Page 216 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes simultaneously in equilibrium. Note also that the initial internal equilibrium point E is on the right
1
side and below the external balance schedule EB. It means that the country is faced with a BOP deficit
at income level OY and interest rate Or .
1 2

i LM LM 1 EB LM 2
0

)
(r
Rate r 3 2 E 3 E 1
Interest r r 1 E 2

IS

O Y Y Y Income (Y)
0 1 2

Figure 19.1: BOP Adjustment through Monetary Policy
Now the question arises : What kind of monetary policy would be helpful in solving the problems of
BOP deficit and surplus and in achieving internal and external balance ? To answer this question, let
us suppose that a country is facing BOP deficit. In that case, the answer is that a contractionary
monetary policy would reduce the BOP deficit. Let us now examine what happens when the
government adopts a contractionary monetary policy, that is, a policy of reducing money supply. When
a contractionary monetary policy is adopted, it decreases money supply. The decrease in money
supply reduces the BOP deficit in two ways.
On the one hand, a decrease in money supply shifts the LM schedule leftward towards LM and the
0
1
internal equilibrium point upward to the left. This takes the internal equilibrium point closure to the
EB schedule. It means reduction in the BOP deficits. The reason is, a decrease in money supply
increases the rate of interest. Increase in the interest rate reduces domestic investment. A fall in
investment reduces the level of income and hence the level of imports. Reduction in imports reduces
the trade deficit and therefore the BOP deficit.
On the other hand, increase in the interest rate results in short-term capital inflow which too reduces
the BOP deficit. As shown in Figure 19.1, a decrease in money supply shifts the LM schedule from LM 1
to LM . This shift increases the interest rate to Or . The rise in the domestic rate of interest works as an
0
3
incentive for foreign investment. This causes inflow of foreign capital. The inflow of foreign capital
reduces the capital account defficits. As a result, the BOP deficit decreases and it may disappear finally.
Let us now see what kind of monetary policy is adopted by a country to correct its BOP disequilibrium
of surplus nature. In that case, the country adopts an expansionary monetary policy. When the
government adopts a policy of monetary expansion, the schedule LM will shift rightward to LM , all
2
1
other things remaining the same, and the internal equilibrium shifts to point E . Point E is below and
2
2
to the right of the EB schedule. It means that monetary expansion would increase the BOP deficit and
reduce BOP surplus. The reason is that monetary expansion reduces the rate of interest. This has a
two-way effects on the economy. On the one hand, it increases the domestic investment which increases
the level of income and increase in income increases imports, widening the gap between exports and
imports. That is, monetary expansion enhances the trade deficit and reduces trade surplus. On the
other hand, a lower interest rate leads to capital outflow which decreases capital account surplus.
Thus, the combined effect of the monetary expansion is deterioration in the BOP surplus.
The conclusions that emerge from the analysis of effects of the monetary policy is that a contractionary
monetary policy reduces the BOP deficits and helps in achieving internal and external balance, and
an expansionary monetary policy reduces country’s BOP surplus.

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