Increasing Fiscal policy

Take expenditure increasing fiscal policy when the government increases its expenditure or / and reduces taxes. As a result, the IS curve shifts upwards to the left as the IS1 curve which cuts the LM curve at E1 as shown in Figure 4.

This new equilibrium shows increase in interest rate from OR1 and rise in income from OY to OY1.

The increase in interest rate leads to capital inflow thereby creating short-run BOP surplus on capital account.

On the other hand, the rise in income increases imports thereby leading to BOP deficit on current account. The net overall effect on the BOP will depend upon the elasticity of the BP curve.

If the BP curve is elastic, as shown, in the figure, and the equilibrium point E1 is above and to the left of the curve BP, there will be overall BOP surplus in an expansionary fiscal policy. In case the BP curve is less elastic, shown as the BP1 curve in the figure, the equilibrium point E1 being below and to the right of BP1 curve there will be overall BOP deficit.

The above analysis shows that a contractionary monetary policy is effective in correcting a BOP deficit. But expansionary fiscal policy can either improve or worsen a BOP deficit. Thus its effects on the overall BOP are ambiguous. The increase in interest rate creates short-run BOP capital account surplus and the increase in income policy will bring both the internal and external balance. The same will not b achieved if the latter effect predominates. To solve the BOP deficit problem and to bring both the internal and external balance, policy makers suggest the mixing of both monetary and fiscal policy.

MONETARY-FISCAL MIX INTERNAL AND EXTERNAL BALANCE POLICIES

We study below internal and external balance in terms of monetary-fiscal mix policies under fixed and flexible exchange rate with perfect and relative capital mobility and their effects on balance of payments of a country. These are explained as under.

1.Fixed exchange Rates with Perfect Capital Mobility.When capital is perfectly mobile, a small change in the domestic interest rate brings large flows of capital. The balance of payments is said to be in equilibrium hen the domestic interest rate, there will be large capital outflows in order to seek better rates abroad which will be self-eliminating. On the contrary, if the domestic interest rate is higher rate down to its initial level.

Since the price of foreign exchange is fixed, the monetary authority will finance the outflow of capital by selling foreign exchange. The sales of foreign exchange will decrease the money supply.

Thus monetary policy is totally ineffective under fixed exchange rates and perfect international capital mobility in maintaining internal balance.

A contractionary money supply would also be ineffective. On the other hand, an expansionary fiscal policy has the effect of raising the income level by international capital mobility.

Thus under perfect capital mobility and fixed exchange rates, fiscal policy is effective in maintaining internal balance and monetary policy is impotent. So far as the external balance is concerned, it is maintained itself because of perfect capital mobility.

2.Flexibility Exchange Rates with Perfect Capital MobilityThese conclusions change when there are flexible exchange rates with perfect capital mobility. Take an expansionary monetary policy which has the effect of lowering the interest rate, increasing capital outflow and thereby bringing deficit in the balance of payments. Thus under flexible exchange rate with perfect capital mobility monetary policy is effective in maintaining internal and external balance and fiscal policy is ineffective.

The above analysis under fixed and flexible exchange rates considers monetary and fiscal policy in isolation. However, it is possible for a small country to combine monetary expansion with fiscal expansion in such a manner that it would be effective under fixed and flexible exchange rates. This is because the small country will be unable to change the equilibrium rate of interest or by its own policies when there is perfect capital mobility. As a result, monetary and fiscal policies are expanded simultaneously.

EXPENDITURE SWITCHING POLICIES

Expenditure switching policies refer ti devaluation or revaluation of a countrys currency in order to switch its expenditure from foreign to domestic goods or vice-versa. They aim at correcting BOP disequilibrium. But Johnson distinguishes between two types of expenditure switching policies. The first is devaluation and the second is the use of direct controls to restrict imports and to correct BOP deficit. We shall follow Johnson in explaining expenditure switching policies. Thus expenditure switching policies aim at increasing the demand for domestic goods and to switch expenditure from imported to domestic goods. Expenditure witching policies aim at maintaining external balance.

1.Devaluation:Devaluation is referred to as expenditure switching policy because I switch expenditure from imported to domestic goods and services. Devaluation means reduction in the external value of a currency in terms of other currencies. But there is no change in the internal purchasing power of the country. Thus when a country with BOP deficit devalues its currency, the domestic price of its imports increases and the foreign price of the its imports increases and the foreign price of its exports falls. This makes its exports cheaper and imports dearer. Now the foreigner can buy more goods as the countries exports increase and the country produces more to meet the domestic and foreign demand for goods. On the other hand, with imports becoming dearer than before, they decline. Thus with the rise in exports and fall imports, BOP deficit is corrected.

Assumptions: This analysis is based on the following assumptions:

1. The elasticity of demand for exports and imports is elastic.2. The supply of exports is sufficient to meet the increased demand exports after devaluation. 3. The internal price level remains constant after devaluation.4. The other country does not devalue its currency simultaneously.5. The other country does not adopt such counter-devaluating country.

2.Direct controlThe second type of expenditure switching policy is the use direct controls to restrict imports of goods in order to correct a BOP deficit. Such a policy increases domestic output for export and encourages consumer to purchase domestic substitute goods. This policy encourages consumers to purchase domestic substitutes and domestic producers to produce import substitutes. To induce producers to switch their expenditure to exportable goods, the government may give them production and export subsidies. It may also restrict import of undesirable or unimportant items by levying heavy import duties, fixation of quotas, etc. At the same time, it may allow imports of essential goods duty free or at lower import duties, or fix liberal imports quotas for them.

In these ways, imports are reduced in order to correct an adverse balance of payments. Johnson calls them commercial controls which operate on the goods side of transactions by preventing people from buying certain goods or forcing them to buy others or providing financial incentives like tariff subsidies etc. for certain kinds of sales or purchases.

The government also adopts financial controls to reduce a BOP deficit. They operate through control over the use of money, by restricting the freedom of the use of domestic money either through regulation of certain uses (as in the case of multiple exchange rates) or by making some uses of money more expensive than others. These are stringent exchange control measures .Exchange controls have a dual purpose. They restrict imports and regulate foreign exchange. They may include full control over all foreign exchange receipts and payments by the monetary authority. Foreign currencies are required to be surrendered to exchange control authorities. There may be restrictions on sale and purchase of foreign currencies and securities; on direct investments abroad on short-term speculative capital outflows; on royalties, interest and amortization payments to foreigners on foreign travels, on tourist expenditure abroad, etc. The government may also resort to multiple exchange rates. It may use a lower exchange rate for non-essential items. Thus direct controls, both commercial and financial, by reducing imports and regulating foreign exchange for the needs of the economy help in correcting an adverse BOP.

Topic: 3TRADE OFF BETWEEN INTERNAL AND EXTERNAL BALANCE (MUNDELL AND FLEMMING MODEL)

The theory of economic policy has concentrated on two distinct problems. First, the relation between the number of policy objectives and the number of policy instruments ; and the number of policy instruments; and second, the assignment of policy instrument to the realization of targets.

In order to achieve given objectives with the same number of policy instruments, the second problem of the assignment of instruments to targets arises. The formulation of the assignments problem will eventually lead to equilibrium values of the objectives, despite lack of co-ordination between them. Thus the assignment problem relates to the assignment of instruments to targets. The solution to the assignment problem has been suggested by Robert Mundell by the Principle of Effective Market Classification.

The Mundellian Model

Mundell discuss the case of relationship between two instruments and two targets. The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure.

The two objectives or targets are full employment (internal balance) and balance of payments equilibrium (external balance). The assignment rule is to assign monetary policy to the objective of external balance and fiscal policy to internal balance.

Assumptions The Mundellian model is based on the following assumptions:

1. Monetary policy is related to changes in interest rate.

2. Fiscal policy is related to deficit or surplus budget.

3. Exports are exogenously given.

4. Imports are a positive function of income.

5. International capital movements respond to domestic interest rate changes.

The ModelGiven these assumption, Mundell states that in countries where employment and balance of payments policies are restricted to monetary and fiscal instrument, monetary policy should be reserved for attaining the desired level of he balance of payments and fiscal policy for preserving internal stability under the conditions assumed here. If monetary and fiscal policies are adjusted smoothly and continuously without long lags, the assignment rule can work very well.

In some cases, it leads straight to the target, while in others it may worsen the other problems temporarily. But ultimately it will achieve the target. This is Mundells principle of effective use of monetary and fiscal policy for internal and external stability, according to which it exerts the greatest relative influence. He calls in the Principle of Effective market Classification. In Mundells slightly modified figure12, the horizontal axis measures interest rate (monetary policy) and the vertical axis budget surplus (fiscal policy). IB is the internal balance line and EB the external balance line. The IB line represents full employment. It is negatively sloped because a reduction in budget surplus must be balanced by an increase in interest rate in order to maintain full employment. There is inflation below this line IB (Zone III and IV) and Recession above this line(Zone I and II).

The EB line represents External balance.. It is also negatively sloped because a reduction in the budget surplus must be counteracted by increase in interest rate.There is deficit in the balance of payments below this line (Zone I and IV), and surplus above this line (Zone II and III).

The EB line is steeper than the IB line because an increase in interest rate in order to balance an expansionary fiscal policy (increase in budget deficit or reduction in budget surplus) induces a short-term capital inflow for an external balance. The more responsive capital short-term capital inflow for an external balance. The more responsive capital movements are to interest rate changes, the steeper is the EB line relative to the IB line. This makes monetary policy relatively more effective for maintaining external balance.

Fig. 12 illustrates external and internal balance and the role played by monetary and fiscal policy in maintaining the two at point E with OR interest rate and OS budget surplus. The two policy measures will take the economy to the equilibrium point E in inflation-deficit and recession-surplus (Zone I) and recession-deficit (Zone III). Suppose the economy is at point A in Zone I where there is full employment and balance of payments deficit, the monetary authority acts first by increasing the interest rate by AB in order to reduce the money supply. The reduction in money supply will reduce demand for goods and this will, in turn, decrease imports, and restore equilibrium in the balance of payments at B. But here the economy is having recession and unemployment. To correct these and to have internal balance, budget surplus will have to be reduced by BC. But at C, there is again deficit in the balance of payments which necessitates further increase in interest rate by CD for reducing money supply. At D the internal balance is again disturbed leading to a further reduction in budget surplus. This process of reduction in money supply followed by reduction in budget surplus will ultimately lead the economy to the equilibrium point E where there is simultaneous internal and external balance will lead to equilibrium in Zones II and IV.

On the other hand, if budget surplus is used to remedy the deficit in balance of payments and monetary policy to correct recession and unemployment, there would be neither external balance nor internal balance.

The following policy measures are suggested for specific imbalances :

ZoneProblemMonetary PolicyFiscal Policy

IUnemployment & BOP Deficit Contractionary Expansionary

IIUnemployment & BOP Surplus Expansionary Expansionary

IIIInflation & BOP Surplus ExpansionaryContractionary

IVInflation & BOP Deficit ContractionaryContractionary

In fact Mundell argues for a judicious monetary and fiscal policy mix. Both objectives will be realized monetary policy is paired with the objective of external balance and fiscal policy with the objective of internal balance.

Criticisms of Mundells Model

1.Unrealistic Assumptions: This model assumes that the authorities know about the IB curves, the zone in which the economy is operating, and the extent to which the economy is away from both internal and external balance so that appropriate monetary and fiscal policy can be applied. It also presupposes that they know the quantitative results which are expected from the application of each policy. But it is not possible to accurately estimate the degree of disequilibrium due to lack of data about them.

2.Ignores stagflation: This analysis overlooks the situation of unemployment and inflation. This is unrealistic because this phenomenon, known as stagflation, is found in almost all developed countries.

3.Neglects other factors: This analysis considers only differences in interest rates as the cause of capital movements and neglects other factors such as exchange rate variations.

4. Practical constraints: Monetary and fiscal policies operate under certain practical constraints. Due to political reasons, some governments are unable to follow a restrictive fiscal policy and a monetary policy of high interest rates.

5.Cannot correct current account deficit: The prescribed policy mix may be unable to correct a current account deficit. Since the policy mix affects both the capital flows and imports, it can only ensure that a negative trade balance is offset by a positive capital flow and vice-versa.

6.Not a true adjustment mechanism: The monetary-fiscal mix is not a true adjustment mechanism. It is just a palliative. It does not adjust the balance of payment but simply stabilizes it.

7.Debt-servicing requirements not considered: This analysis does not take into account. The debt servicing requirements that a continuous capital inflow would have on the current account of the balance of payments when the domestic interest rate is raised.

8.Retards capital formation: When the interest rate is raised through monetary policy, it will lead to a decrease in investment at home. This must be accompanied either by an increase in government expenditure or by tax reduction or by a combination of both. Such a monetary-fiscal mix wastes the economys savings by diverting them into debt-financed government expenditure which retards capital formation.

9.Conflicting Policies: There is the possibility of conflicts between the prescribed policy mixes among governments of different countries. According to Johnson, it is difficult and highly complicated process to arrive at the right combination of monetary and fiscal policies in all countries simultaneously.

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