Page 218 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes It is, however, important to note that whether a contractionary fiscal policy worsens or improves EB
depends on the slope of the EB schedule in relation to the LM curve. Given the slope of the LM
schedule, for example, if EB schedule rotates anticlockwise, it will get closer to the equilibrium point
E , showing improvement in EB, as shown by EB’ schedule. It is however equally important to note
1
that the improvement in EB achieved by contractionary fiscal policy results in a lower level of
equilibrium income and employment and also at a lower rate of interest. Fall in the interest rate may
cause outflow of capital which will have adverse effect on the economy.
Let us now examine the effect of expansionary fiscal policy. An expansionary fiscal policy will shift the
schedule IS upward to IS . Note that the schedules IS , LM and EB all intersect at point E . This implies
3
3
2
3
that E is the point of internal and external balance which determines the income level at OY and
2
3
interest rate at Or . Although imports increase due to increase in income, capital inflow and increase in
3
imports are presumably in balance. Therefore, external sector is in balance with the internal sector.
The effect of expansionary fiscal policy on BOP may appear to be ambiguous. As noted above, the effect
of expansionary fiscal policy depends on the slope of the EB schedule. If EB schedule has a higher slope
as shown by the dashed schedule EB’ and LM schedule is curvilinear, then there will be two equilibrium
points E and E . Then the country will have to make a choice between the expansionary fiscal policy
1
3
and contractionary fiscal policy. An expansionary fiscal policy is however a clear choice as it gives a
higher level of income and employment and solves the problem of BOP deficit.
Monetary-Fiscal Mix and BOP Adjustment
In the preceding sections, we have examined the effects of monetary and fiscal policies assuming the
only one of these policies is adopted at a time. In practice, however, most countries use a monetary-
fiscal mix to correct their adverse BOP. We have noted that a contractionary monetary policy is
helpful in correcting the BOP deficit, whereas an expansionary fiscal policy is preferable for correcting
the BOP deficit. So a country opting for using a monetary-fiscal mix for correcting its BOP deficit
would adopt a combination of contractionary monetary and an expansionary fiscal policy. We will
discuss here how a policy-mix works to correct the BOP deficit and to attain internal and external
balance, assuming fixed exchange rate and relative interest-elasticity of capital mobility.
The working of monetary-fiscal mix is illustrated in Figure 19.3 which is a combination of Figures 19.1
and 19.2. Suppose that the initial internal equilibrium of a country is given at point E, the point of intersection
between schedules IS and LM . Since point E is below and to the right of EB schedule, the country has a
1
3
BOP deficit. Now the problem before the country is how to correct the BOP deficit. To achieve this goal,
the country has three alternative options : (i) to use only monetary policy, (ii) to use only fiscal policy, and
(iii) to use a mix of monetary and fiscal policies. The effects of monetary and fiscal policies have already
been discussed. This part of the analysis will however be repeated here briefly to show the links between
the three options. We will then analyse the combined effect of monetary-fiscal mix.

LM 1 LM 2 LM 3
EB

)
(r r 4 H
Rate r 3 G
Interest r 2 F

r D
1 E
IS 3
IS 2
IS 1
O Y 0 Y 1 Y 2 Y 3
Income (Y)
Figure 19.3: Monetary-Fiscal Policy-Mix for Eliminating BOP Deficit

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