In this essay I will be discussing the way in which free capital flows can cause constraints on monetary policies. I will be looking at the balance of payments and how when it is applied to the Keynesian IS/LM model produces the Mundell - Fleming model. The Mundell - Fleming model shows the relationship between exchange rates and national income. Additionally, to further investigate this situation I will be looking into the ways in which monetary policies behave according to various exchange rate schemes, namely fixed and floating exchange rates.
The balance of payments consists of the current account and the capital account. In theory, these two accounts should balance. The current account concerns the imports and exports of goods and services. The largest component of the current account is net export and therefore the current account balance, which is the difference between exports and imports, moves with net exports. Exports are mainly affected by foreign economic conditions, for instance, when incomes rise in foreign countries, demand for exports will increase, therefore exports are exogenous. Imports however depend on domestic income, for instance when domestic incomes rise, consumers will buy more imported goods and services. Net export is equal to exports minus imports; therefore there is an inverse relationship between imports and net exports. Another important component of the balance of payments is the capital account which is inflow and outflow of financial capital which will flow into countries that have high rate of return, which can be reflected through interest rates. (Colander & Gamber, 2006, pages 273-274)
The Balance of payments curve is a curve that represents combinations of interest rates and income levels at a given exchange rate at which the private balance of payments is in equilibrium. The balance of payments curve is derived from how the current account and the private capital account change with various interest rates. The reason for this is because we assume that the official reserve transaction is zero, so the balance of payments curve is determined only by the private balance of payments account. The following diagram shows a balance of payments curve. If incomes increase domestically, imports will increase and therefore the current account will go into deficit. In order for this deficit to be offset, the capital account will have to be in surplus. Therefore when incomes rise, interest rates will also rise. This is shown by a movement from point A to point B. In the instance when incomes fall domestically, the current account will go into surplus, and as a reflex, the capital account will be in deficit. Therefore when incomes fall, interest rates will also fall and this is shown by a movement from point A to point C. (Colander & Gamber, 2006, pages 274-276)
In the diagram above, the left of the curve shows a situation where the balance of payments is in surplus and any region to the right of the curve shows a situation where the balance of payments is in deficit. The balance of payments may be in a situation of surplus because interest rates are higher than the interest rate that is coherent to the balance of payments equilibrium; Capital flows will flow into the country which will offset the current account deficit. The governing body that sets the interest rates are interested in the slope of the balance of payments curve. When the curve is too steep, in order to maintain the equilibrium, the interest rates will have to increase by a lot relatively. If the balance of payments curve is relatively flat however, in order to maintain the balance of payments equilibrium, the interest rate will have to increase by a little amount relatively. In summary, the balance of curve slope is determined by the responsiveness of capital movements to domestic...