Answer to Question #157615 in Economics for Nisha chaudhary

Question

Illustrate the effect of imperfect capital mobility under fixed and flexible exchange rate

regimes.

Answer 1

Let us consider as an example the consequences of a stimulating fiscal policy (for example, an increase in government spending G or a decrease in taxes T) in an economy with low capital mobility (Fig.).

An increase in G, causing an increase in aggregate demand, shifts the IS1 curve to the right to position IS2, the point of internal equilibrium moves from point A to point B. Y1 income rises to Y2, and a greater demand for money for transactions pushes up the interest rate to i2.

In the absence of international capital mobility, an increase in government spending would have an impact on the external balance only through an increase in imports and the emergence of a current account deficit, and, consequently, the overall balance of payments.

However, now, when the capital account is included in the analysis, the overall balance of payments situation changes: higher interest rates attract capital to the country, which positively affects the overall balance of payments situation, leading to the formation of a capital account surplus.

On the other hand, higher income levels increase imports and worsen the current account, which negatively affects the balance of payments. Which factor - an increase in interest rates or an increase in income - affects the balance of payments more strongly? It depends on the degree of capital mobility. In this case, when capital flows are not too sensitive to changes in interest rates, the improvement in the capital account will be negligible and the overall balance of payments deficit generated by the large current account deficit will persist.

The BP curve with a positive slope is steeper than the LM curve, i.e. capital mobility is low. In this case, the new point of internal equilibrium (point B) is to the right, or below the BP graph. Any point to the right or below the BP curve indicates a balance of payments deficit: either the level of income, and therefore imports, is too high and not balanced by the existing capital inflows, or the interest rate and, therefore, capital inflows are too low.

Thus, a stimulating fiscal policy with low capital mobility leads to a deficit in the balance of payments, although capital inflows partially offset the current account deficit.