Balance of Payments Curve

The BP curve (as described in the Mundell-Fleming model) is that curve that represents the balance of payments when outgoing payments and in-coming are in equilibrium. Such a concept (i.e. an equilibrious balance of payments) is only meaningful only under conditions of a fixed (or pegged) exchange rate. This equilibrium occurs when there is a balance or an equality between debits and credits. This defines the concept of external balance.

This curve is normally an upward slope, reflecting the fact that an increase in income tend to result in an increase in imports any increase in the interest rate tends to increase the influx of capital. As noted, this model is only useful with a pegged exchange rate.

While most of us are familiar with the term “exchange rate” we may not have a good sense of the technical way in which economics use that term. For an economist, the exchange rate is the price of one country’s money in relation to the price of any other country’s money. There are two different basic forms of exchange rates. The rate is said to be “fixed” between two (or more) countries when those countries agree to use a standard (traditionally the gold standard, or the value of gold bullion on the world market). In such a situation, each currency involved is worth a specific measure of the metal (i.e. 100 pesos might be worth one troy ounce). The currencies may change value, but only vis-a-vis this fixed standard (gold, platinum, wheat, etc.) They do not change value relative to each other, or at least not directly.

This system seems to be a relatively fair and stable one, and while such a fixed rate of exchange does have its advantages, it also has disadvantages that may be especially harmful to developing countries. The advantages of a fixed standard such as the gold standard. Perhaps the most important safeguard that a fixed exchange rate offers is that it fundamentally limits the power of either a central government or a bank…

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