1) The document discusses economic policy under fixed exchange rates using the IS/LM/BP model. It describes how the money market equilibrium (LM curve), real sector equilibrium (IS curve), and balance of payments equilibrium (BP curve) interact.
2) Fiscal and monetary policy are less effective at increasing output under fixed exchange rates due to capital mobility. If capital is mobile, these policies do not affect interest rates.
3) Devaluations shift the IS, LM, and BP curves right, increasing output. Devaluations are more effective at increasing output when capital is mobile.
In Keynesian Economics equilibrium is reached at a point where Ad equals AS. On the Other hand for equilibrium Consumption must equal Investment given the fact that S = I. The rete of interest which is the major determinant of Investment is determined in Money Market. It is therefore essential that at equilibrium all these markets should be in equilibrium. IS LM explains simultaneous equilibrium in all the markets.
In Keynesian Economics equilibrium is reached at a point where Ad equals AS. On the Other hand for equilibrium Consumption must equal Investment given the fact that S = I. The rete of interest which is the major determinant of Investment is determined in Money Market. It is therefore essential that at equilibrium all these markets should be in equilibrium. IS LM explains simultaneous equilibrium in all the markets.
ECON5002 – Macroeconomic TheoryWeek 10 Open economy II – EvonCanales257
ECON5002 – Macroeconomic Theory
Week 10: Open economy II – IS-LM-IP model
Reading: Blanchard chapter 20 (excluding 460-464) and
chapter 21 (excluding 471-480)
Dr Kim Hawtrey
2
› money market equilibrium - open economy
! in a closed economy, recall (Week 2) that the LM relation captures
equilibrium between demand and supply of money M, where:
- the supply of money is measured in real terms (M/P) and is given
exogenously by policymakers
- the demand for money YL(i) is measured in real terms and depends on
transactions (proxied by output Y) and on opportunity cost (= a function
of i, interest rate on bonds B, the opportunity cost of holding M)
! Q: does the LM equation change in the open economy?
A: no - demand for M is still determined by domestic residents because
foreigners have no daily use for Australian dollars, and supply of M is
still determined by Australia’s central bank
" the open economy LM equation remains unaltered: M/P = YL(i) .. no
foreign variables appear in the LM relation
! for simplicity, we will assume that monetary policy follows Rule 2 .. the
central bank sets the interest rate at a target value, say i = i0
Open economy LM curve
3
› IS-LM-IP equilibrium - open economy (algebraic)
! by solving the IS (Week 9) and LM (slide 2) equations simultaneously for
(i,E) we can determine the ISLM equilibrium for open economy
IS: Y = C (Y-T) + I(Y, i) + G + NX [Y, Y*, ((1+i)/(1+i*))Ee]
the open economy IS relation between the interest rate and output is
derived for given values of T, G, Y*, i*,and Ee .. it is still a downward
sloping curve because i leads to ¯Y, but in the open economy this now
occurs via two channels, direct (¯I) and indirect (¯NX)
LM: M/P = YL(i)
the open economy LM relation is exactly the same as in the closed
economy and is derived for a given value of (M/P) .. it is still an upward
sloping curve because Y leads to higher M demand which would
require i, but we are assuming i = i0 and so money supply M must adjust
endogenously (and LM shift up/down) to maintain money market
equilibrium at i0
Open economy IS-LM-IP model
4
› IS-LM-IP equilibrium - open economy (geometric)
Open economy IS-LM-IP model
The equilibrium interest rate occurs i0, at the intersection of the downward
sloping IS curve and upward sloping LM curve.
Projecting across to panel (b) at equilibrium interest rate i0, the interest parity
relation implies equilibrium exchange rate E.
5
› IS-LM-IP equilibrium - open economy
! the procedure for the economy to be at equilibrium is:
- with the central bank choosing the interest rate i0, equilibrium output Y0 is
determined from the IS curve Þ the quantity of money M adjusts endogenously
so that the LM curve goes through the point (i0,Y0)
- given the foreign interest rate i* and the expected future exchange rate Ee, the
equilibrium interest rate (i0) determines the equilibrium exchange rate (E0)
! the e ...
3. Targets, Instruments, and Policy: A Model “External balance” Any decrease in the interest rate (e.g., because of expansionary monetary policy) will cause a decrease in short-term capital inflows or an increase in short-term capital outflows and a BOP deficit. Expansionary fiscal policy (by increasing Y and M) also leads to a BOP deficit. “Internal balance” Expansionary monetary policy lowers interest rates and increases I; this will be inflationary unless fiscal policy offsets it.
4. Targets, Instruments, and Policy: A Model Recalled , there are four situations when there are internal and external imbalances: Case I: BOP deficit; unacceptably rapid inflation, Case II: BOP surplus; unacceptably high unemployment, Case III: BOP deficit; unacceptably high unemployment, and Case IV: BOP surplus; unacceptably rapid inflation.
5. The Mundell-Fleming Diagram i Internal Balance IV II External Balance I To achieve internal and external balance, fiscal and monetary policy must both be used. III G-T
6. General Equilibrium in the Open Economy: the IS/LM/BP Model To understand the effects of policies on the open economy, we need to use a general equilibrium model. The IS/LM/BP model is built around three sorts of equilibria: money market equilibrium (the LM curve), real sector equilibrium (the IS curve), and BOP equilibrium (the BP curve).
8. Money Market Equilibrium: the LM Curve The LM curve comprises all combinations of the interest rate (i) and income (Y) such that money supply and money demand are equal.
9. Money Market Equilibrium: the LM Curve Money supply is assumed to equal money demand. Money supply is fixed. Money demand depends inversely on the interest rate (i) and positively on income (Y). As interest rates rise, the opportunity cost of holding money rises, and so the quantity demanded of money decreases. As income rises demand for money increases.
10. Money Market Equilibrium: the LM Curve Ms i At i1, Ms>Md: people will buy bonds, reducing i. At i2, Ms<Md: people will sell bonds, increasing i. i1 ie L = f(i,Y) i2 money
11. Money Market Equilibrium: the LM Curve If income rises, money demand will exceed money supply, and interest rates will rise. Therefore, the LM curve is the positive relationship between the interest rate and income (Y). Points to the left of the LM curve mean there is an excess supply of money; points to the right imply an excess demand.
13. Money Market Equilibrium: the LM Curve Increases in Ms or decreases in Md will shift LM to the right. Decreases in Ms or increases in Md will shift LM to the left. i LM income
15. Real Sector Equilibrium: the IS Curve The IS curve comprises all combinations of the interest rate (i) and income (Y) such that the real sector of the economy is in equilibrium.
16. Real Sector Equilibrium: the IS Curve Investment should depend inversely on the interest rate (i). As interest rates rise, the cost of borrowing rises, so I falls. As before, consumption (C) depends positively on income (Y). Also, exports (X) and government spending (G) are fixed.
17. Real Sector Equilibrium: the IS Curve The IS curve is the relationship between the interest rate and Y. As the interest rate falls, investment increases, thereby increasing Y. As the interest rate rises, investment decreases, thereby decreasing Y. Therefore, the IS curve is downward- sloping.
19. Real Sector Equilibrium: the IS Curve Increases in autonomous I, X, G or decreases in T will shift IS to the right. Decreases in autonomous I, X, G or increases in T will shift IS to the left. i IS income
21. BOP Equilibrium: the BP Curve The BP curve comprises all combinations of the interest rate (i) and income (Y) such that the balance of payments is in equilibrium.
22. BOP Equilibrium: the BP Curve The BP curve is the relationship between the interest rate and Y. If Y increases and i is unchanged M will increase BOP deficit will open. To return to BOP balance, i must rise. This would trigger net short-term capital inflows. Therefore, the BP curve is upward- sloping.
24. BOP Equilibrium: the BP Curve Points to the left of the BP curve imply a BOP surplus. Points to the right of the BP curve imply a BOP deficit. i BP BOP deficit BOP surplus income
25. BOP Equilibrium: the Slope of the BP Curve The slope of the BP curve depends on how responsive short-term private capital flows are to changes in the interest rate. Points to the right of the BP curve represent BOP deficits, triggering an increase in i, which would cause in increase in capital inflows. If capital inflows are very responsive, a small Δi will bring us back to BOP equilibrium (that is, a relatively flat BP curve).
26. BOP Equilibrium: the Slope of the BP Curve The typical upward slope of the BP curve results from impediments to capital flows or when the country is large enough to influence international interest rates. The upward-sloping BP represents “imperfect capital mobility.”
27. BOP Equilibrium: the Slope of the BP Curve Capital could be perfectly mobile. This would occur if any deviation of the domestic i away from the international rate immediately triggered capital flows that brought interest rates back in line. When capital is perfectly mobile, the BP curve is a horizontal line.
28. BOP Equilibrium: the Slope of the BP Curve Capital could be perfectly immobile. If a country fixes its exchange rate, it typically maintains strict foreign exchange controls. When capital is perfectly immobile, the BP curve is a vertical line.
29. BOP Equilibrium: the BP Curve A depreciation of the home currency, an autonomous increase in exports, or an autonomous decrease in imports will shift BP to the right. An appreciation of the home currency, an autonomous decrease in exports, or an autonomous increase in imports will shift BP to the left. i BP income
30. Equilibrium in the Open Economy LM i BP Only at point E is the economy in full equilibrium. E iE IS YE income
31. Equilibrium in the Open Economy: Adjustments Suppose exchange rates are fixed. How does the system adjust to a “shock” such as an increase in foreign income? This should increase exports Shifting BP rightwards to BP′.
33. Equilibrium in the Open Economy: Adjustments Suppose exchange rates are fixed. How does the system adjust to a “shock” such as an increase in foreign income? This should increase exports Shifting BP rightwards to BP′. The IS curve will shift rightwards to IS′.
35. Equilibrium in the Open Economy: Adjustments Suppose exchange rates are fixed. How does the system adjust to a “shock” such as an increase in foreign income? This should increase exports Shifting BP rightwards to BP′. The IS curve will shift rightwards to IS′. To maintain the fixed exchange rate, the central bank must purchase the surplus foreign currency; this shifts LM rightwards to LM′. Eventually, a new equilibrium is reached at E''.
36. Equilibrium in the Open Economy LM i LM' BP BP' E i* i'' E'' IS' IS Y* Y'' income
38. Fiscal Policy Under Fixed Exchange Rates With perfect capital immobility Fiscal stimulus initially increases Y and M (and also i) Because capital is immobile, a BOP deficit emerges,
39. Fiscal Policy Under Fixed Exchange Rates BP LM i Perfect capital immobility E iE IS IS' YE income
40. Fiscal Policy Under Fixed Exchange Rates With perfect capital immobility Fiscal stimulus initially increases Y and M (and also i) Because capital is immobile, a BOP deficit emerges, Decreasing the money supply Increasing i further. In the end, Y returns to its original level The fiscal stimulus completely crowds out domestic investment (I).
41. Fiscal Policy Under Fixed Exchange Rates LM' BP LM i Perfect capital immobility E' i' E iE IS IS' YE income
42. Fiscal Policy Under Fixed Exchange Rates With perfect capital mobility, any fiscal stimulus increases Y and M i does not rise due to capital inflows.
43. Fiscal Policy Under Fixed Exchange Rates LM i Perfect capital mobility BP E iE IS IS' YE income
44. Fiscal Policy Under Fixed Exchange Rates With perfect capital mobility, any fiscal stimulus increases Y and M i does not rise due to capital inflows. To maintain the fixed exchange rate, the central bank must increase the domestic money supply. In the end, Y rises, but i stays the same.
45. Fiscal Policy Under Fixed Exchange Rates LM i LM' Perfect capital mobility E' BP E iE IS IS' YE Y' income
46. Fiscal Policy Under Fixed Exchange Rates The bottom line: When capital is relatively mobile, Fiscal policy is more effective at increasing national income. When capital is relatively immobile Fiscal policy is less effective at increasing national income.
48. Monetary Policy Under Fixed Exchange Rates With perfect capital immobility Monetary stimulus initially increases Y and M (and lowers i) Because capital is immobile, a BOP deficit emerges. The central bank must sell foreign exchange (decreasing the money supply) to maintain the fixed exchange rate. In the end, the LM curve returns to its original place The monetary stimulus doesn’t change Y.
49. Monetary Policy Under Fixed Exchange Rates LM LM' BP i Perfect capital immobility E iE IS YE income
50. Monetary Policy Under Fixed Exchange Rates With perfect capital mobility Monetary stimulus increases Y and M But i does not fall due to capital inflows. Again, to maintain the fixed exchange rate, the central bank must decrease the domestic money supply. In the end, the LM curve returns to its original place The monetary stimulus doesn’t change Y.
51. Monetary Policy Under Fixed Exchange Rates LM i LM' Perfect capital mobility BP E iE IS YE income
52. Monetary Policy Under Fixed Exchange Rates The bottom line: When capital is relatively mobile Monetary policy is ineffective at increasing national income. When capital is relatively immobile Monetary policy is ineffective at increasing national income. Maintaining a fixed exchange rate system means losing monetary policy as an effective tool.
54. Effects of Official Changes in the Exchange Rate System To maintain a fixed exchange rate system, A country would not want to devalue or revalue the currency often. However, such policy actions are occasionally required: what will be the effects?
55. Effects of Official Changes in the Exchange Rate System If the home country’s exchange rate is devalued Exports rise and imports fall. This shifts both the IS and BP curves rightward. The money supply must be expanded Central bank must buy foreign exchange. This means the LM curve also shifts rightward. The devaluation increases Y.
56. Effects of Official Changes in the Exchange Rate System The bottom line: When capital is relatively immobile Devaluation increases national income. When capital is relatively mobile Devaluation increases national income to an even greater extent.