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expected rate of depreciation of the domestic currency

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The balance of payments schedule is assessed.

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<br>The balance of payments schedule that is usually drawn with the IS-LM lines in an open economy shows the combinations for which the overall balance of payments is zero. The shape of this line varies according to the economy's policies regarding capital flows. Let's see first how it is derived. (see attachment 1)
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<br>You have seen attachment 1 the 3 different forms the BP (balance of payments) line can take:
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<br>- It's vertical in the case of no capital mobility. In this case, net capital inflow is always 0, and therefore, the BP line becomes (X-M)=0. Since in this graph the exchange rate is taken to be fixed, then the BP line is vertical at the level of income (Y) that makes imports equal to exports.
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<br>- It's upward sloping in the case of imperfect capital mobility. In this case, net capital inflow is a positive function of domestic interest rate. Therefore, as the interest rate increases, ceteris paribus, there will be a BP surplus. In order to return to BP equilibrium, Y must rise, so that imports rise and (X-M) falls, thus restoring (X-M)+K to 0.
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<br>- It's horizontal in the case of perfect capital mobility. In this case, if the domestic interest rate is even slightly higher than the international one, there will be a huge (infinite theoretically) capital inflow. Thus the only possible BP equilibrium occurs when the domestic ...

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