Effectiveness of Monetary and Fiscal policy in an Open

Economy under Flexible Exchange rate

Tehseen Iqbal

tehseen.iqbal@aerc.edu.pk
tiqbal@iba.edu.pk

March 10, 2025

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 1 / 21

 Model

Money and Goods Market in Open Economy

In case of flexible exchange rate regime, IS equation can be written as

Ir + G + X (e) = S(y ) + Z (y , e) (1)

I0 + Ir .r + G + X0 + Xe .e = S0 + Sy .y + Z0 + Zy .y + Ze .e (2)

(Sy + Zy )y − Ir .r + (Ze − Xe )e = I0 + X0 − S0 − Z0 + G (3)

LM equation
Ms = L0 + Ly .y + Lr .r (4)

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 2 / 21

 Model

The External Sector in Open Economy

FB is given as function

X (e) − Z (y , e) + K (r ) = 0 (5)

X0 + Xe .e − Z0 − Zy .y − Ze .e + K0 + Kr .r = 0 (6)

Zy .y − Kr .r + (Ze − Xe )e = X0 − Z0 + K0 (7)

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 3 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

Total differentiation of IS, LM and FB equations yields

(Sy + Zy )dy − Ir dr + (Ze − Xe )de = dG (8)

Ly dy + Lr dr = dMs (9)

Zy dy − Kr dr + (Ze − Xe )de = 0 (10)

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 4 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

    
Sy + Zy −Ir Ze − Xe dy dG
 Ly Lr 0   dr  = dMs 
Zy −Kr Ze − Xe de 0
| {z } | {z } | {z }
A X B

Solving for |A|.

−Ir Ze − X e S + Zy Ze − Xe
−Ly + Lr y +0
−Kr Ze − X e Zy Ze − Xe
n o n o
|A| = − Ly − Ir (Ze − Xe ) + Kr (Ze − Xe ) + Lr (Sy + Zy )(Ze − Xe ) − Zy (Ze − Xe )
n o
=(Ze − Xe ) Ly Ir − Ly Kr + Lr (Sy + Zy ) − Lr Zy
n o
=(Ze − Xe ) Ly Ir − Ly Kr + Lr Sy + Lr Zy − Lr Zy

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 5 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

    
Sy + Zy −Ir Ze − Xe dy dG
 Ly Lr 0   dr  = dMs 
Zy −Kr Ze − Xe de 0
| {z } | {z } | {z }
A X B

Solving for |A|.

−Ir Ze − X e S + Zy Ze − Xe
−Ly + Lr y +0
−Kr Ze − X e Zy Ze − Xe
n o n o
|A| = − Ly − Ir (Ze − Xe ) + Kr (Ze − Xe ) + Lr (Sy + Zy )(Ze − Xe ) − Zy (Ze − Xe )
n o
=(Ze − Xe ) Ly Ir − Ly Kr + Lr (Sy + Zy ) − Lr Zy
n o
=(Ze − Xe ) Ly Ir − Ly Kr + Lr Sy + Lr Zy − Lr Zy

The determinant of the matrix is obtained as

|A| = D = (Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly ) > 0
Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 5 / 21
 Model

IS,LM and FB model under Flexible Exchange rate

Fiscal and monetary policy multipliers are calculated by using

Cramer’s rule as following

 
dG −Ir Ze − Xe
dMs Lr 0 
0 −Kr Ze − Xe

Lr 0 dMs 0 dMs Lr
dG + Ir + (Ze − Xe )
−Kr Ze − Xe 0 Ze − Xe 0 −Kr

dG [Lr (Zr − Xe )] + Ir dMs (Ze − Xe ) − (Ze − Xe )Kr dMs

dy = (11)
D

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 6 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

If dMs = 0, Fiscal policy multiplier is given as:

dy Lr (Ze − Xe )
= >0 (12)
dG (Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly )

By assuming dG = 0, Monetary policy multiplier is given as:

dy (Ir − Kr )(Ze − Xe )
= >0 (13)
dMs (Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly )

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 7 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

The Impact of change in monetary and fiscal policy on equilibrium

interest rate are obtained from |A 2|
|A| .
 
Sy + Zy dG Ze − Xe
 Ly dMs 0 
Zy 0 Ze − Xe

dMs 0 L 0 L dMs
(Sy + Zy ) − dG y + (Ze − Xe ) y
0 Ze − Xe Zy Ze − Xe Zy 0

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 8 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

(Sy + Zy )(Ze − Xe )dMs − (Ze − Xe )Zy dMs − (Ze − Xe )Ly dG

dr =
D
(14)

Impact of change in fiscal policy on interest rate1 :

dr −Ly
= >0 (15)
dG (Lr .Sy − Ly .Kr + Ir .Ly )

Impact of change in monetary policy on interest rate2 :

dr Sy
= <0 (16)
dMs (Lr .Sy − Ly .Kr + Ir .Ly )
1
By assuming dMs = 0
2
By assuming dG = 0
Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 9 / 21
 Model

IS,LM and FB model under Flexible Exchange rate

The Impacts of change in monetary and fiscal policy on exchange rate

are obtained from |A 3|
|A| .
 
Sy + Zy −Ir dG
 Ly Lr dMs 
Zy −Kr 0

Lr dMs L dMs L Lr
(Sy + Zy ) + Ir y + dG y
−Kr 0 Zy 0 Zy −Kr

Kr (Sy + Zy )dMs − Ir Zy dMs + (−Ly .Kr − Lr .Zy )dG

de = (17)
(Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly )

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 10 / 21

 Model

IS,LM and FB model under Flexible Exchange rate

The impact of change in government spending on exchange rate3

de (−Ly .Kr − Lr .Zy )

= ≶0 (18)
dG (Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly )

The impact of change in money supply on exchange rate4 :

de Kr (Sy + Zy ) − Ir Zy
= >0 (19)
dMs (Ze − Xe )(Lr .Sy − Ly .Kr + Ir .Ly )

3
By assuming dG = 0
4
By assuming dMs = 0
Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 11 / 21
 Graphical Analysis of Macroeconomic policies

Investment-Saving Curve

Figure 1: IS Curve

A decline in the value of a nation’s currency from S1 to S2 makes imports more expensive for a nation’s residents and, at the
same time, the nation’s export goods become less expensive for foreign residents. Together, these effects cause an increase in
the nation’s aggregate autonomous expenditures at any given nominal interest rate, the real income level consistent with an
income–expenditure equilibrium increases from y1 at point A to y2 at point B. Consequently, the IS schedule shifts rightward

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 12 / 21

 Graphical Analysis of Macroeconomic policies

Balance of Payment Curve

Figure 2: BOP Curve

At a given real income–interest rate combination, such as at point A, an increase in the exchange rate from S1 to S2 results in
an improvement in the trade balance. Consequently, a balance-of-payments surplus occurs at point A. Reattainment of
balance-of-payments equilibrium requires an increase in the nation’s real income to a level such as y2, which generates a
sufficient increase in import expenditures to return the trade balance to its previous level. Hence, point B lies on the scheduled
denoted BP(S2), which implies that a currency depreciation causes the BP schedule to shift to the right.

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 13 / 21

 Graphical Analysis of Macroeconomic policies

Monetary Policy under Flexible Exchange rate

Figure 3: Monetary Policy

An increase in the money stock causes the LM schedule to shift rightward. Because point B lies below and to the right of the
BP(S1) schedule, there is a balance-of payments deficit at point B in both panels. The rise in import spending and acquisition
of foreign financial assets by the nation’s residents and the reduction in export spending and acquisition of domestic financial
assets by foreign citizens causes the home currency to depreciate, so the exchange rate rises from S1 to S2. As a result, the IS
and BP schedules shift rightward. At the final equilibrium point C, balance-of-payments equilibrium is reattained in both panels.

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 14 / 21

 Graphical Analysis of Macroeconomic policies

Monetary Policy under Flexible Exchange rate

Figure 4: Monetary Policy and Perfect Capital Mobility

If there is perfect capital mobility under a floating exchange rate, an increase in the amount of money in circulation causes a
rightward shift of the LM schedule along the IS schedule, from point A to point B, which induces a decline in the nominal
interest rate that leads, in turn, to capital outflows. The resulting balance-of-payments deficit causes the nation’s currency to
depreciate. This results in higher export spending and lower expenditures, so the IS schedule shifts rightward to a final
equilibrium at point C

.
Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 15 / 21
 Graphical Analysis of Macroeconomic policies

Fiscal Policy under Flexible Exchange rate

Figure 5: Fiscal Policy

In both panels, an increase in government expenditures causes an initial rightward shift in the IS schedule, which leads to an
increase in the equilibrium nominal interest rate and an increase in equilibrium real income. In panel (a), in which the relatively
steep slope of the BP schedule implies low capital mobility, greater import spending more than offsets a small capital inflow in
causing a balance-of-payments deficit to arise at point B. This induces a currency depreciation that shifts both the IS and BP
schedules to the right, leading to a final equilibrium with a balance-of-payments equilibrium at point C. In panel (b), in which
the relatively shallow slope of the BP schedule implies high capital mobility, significant capital inflows more than offset greater
import expenditures in causing a balance-of-payments surplus to occur at point B. This induces a currency appreciation that
shifts both the IS and BP schedules leftward, leading to a final balance-of-payments equilibrium at point C
Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 16 / 21
 Graphical Analysis of Macroeconomic policies

Fiscal Policy under Flexible Exchange rate

Figure 6: Fiscal Policy and Perfect Capital Mobility

If there is perfect capital mobility under a floating exchange rate, an increase in government expenditures shifts the IS schedule
rightward along the LM schedule, from point A to point B. The resulting rise in the nominal interest rate induces capital inflows
that lead to a balance-of-payments surplus that causes a currency appreciation. Consequently, export spending declines and
export expenditures increase, causing the IS schedule to return to its original position at point A.

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 17 / 21

 Fiscal and Monetary Policy Multipliers

Fiscal Policy Multiplier with Perfectly immobile capital

Kr −→ 0
dy Lr
= >0 (20)
dG (Lr .Sy + Ir .Ly )
dr −Ly
= >0 (21)
dG (Lr .Sy + Ir .Ly )
de −Ly Kr − Lr Zy
= >0 (22)
dG (Ze − Xe )(Lr .Sy + Ir .Ly )

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 18 / 21

 Fiscal and Monetary Policy Multipliers

Fiscal Policy Multiplier with Perfectly mobile capital

Kr −→ ∞

dy
=0 (23)
dG
dr
=0 (24)
dG
de 1
= ≤0 (25)
dG (Ze − Xe )

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 19 / 21

 Fiscal and Monetary Policy Multipliers

Monetary Policy Multiplier with Perfectly immobile capital

Kr −→ 0
dy Ir
= >0 (26)
dMs (Lr .Sy + Ir .Ly )
dr Sy
= <0 (27)
dMs (Lr .Sy + Ir .Ly )
de −Ir Zy
= >0 (28)
dMs (Ze − Xe )(Lr .Sy + Ir .Ly )

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 20 / 21

 Fiscal and Monetary Policy Multipliers

Monetary Policy Multiplier with Perfectly mobile capital

Kr −→ ∞
dy 1
= >0 (29)
dMs Ly
dr
=0 (30)
dMs
de Sy + Zy
= >0 (31)
dMs −(Ze − Xe )Ly

Tehseen Iqbal (IBA) Macroeconomic Theory March 10, 2025 21 / 21