A country begins with external balance (its official settlements balance is zero). Explain the effects of a shift by the country to an expansionary monetary policy on the balance of payments of the country. (Assume that the exchange rate is fixed, but do not consider any follow-on effects from defending the fixed rate.)

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: Beginning from an external balance, an expansion in the money supply increases banks' liquidity. In the short run, as banks compete with each other to lend money, interest rates are bid down. The fall in interest rates causes some holders of financial assets denominated in the domestic currency to seek higher returns abroad. The international capital outflow causes the financial account to deteriorate. The fall in interest rates encourages interest-sensitive spending. The expansion in spending increases real domestic product and income. The rise in production and income increases imports of goods and services and worsens the current account balance. In addition, extra spending puts upward pressure on prices. If prices and costs in the economy rise, then the country's international price competitiveness deteriorates and the country's current account worsens.