This paper discusses the determination of the balance of payments, exchange rates, mployment and other vaviables in a small, underemployed open economy with a flexible exchange rate regime. Two models are developed, one for an economy without capital mobility and one for an economy with the perfect capital mobility. The determinations of the short-run and the long run equilibrium are explained diagramatically, and the effects of policy and parameter changes are analysed. The following are among the results obtained. In the long run, where the balance of payments on current account is in equilibrium, changes in the stock of money have no effect on the level of total income, if capital is perfectly mobile. Interventions into exchange market do not have any substantial effects on the exchange rate and employment in the long run.
In the short run, purchases, for example, of foreign currency by central bank from domestic residents result in an improvement in the balance of payments on current account, through the exchange rate depreciates.
An increase in the domestic expenditure has no effect on employment in the short run and only deteriorates the balance of payments on current account. However, it increases employment and income in the long run by reducing the stock of foreign assets and the total wealth held by the residents of the country, which results in a depreciation in the exchange rates and a reduction in the demand for money for given levels of interest rate and income.
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