Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
Evaluation: 
The BOP theory provides a fairly satisfactory explanation of 
the determination of the rate of exchange. This theory has the 
following advantages; 
Unlike the PPP theory, BOP theory recognizes the 
importance of all the items in the BOP, in determining the 
exchange rate. 
This demand and supply theory in conformity with the 
general theory of value-like the price of any commodity in a 
free market, the rate of exchange is determined by the 
forces of demand and supply. 
It also indicates that BOP disequilibrium can be corrected by 
adjustments in the exchange Rate by devaluing or revaluing 
currency value. 
This theory brings the determination of the rate of exchange 
within the purview of the General Equilibrium Theory. That is 
why this theory is also called the general equilibrium theory 
of exchange rate determination. 
Haberler says that its greatest weakness is that it assumes 
balance of payments to be fixed quantity. 
Check your progress 
1) How is exchange rate is determined in free market? 
 
 
 
 
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10.4 MUNDELL- FLEMING MODEL- THE IMPOSSIBLE 
TRINITY 
 
Mundell 
– Fleming Open Economy Model: 
 
This model was developed by Robert Mundell and Marcus 
Fleming in the 1960s. It is an extension of the standard Keynesian 
IS 
– LM model than open economy. It analyses new monetary and 
fiscal policies work is an open economy that is characterized by 
absolute exchange rate flexibility and perfect mobility. 

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Under the absolute flexible exchange rate system there is no 
need for the central bank in the foreign exchange market. It always 
clear and the balance of payments is always zero since 
adjustments in the exchange rate assure the balancing of the 
current and capital account. 
Further under this system, there is no link between the 
balance of payments and money supply; so the central bank is fee 
to set the money at will. In other words, money supply is given. 
Zero balance of payments implies equality between the 
domestic interest rate (i) and foreign interest rate; so i = i
f
. Should 
there be any difference between i and i
f
, capital plans will be 
generated, either way as may be required, and balance of payment 
will cease to be equal to zero. 
In the diagram below this condition (i = i
f
) is shown by the 
horizontal line (BOP = 0) at the level of the world interest rate i
f
. If 
the home interest rate (i) were higher than the world interest rate (i
f
)
capital inflows would be taken place and this results in currency 
appreciation. This will raise the real exchange rate and lower 
aggregate demand by shifting the IS curve to the left. (Real 
exchange rate is a determinant of aggregate demand and is a shift 
variable in the IS schedule). Any point below BOP = 0 means 
currency depreciation caused by capital outflows (i < i
f
); this 
improves competitiveness and increases aggregate demand. In this 
case the IS curve shifts to the right.