2. Capital mobility, IS-LM-BP model and effects on firms

There are three forms of foreign private capital flows to emerging countries. These are bond finance, commercial bank loans and foreign investment.

To increase capital inflow for investment, emerging countries can issue bonds to foreign investors. These bonds may be either in foreign or domestic currency. Of course there exist particular risks for the investors. There is an inflation risk when bonds are issued in the domestic currency, whereas they are also subject to default risk, in the sense that a poor country may not be able to reimburse the bond when bonds are issued in the foreign currency. If selling bond option does not work to raise capital, emerging countries may borrow from foreign commercial banks. Commercial bank loans may be either short term or long term. Also interest rates may be fixed or flexible by a group of banks or a single bank. The last form of capital mobility is foreign direct investment. This is another type of capital flow to emerging countries. A multinational company may establish a new enterprise or expand its existing one.

Direct investment is the most important one among the three forms explained above. Therefore, capital flow as the form of direct investment is the driving force of growth and raises the employment in emerging country (see [1]).

As described in the first section, there are seven exchange rate determination models. However three of them are the fundamentals. These are Mundell-Fleming model, flexible price monetary model and sticky price monetary model. Together with foreign private capital flow information and different types of restrictions on capital flows, the common point for these three is that IS-LM-BP model is an important phenomenon in the exchange rate determination literature.

Mundell-Fleming model has a wide usage area among the open economy macro models. This model consists of a Keynesian structure and is the expanded form of IS-LM model. The Mundell-Fleming model is based on the following assumptions:


Constant wage and price assumptions state the distinct part of the Keynesian model that has a perfect elastic supply curve, i.e. output is determined by aggregate demand curve. The degree of capital flow is determined by the sensitivity of real-interest rate differentials in the Mundell-Fleming model [1].

Mundell-Fleming model combines the assumption of net international capital flow that depends on domestic interest rates and the simple Keynesian model consisting of goods and money markets. In the analysis, model focuses on the domestic money supply and interest rates as a monetary policy agent, while foreign prices and interest rates are exogenous [3].

BP curve is the balance of payments, and the slope of BP curve indicates the degree of capital movements. If BP curve is vertical, capital movements are completely limited. On the other hand, if BP curve is horizontal, free movements of capital occur, i.e. perfect capital mobility.

The equilibrium condition for commodity, money and currency markets is given in Figure 1. Point E shows the simultaneous equilibrium of all three markets with the internal and external balances at the same time. Points on the left (right) side of the IS curve indicate goods supply (demand) surplus. Points on the left (right) side of the LM curve indicate money demand

Figure 1. Internal and external balance under open economy.

capital mobility is foreign direct investment. This is another type of capital flow to emerging countries. A multinational company may establish a new enterprise or expand its existing one. Direct investment is the most important one among the three forms explained above. Therefore, capital flow as the form of direct investment is the driving force of growth and raises the

As described in the first section, there are seven exchange rate determination models. However three of them are the fundamentals. These are Mundell-Fleming model, flexible price monetary model and sticky price monetary model. Together with foreign private capital flow information and different types of restrictions on capital flows, the common point for these three is that IS-LM-BP model is an important phenomenon in the exchange rate determination literature. Mundell-Fleming model has a wide usage area among the open economy macro models. This model consists of a Keynesian structure and is the expanded form of IS-LM model. The

• Aggregate demand is positively related with government expenditure (G), foreign output (Yf) and exchange rate (e) and negatively related with domestic interest rate (rd).

• Money demand (Md) is a function of domestic interest rate (negatively) and domestic

• Money supply (Ms) is negatively affected from the deviation of exchange rate's targeting

• Capital account is determined by domestic and foreign real-interest rate differentials (rdrf). Constant wage and price assumptions state the distinct part of the Keynesian model that has a perfect elastic supply curve, i.e. output is determined by aggregate demand curve. The degree of capital flow is determined by the sensitivity of real-interest rate differentials in the Mundell-

Mundell-Fleming model combines the assumption of net international capital flow that depends on domestic interest rates and the simple Keynesian model consisting of goods and money markets. In the analysis, model focuses on the domestic money supply and interest rates as a

BP curve is the balance of payments, and the slope of BP curve indicates the degree of capital movements. If BP curve is vertical, capital movements are completely limited. On the other hand, if BP curve is horizontal, free movements of capital occur, i.e. perfect capital mobility.

The equilibrium condition for commodity, money and currency markets is given in Figure 1. Point E shows the simultaneous equilibrium of all three markets with the internal and external balances at the same time. Points on the left (right) side of the IS curve indicate goods supply (demand) surplus. Points on the left (right) side of the LM curve indicate money demand

monetary policy agent, while foreign prices and interest rates are exogenous [3].

employment in emerging country (see [1]).

254 Financial Management from an Emerging Market Perspective

• Nominal wages and prices are constant.

income (Yd) level (positively).

level.

Fleming model [1].

Mundell-Fleming model is based on the following assumptions:

• Trade account is determined by domestic output level.

(supply) surplus. If BP curve shifts to the right (left), this means the existence of a balance of payment deficit (surplus). This situation shows that capital flows are constant at a certain interest rate. However, more domestic income level means more trade deficit.

Three markets must be stable both inland and outland since unsterilized capital movements match up to perfectly elastic exchange rate regime at the fixed exchange rate regime. When the internal balance shifts to the left side of the balance of payments due to a shock, LM curve shifts to the left. Following this, if the exchange rate that gives rise in net exports is perfectly elastic, it will depreciate.

In an open economy, relative efficiency of monetary and fiscal policies depends on the degree of capital mobility and the applied exchange rate regime. Although most of the emerging economies are affiliated with international markets, there may be limitations in the capital movements. Therefore, it is difficult to say there exists a perfect liberalization. Interest rate does not have an important role in money demand since financial sector in emerging countries is not developed. Hence, LM curve is relatively vertical in emerging countries because of low sensitivity to interest rate.

According to the traditional approach of the Mundell-Fleming model, monetary devaluation has an expansionary effect on the output. Devaluation makes the cost of goods produced at home more expensive than the cost of goods produced from the rest of the world. This causes economic agents at home to consume more. The more the consumptions, the more the expansions in output become. This effect is known as the expenditure shift policy, and it is the fundamental expansionary channel of devaluation. On the other hand, devaluations in the 1990s, during the crisis in Asian economies, started to question this fundamental macroeconomic model. Living the economic collapses in the emerging countries makes the academicians and politicians deal with the expansionary and contractionary effects of devaluation.

#### 2.1. Macroeconomics policy under the fixed exchange rate system

Central Bank can intervene at the currency through a fixed exchange rate regime by buying or selling bonds [8]. In this context, monetary and fiscal policies are examined particularly taking into account the capital mobility, whether perfect or not. Five successive equations below present the IS-LM-BP model by using I0,S0, Z0, L<sup>0</sup> and K<sup>0</sup> constant terms. In these equations, investment, saving, import, net capital inflow, money demand, money supply (stock), interest rate and income are expressed with I, S, Z, K, L, Ms, r and y, respectively:

$$I = I\_0 + I\_r r \tag{1}$$

$$S = S\_0 + S\_y y \tag{2}$$

$$Z = Z\_0 + Z\_y y \tag{3}$$

$$M\_s = L\_0 + L\_\theta y + L\_r r \tag{4}$$

$$K = K\_0 + K\_r r \tag{5}$$

According to the five equations above, resulting IS-LM-BP equations and appropriate equilibrium points E1 and E2 are as follows:

$$\text{ISS} \left( \text{S}\_y + Z\_y \right) y - I\_r r = -\text{S}\_0 - Z\_0 + I\_0 + G + X = E\_1 \tag{6}$$

$$\text{LM } L\_y y + L\_r r = M\_s - L\_0 \tag{7}$$

BP � Zyy þ Krr ¼ �X þ Z<sup>0</sup> � K<sup>0</sup> ¼ E<sup>2</sup> (8)

Government expenditure (G) and export level (X) variables are added. Equilibrium points can then be calculated using IS-LM-BP equations in matrix form:

$$
\begin{pmatrix} S\_y + Z\_y & -I\_r \\ & & \\ -Z\_y & & K\_r \end{pmatrix} \begin{bmatrix} y \\ r \end{bmatrix} = \begin{bmatrix} E\_1 \\ E\_2 \end{bmatrix} \tag{9}
$$

$$
\begin{bmatrix} y^{\epsilon} \\ r^{\epsilon} \end{bmatrix} = \begin{pmatrix} \mathbf{K}\_{\mathbf{r}}/T & \mathbf{I}\_{\mathbf{r}}/T \\\\ -\mathbf{Z}\_{\mathbf{y}}/T & \left(\mathbf{S}\_{\mathbf{y}} + \mathbf{Z}\_{\mathbf{y}}\right)/T \end{pmatrix} \begin{bmatrix} E\_1 \\\\ E\_2 \end{bmatrix} \tag{10}
$$

The result calculated in Eq. (10), while T = Kr(Sy +Zy) � IrZy > 0, gives the equilibrium for points y and r.

#### 2.1.1. Monetary policy

The money supply Eq. (11) is found by putting the equilibrium points calculated in Eq. (10) to the LM equation:

$$M\_s^\varepsilon = L\_0 + \left(L\_y K\_r + L\_r Z\_y\right) E\_1 + \left[L\_y I\_r + L\_r \left(S\_y + Z\_y\right)\right] E\_2 \tag{11}$$

Money supply is constant in the equilibrium. It determines to conserve the defined fixed exchange rate. Monetary policy is only used for adjusting the currency reserve level and causes an economic imbalance. This result is independent from the international capital mobility [15]. Because an expansionary domestic credit shock places pressure on interest rates to decrease it, capital outflow starts and currency depreciates. So the intervention of Central Bank will be inevitable. Only way for Central Bank is to sell foreign currency from the reserve equal to the domestic credit expansion to avoid the depreciation of the exchange rate. Policymaker has to maintain value of the national currency because of fix exchange rate. Therefore, Central Bank sells dollar at the current exchange rate which leads to the tightening of money supply. Figure 2 shows that LM curve will come back the original level at each case. As a result, monetary policy is totally ineffective. As described before, this result is independent from the international capital mobility and valid for all four cases.

#### 2.1.2. Fiscal policy

2.1. Macroeconomics policy under the fixed exchange rate system

256 Financial Management from an Emerging Market Perspective

rate and income are expressed with I, S, Z, K, L, Ms, r and y, respectively:

rium points E1 and E2 are as follows:

y and r.

2.1.1. Monetary policy

the LM equation:

IS Sy þ Zy

then be calculated using IS-LM-BP equations in matrix form:

ye

" #

re

M<sup>e</sup>

¼

<sup>s</sup> ¼ L<sup>0</sup> þ LyKr þ LrZy

Central Bank can intervene at the currency through a fixed exchange rate regime by buying or selling bonds [8]. In this context, monetary and fiscal policies are examined particularly taking into account the capital mobility, whether perfect or not. Five successive equations below present the IS-LM-BP model by using I0,S0, Z0, L<sup>0</sup> and K<sup>0</sup> constant terms. In these equations, investment, saving, import, net capital inflow, money demand, money supply (stock), interest

According to the five equations above, resulting IS-LM-BP equations and appropriate equilib-

Government expenditure (G) and export level (X) variables are added. Equilibrium points can

r

! E<sup>1</sup>

� �=T

¼

" #

Sy þ Zy �Ir

! y

Kr=T Ir=T

�Zy=T Sy þ Zy

The result calculated in Eq. (10), while T = Kr(Sy +Zy) � IrZy > 0, gives the equilibrium for points

The money supply Eq. (11) is found by putting the equilibrium points calculated in Eq. (10) to

� �E<sup>1</sup> <sup>þ</sup> LyIr <sup>þ</sup> Lr Sy <sup>þ</sup> Zy

�Zy Kr

I ¼ I<sup>0</sup> þ Irr (1)

S ¼ S<sup>0</sup> þ Syy (2)

Z ¼ Z<sup>0</sup> þ Zyy (3)

K ¼ K<sup>0</sup> þ Krr (5)

Ms ¼ L<sup>0</sup> þ Lyy þ Lrr (4)

LM Lyy þ Lrr ¼ Ms � L<sup>0</sup> (7)

(9)

(10)

� �<sup>y</sup> � Irr ¼ �S<sup>0</sup> � <sup>Z</sup><sup>0</sup> <sup>þ</sup> <sup>I</sup><sup>0</sup> <sup>þ</sup> <sup>G</sup> <sup>þ</sup> <sup>X</sup> <sup>¼</sup> <sup>E</sup><sup>1</sup> (6)

BP � Zyy þ Krr ¼ �X þ Z<sup>0</sup> � K<sup>0</sup> ¼ E<sup>2</sup> (8)

E1

" #

E2

E2

� � � � E<sup>2</sup> (11)

" #

To see the effect of fiscal policy, government expenditure (G) is taken exogenous. The following multipliers are calculated by taking total differentials of Eqs. (10) and (11):

Figure 2. Monetary policy under fixed exchange rate. (a) Imperfect capital mobility, (b) low capital mobility, (c) high capital mobility and (d) perfect capital mobility.

$$\frac{dy^{\varepsilon}}{dG} = \frac{K\_r}{K\_r \left(S\_y + Z\_y\right) - I\_r Z\_y} > 0\tag{12}$$

$$\frac{dr^{\varepsilon}}{dG} = \frac{Z\_r}{K\_r \left(S\_y + Z\_y\right) - I\_r Z\_y} > 0\tag{13}$$

$$\frac{dM\_s^\epsilon}{dG} = \frac{L\_y K\_r + L\_r Z\_y}{K\_r \left(S\_y + Z\_y\right) - I\_r Z\_y} > < 0\tag{14}$$

Fiscal policy effects under fixed exchange rate are examined in Figure 3. When capital mobility is perfect, Kr! ∞ and multipliers Eqs. (12)–(14) are calculated as follows:

$$\frac{dy^e}{dG} = \frac{1}{S\_y + Z\_y} > 0\tag{15}$$

$$\frac{dr^\epsilon}{dG} = 0\tag{16}$$

Figure 3. Fiscal policy under fixed exchange rate. (a) Imperfect capital mobility, (b) low capital mobility, (c) high capital mobility and (d) perfect capital mobility.

The Economics of Foreign Exchange in Emerging Markets http://dx.doi.org/10.5772/intechopen.71752 259

$$\frac{dM\_s^\epsilon}{dG} = \frac{L\_y}{S\_y + Z\_y} = L\_y \left(\frac{dy^\epsilon}{dG}\right) > 0\tag{17}$$

As shown in Figure 3d, when expansionary fiscal policy is applied at the point a with coordinates (r0, Y0), IS curve shifts to IS'. New equilibrium is now at point b. There is a balance of payment surplus at this point. This is the difference between expansionary fiscal policy and expansionary monetary policy. This surplus at point b means there exists a capital inflow. Thus, the monetary authority purchases dollar at the current currency to prevent the appreciation of the national currency. Then, the domestic money supply rises. Hence, LM curve shifts to LM' and reaches the equilibrium at point c as shown in Figure 3d.

dye

258 Financial Management from an Emerging Market Perspective

dre

dM<sup>e</sup> s

LM

IS\*

LM LM\*

IS

Y0 Y1 Y2

mobility and (d) perfect capital mobility.

IS\*

LM\*

IS

BP

r0 r1 r2

r0 r2 r1 Y0 Y1

is perfect, Kr! ∞ and multipliers Eqs. (12)–(14) are calculated as follows:

dye dG <sup>¼</sup> <sup>1</sup>

dG <sup>¼</sup> Kr Kr Sy þ Zy

dG <sup>¼</sup> Zr Kr Sy þ Zy

dG <sup>¼</sup> LyKr <sup>þ</sup> LrZy Kr Sy þ Zy

� IrZy

� IrZy

� IrZy

Fiscal policy effects under fixed exchange rate are examined in Figure 3. When capital mobility

Sy þ Zy

dre

a) b)

BP

r0

r0 r1 r2

c) d)

Figure 3. Fiscal policy under fixed exchange rate. (a) Imperfect capital mobility, (b) low capital mobility, (c) high capital

> 0 (12)

> 0 (13)

>< 0 (14)

> 0 (15)

BP

LM

LM LM\*

IS IS\*

Y0 Y2 Y1

a

BP LM\*

IS

Y0 Y1

b

c

IS\*

dG <sup>¼</sup> <sup>0</sup> (16)

Under imperfect capital mobility is Kr =0(Figure 3a). After some manipulations the multipliers are as follows:

$$\frac{dy^{\varepsilon}}{d\mathbb{G}} = 0\tag{18}$$

$$\frac{dr^{\varepsilon}}{d\mathbf{G}} = \frac{-1}{I\_r} \tag{19}$$

$$\frac{dM\_s^e}{dG} = \frac{-L\_r}{I\_r} \tag{20}$$

According to the calculated multipliers, after an expansionary fiscal policy, equilibrium money stock declines (Eq. (20)). This is because the higher interest rate induces liquidity choices. So currency reserves reduce at the same rate. At the last equilibrium while interest rate is increasing, income level can be as same as the beginning [15].

When capital mobility is high or imperfect, Eqs. (12)–(14) are used. As a response to fiscal mobility, both output and interest rates increase. By inspecting Eq. (14), the equilibrium money stock may rise or fall, depending on whether LyKr + LrZy are greater or less than zero. If LyKr + LrZy > 0, the slope of the LM curve is greater than the slope of the BP curve (Figure 3b). In this case, �Ly =Lr > Zy =Kr . The left side of inequality gives the slope of the LM curve, and the right side gives the slope of the BP curve. Economically, the equilibrium money stock rises as foreign exchange is accumulated by the monetary authority. However, if LyKr + LrZy < 0, the slope of the BP curve is greater than the slope of the LM curve (Figure 3c). Monetary authority loses foreign exchange, LM shifts right, and equilibrium money stock declines.

#### 2.2. Macroeconomics policy under the flexible exchange rate system

Flexible exchange rate is a system which allows the exchange rate to freely change within the market. These variations in the exchange rate demand/supply provide the equilibrium that pass through the nominal rate. Exchange rate changes that are part of the expenditure shift policies are used to provide the external balance in the exchange rate systems. Potential external surplus keeps decreasing the exchange rate, while potential external deficit gives a rise in the exchange rate. Both of them separately prevent a real external imbalance. Central Bank has no responsibility on the exchange rate and BP under the flexible exchange rate system. If there is an imbalance in the exchange rate or BP, it recovers automatically.

Governments cannot control exchange rate, interest rate and capital movements at the same time using flexible exchange rates. This is known as the impossible trinity, asserted by [16]. Two of them are chosen as policy instruments, and the other is determined by market dynamics. Under the perfect capital mobility with a flexible exchange rate system, the two policy instruments (interest rate and capital movements) can be effectively controlled since exchange rate is determined by market dynamics. However, it is asserted that exchange rates are not allowed to be determined by interest rates in many countries using flexible exchange rate systems [17].

Setting "e" as exchange rate, the IS-LM-BP equation system with a flexible exchange rate can be written as follows:

$$I(r) = S(y) - G + Z(y, \varepsilon) - X(e) \tag{21}$$

$$M\_s = L(y, r) \tag{22}$$

$$X(e) - Z(y, e) + K(r) = 0\tag{23}$$

When we differentiate the equations above according to the endogenous variables y, r and e:

$$
\begin{pmatrix} \mathbf{S}\_{\mathcal{Y}} + \mathbf{Z}\_{\mathcal{Y}} & -\mathbf{I}\_{r} & \mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon} \\\\ \mathbf{L}\_{\mathcal{Y}} & \mathbf{L}\_{r} & \mathbf{0} \\\\ \mathbf{Z}\_{\mathcal{Y}} & -\mathbf{K}\_{r} & \mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon} \end{pmatrix} \begin{bmatrix} dy \\ dr \\ dr \\ de \end{bmatrix} = \begin{bmatrix} d\mathbf{G} \\ d\mathbf{M}\_{s} \\ \mathbf{0} \end{bmatrix} \tag{24}
$$

Using T = (Ze � Xe)(LrSy � LyKr + IrLy) > 0, the result of the matrix system for dy, dr and de is as follows:

$$
\begin{bmatrix} dy \\ dr \\ de \\ de \end{bmatrix} = \begin{pmatrix} \mathcal{L}\_{r}(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T & (\mathcal{I}\_{r} - \mathbf{K}\_{r})(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T & -\mathcal{L}\_{r}(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T \\\ -\mathcal{L}\_{y}(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T & \mathcal{S}\_{y}(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T & \mathcal{L}\_{y}(\mathbf{Z}\_{\varepsilon} - \mathbf{X}\_{\varepsilon})/T \\\ -\left(\mathcal{L}\_{y}\mathcal{K}\_{r} + \mathcal{L}\_{r}\mathcal{Z}\_{y}\right)/T & \left[\mathcal{K}\_{r}\left(\mathcal{S}\_{y} + \mathcal{Z}\_{y}\right) - \mathcal{K}\_{r}\mathcal{Z}\_{y}\right]/T & \left[-\mathcal{L}\_{r}\left(\mathcal{S}\_{y} + \mathcal{Z}\_{y}\right) + \mathcal{L}\_{y}\mathcal{I}\_{r}\right]/T \end{bmatrix} \begin{bmatrix} d\mathbf{G} \\ d\mathbf{M}\_{s} \\ \mathbf{0} \end{bmatrix} \tag{25}
$$

#### 2.2.1. Monetary policy

We obtain the following multipliers, which can be used for observing the monetary policy functions after mathematical manipulations, in Eq. (25):

$$\frac{dy}{dM\_s} = \frac{I\_r - K\_r}{L\_r S\_y - L\_y K\_r + I\_r L\_y} > 0\tag{26}$$

$$\frac{dr}{dM\_s} = \frac{S\_y}{L\_r S\_y - L\_y K\_r + I\_r L\_y} < 0\tag{27}$$

The Economics of Foreign Exchange in Emerging Markets http://dx.doi.org/10.5772/intechopen.71752 261

$$\frac{de}{dM\_s} = \frac{K\_r S\_y}{(Z\_\varepsilon - X\_\varepsilon) \left(L\_r S\_y - L\_y K\_r + I\_r L\_y\right)} > 0\tag{28}$$

The multipliers are as follows, under perfect capital mobility (Figure 4d), Kr!∞:

on the exchange rate and BP under the flexible exchange rate system. If there is an imbalance in

Governments cannot control exchange rate, interest rate and capital movements at the same time using flexible exchange rates. This is known as the impossible trinity, asserted by [16]. Two of them are chosen as policy instruments, and the other is determined by market dynamics. Under the perfect capital mobility with a flexible exchange rate system, the two policy instruments (interest rate and capital movements) can be effectively controlled since exchange rate is determined by market dynamics. However, it is asserted that exchange rates are not allowed to be determined by interest rates in many countries using flexible exchange rate

Setting "e" as exchange rate, the IS-LM-BP equation system with a flexible exchange rate can

When we differentiate the equations above according to the endogenous variables y, r and e:

Using T = (Ze � Xe)(LrSy � LyKr + IrLy) > 0, the result of the matrix system for dy, dr and de is as

Lrð Þ Ze � Xe =T Ið Þ <sup>r</sup> � Kr ð Þ Ze � Xe =T �Lrð Þ Ze � Xe =T

�Lyð Þ Ze � Xe =T Syð Þ Ze � Xe =T Lyð Þ Ze � Xe =T

We obtain the following multipliers, which can be used for observing the monetary policy

LrSy � LyKr þ IrLy

<sup>¼</sup> Ir � Kr LrSy � LyKr þ IrLy

<sup>¼</sup> Sy

� � � KrZy

1

dy

dr

de

CCCA

� �=<sup>T</sup> �Lr Sy <sup>þ</sup> Zy

Sy þ Zy �Ir Ze � Xe

Zy �Kr Ze � Xe

Ly Lr 0

0

BBB@

� �=T Kr Sy <sup>þ</sup> Zy

functions after mathematical manipulations, in Eq. (25):

dy dMs

dr dMs

� LyKr þ LrZy

I rð Þ¼ S yð Þ� G þ Z yð Þ� ;e X eð Þ (21)

X eð Þ� Z yð Þþ ;e K rð Þ¼ 0 (23)

dG

� � <sup>þ</sup> LyIr � �=T

> 0 (26)

< 0 (27)

(24)

1

dG

(25)

dMs

0

CCCA

dMs

0

Ms ¼ L yð Þ ;r (22)

the exchange rate or BP, it recovers automatically.

260 Financial Management from an Emerging Market Perspective

systems [17].

follows:

dy

0

BBB@

2.2.1. Monetary policy

dr

de

be written as follows:

$$\frac{dy}{dM\_s} = \frac{1}{L\_y} > 0\tag{29}$$

$$\frac{dr}{dM\_s} = 0\tag{30}$$

$$\frac{de}{dM\_s} = \frac{S\_y}{-(Z\_e - X\_e)L\_y} > 0\tag{31}$$

There is no difference in the interest rate with a perfect capital mobility as shown in Eq. (30). When we observe Figure 4d, LM shifts to LM' after an expansionary monetary policy. Hence, the domestic interest rate will be lower than the world interest rate, and the national currency will depreciate due to the capital outflow. As a response, exports will rise and imports will fall.

Figure 4. Monetary policy under flexible exchange rate. (a) Imperfect capital mobility, (b) low capital mobility, (c) high capital mobility and (d) perfect capital mobility.

This gives rise to an increase in the aggregate demand, and IS will shift to IS'. The last equilibrium point will be at Y2. Finally, it is obviously and can be seen that monetary policy is really efficient under flexible exchange rate.

On the other hand, when Kr! 0 with imperfect capital mobility, the multipliers for y, r and e will be as follows, respectively:

$$\frac{dy}{dM\_s} = \frac{I\_r}{L\_r S\_y + I\_r L\_y} > 0\tag{32}$$

$$\frac{dr}{dM\_s} = \frac{\mathcal{S}\_y}{L\_r \mathcal{S}\_y + I\_r L\_y} < 0 \tag{33}$$

$$\frac{de}{dM\_s} = 0\tag{34}$$

IS-LM-BP curves move similarly in imperfect capital mobility, low capital mobility and high capital mobility (Figure 4a–c). As a result, income and interest rate efficiencies resemble each other for all cases in Figure 4.

#### 2.2.2. Fiscal policy

Applying Cramer Rule on Eq. (25), the following multipliers are calculated to observe the fiscal policy functions:

$$\frac{dy}{dG} = \frac{L\_r}{L\_r S\_y - L\_y K\_r + I\_r L\_y} > 0\tag{35}$$

$$\frac{dr}{dG} = \frac{-L\_y}{L\_r S\_y - L\_y K\_r + I\_r L\_y} > 0\tag{36}$$

$$\frac{de}{dG} = \frac{-\left(L\_y K\_r + L\_r Z\_y\right)}{\left(Z\_\ell - X\_\ell\right)\left(L\_r S\_y - L\_y K\_r + I\_r I\_y\right)} > <0\tag{37}$$

The multipliers for y, r and e are as follows under perfect capital mobility (Figure 5d), Kr! ∞:

$$\frac{dy}{dG} = 0\tag{38}$$

$$\frac{dr}{dG} = 0\tag{39}$$

$$\frac{de}{dG} = \frac{1}{(Z\_e - X\_e)} \le 0\tag{40}$$

According to Eqs. (38)–(40), the national currency depreciation is not possible since the capital account effect of fiscal policy is dominant. Because of this, fiscal policy is not efficient under flexible exchange rate. On the other hand, efficiency of fiscal policy may be observed from

This gives rise to an increase in the aggregate demand, and IS will shift to IS'. The last equilibrium point will be at Y2. Finally, it is obviously and can be seen that monetary policy is

On the other hand, when Kr! 0 with imperfect capital mobility, the multipliers for y, r and e

> 0 (32)

< 0 (33)

> 0 (35)

> 0 (36)

>< <sup>0</sup> (37)

dG <sup>¼</sup> <sup>0</sup> (38)

dG <sup>¼</sup> <sup>0</sup> (39)

≤ 0 (40)

¼ 0 (34)

<sup>¼</sup> Ir LrSy þ IrLy

<sup>¼</sup> Sy LrSy þ IrLy

> de dMs

IS-LM-BP curves move similarly in imperfect capital mobility, low capital mobility and high capital mobility (Figure 4a–c). As a result, income and interest rate efficiencies resemble each

Applying Cramer Rule on Eq. (25), the following multipliers are calculated to observe the fiscal

LrSy � LyKr þ IrLy

LrSy � LyKr þ IrLy

 ð Þ Ze � Xe LrSy � LyKr þ IrLy

The multipliers for y, r and e are as follows under perfect capital mobility (Figure 5d), Kr! ∞:

dy

dr

ð Þ Ze � Xe

According to Eqs. (38)–(40), the national currency depreciation is not possible since the capital account effect of fiscal policy is dominant. Because of this, fiscal policy is not efficient under flexible exchange rate. On the other hand, efficiency of fiscal policy may be observed from

dy dMs

dr dMs

dy

dr

de

dG <sup>¼</sup> Lr

dG <sup>¼</sup> �Ly

dG <sup>¼</sup> � LyKr <sup>þ</sup> LrZy

de dG <sup>¼</sup> <sup>1</sup>

really efficient under flexible exchange rate.

262 Financial Management from an Emerging Market Perspective

will be as follows, respectively:

other for all cases in Figure 4.

2.2.2. Fiscal policy

policy functions:

Figure 5. Fiscal policy under flexible exchange rate. (a) Imperfect capital mobility, (b) low capital mobility, (c) high capital mobilit and (d) perfect capital mobility.

different sights due to the degree of capital mobility. In this context, since the inequalities LyKr > 0 and LrZy < 0, Eq. (37) may be positive or negative. As it is described before Zy =Kr is the slope of the BP curve, and �Ly =Lr is the slope of the LM curve. We get the following Eq. (41) since LyKr + LrZy > 0:

$$\left| \mathbf{Z}\_{\mathcal{Y}} \right\rangle\_{\mathcal{K}\_{\mathbf{r}}} < \left| \mathbf{-}\_{\mathbf{r}} \right\rangle\_{\mathcal{L}\_{\mathbf{r}}} \tag{41}$$

It is obvious that the slope of the LM curve is larger than the slope of the BP curve. This indicates the low capital mobility case. The shifting of IS-LM-BP system is examined in Figure 5b. If LyKr + LrZy < 0, the slope of the LM curve will be lower than the slope of the BP curve. Hence, high capital mobility case occurs. The movements of IS-LM-BP of this case are given in Figure 5c.

At last, the multipliers are as follows under imperfect capital mobility, i.e. Kr = 0:

$$\frac{dy}{dG} = \frac{L\_r}{L\_r S\_y + I\_r L\_y} > 0\tag{42}$$

$$\frac{dr}{d\mathbf{G}} = \frac{-L\_y}{L\_r \mathbf{S}\_y + I\_r L\_y} > 0\tag{43}$$

$$\frac{de}{dG} = \frac{-L\_r Z\_y}{(Z\_e - X\_e)\left(L\_r S\_y + I\_r L\_y\right)} > 0\tag{44}$$

According to the three multipliers Eqs. (42)–(44), fiscal policy affects only current account so national currency depreciates, i.e. exchange rate rises.

#### 2.3. Effects on firms

Firms are influenced by exchange rate changes due to the effects they have on the general economy and also because of the activities they carry out in foreign currency. Fluctuations in exchange rates affect firms either positively or negatively, which is defined as exposure to exchange rate or exchange rate risk in financial literature. The exchange rate sensitivity is the potential for changes in exchange rates, company cash flows and hence the market value. Exchange risk is not an issue if the change in the cash flows of a firm that is exposed to this exchange rate effects can be predicted in advance. In short, if there is no difference between expected cash flows and realized cash flows due to exchange rate changes, exchange rate risk is not a concern. Openness to exchange rate, in general, becomes clear in three ways: accounting, economic and transaction effects. The accounting effect, also called the translation exposure, is an effect that occurs when the financial statements of the subsidiary are converted into the central currency of the country during the consolidation of the financial statements, and it is the measurement of the change that this effect causes on the firm's equity. The main way of protecting from accounting effect is to increase liabilities by reducing assets from weaker currencies and reducing liabilities by holding assets from stronger (revalued) currencies. A position in the derivative markets can be taken to support this approach. The economic impact, defined as the effect of unexpected changes in the exchange rate on the future cash flows of firms, is important as much as the degree it affects company value. However, since future cash flows are not easy to predict, many researchers describe the effects of exchange rate changes on the firm value, which is assumed to be the present value of future cash flows, as an economic impact. Since the effects of exchange rate changes on the economic side are long term, the hedging methods in derivative currencies lose their validity in decreasing the economic effect; instead, firms can develop their own strategies and avoid the risks of economic vulnerability. The transaction effect is the effect of exchange rate changes on the sales and profitability plans together with the foreign currency denominated receivables and payables of firms. In order to be able to determine the presence of the transaction effect, the estimation of the net cash flows in foreign currency, and its potential effect should be measured. Since they are mostly short lived, it is possible to solve the problem with the help of derivatives (forward, future, option contracts) and money (hedge transactions) markets. Due to the growth strategy that Turkey has embraced, exporting companies have a critical prescription in the economic structure. For this reason, it is important for policymakers to determine the effect of the exchange rate variability on firms' performance. The effects of changes in exchange rates on firms can be listed as follows [23, 24]:

