IS LM Model 5

MOOCS by Dr. Subir Maitra
Course Name: M.Com Year: First
Session: 2017-18
Paper- 1.3
Macroeconomics and Business Environment
Module: One
University of Calcutta
Department of Commerce
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs 1

General Equilibrium: Aspects of Closed
Economy--Commodity Market and Money
Market Equilibrium--IS-LM Approach.
LECTURE-10
OPEN ECONOMY IS-LM MODEL: THE MUNDELL–FLEMING MODEL
2

Economies that are open, as all economies are to some
extent, have trade and capital flows with other economies.
We now consider monetary and fiscal policy in an open
economy model.
There are several open economy macroeconomic
frameworks. We shall discuss the Mundell–Fleming model,
often called the ‘workhorse model’ for open economy
macroeconomics.
3

❑ The Mundell–Fleming model is an open economy version of the IS − LM
model.
❑ The closed economy IS − LM model consists of the following two
equations:
C (Y-T) + I(r) + G0 = Y
K(Y) + L(r) = 𝑀
𝑃
❑ The first equation gives the goods market equilibrium ( IS schedule) and
the second equation the money market equilibrium (LM schedule).
❑ The model simultaneously determines the nominal interest rate ( r ) and
the level of real income ( Y ), with the aggregate price level held constant.
4MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs

The Mundell–Fleming Model
Money Market in an Open Economy:
• In case of an open economy, there is no change in Money Market and
therefore, no change in the LM schedule.
• Thus, K(Y) + L(r) = 𝑀
𝑃
continues to depict the money market equilibrium for
an open economy.
• This equation states that the real money supply, which we assume to be
controlled by the domestic policy maker, must, in equilibrium, be equal to
the real demand for money. It is the nominal supply of money that the
policy maker controls, but with the assumption of a fixed price level,
changes in the nominal money supply are changes in the real money
supply as well.

• Goods Market in an Open Economy:
• In case of an open economy, there will be changes in the Goods Market
and therefore, some change in the IS schedule.
• As we add imports ( Z ) and exports ( X ) to the model, equation
C (Y-T) + I(r) + G0 = Y is replaced by C (Y-T) + I(r) + G0 + (X-Z)= Y where (X− Z)
net exports, is the foreign sector’s contribution to aggregate demand.
• Since C + I + G + (X –Z) = C + S + T, we can rewrite the above equation as:
I(r) + G0 + (X--Z) = S(Y—T(Y)) + T(Y)
Consumption and Investment:
• Consumption and investment are the same as in the closed economy
model.
6

Imports:
• Imports depend positively on income and negatively on the exchange rate.
Z = Z(Y, π), > 0 ; < 0
• As the income level of the economy increases, people start importing more goods
from the other countries.
• The exchange rate is defined as the price of foreign currency—for example, U.S.
Dollar per Euro. A rise in the exchange rate will, therefore, make foreign goods
more expensive and cause imports to fall.

Exports:
• U.S. exports are other countries’ imports and thus depend positively on foreign income
( ) and the exchange rate:
X = X( , π), X > 0; > 0
• The latter relationship follows because a rise in the exchange rate lowers the cost of dollars
measured in terms of the foreign currency and makes U.S. goods cheaper to foreign
residents.
Product Market Equilibrium Condition:
• Thus, the product market equilibrium condition can be written as:
I(r) + G0 + [X( , π) — Z(Y, π)] = S(Y—T(Y)) + T(Y)
From this equation, the IS schedule is obtained for the open economy.

• High values of the interest rate will result in low levels
of investment. To satisfy equation
I(r) + G0 + [X( , π) — Z(Y, π)] = S(Y—T(Y)) + T(Y)
at such high levels of the interest rate, income must
be low so that the levels of imports and saving will be
low.
▪ Alternatively, at low levels of the interest rate, which
The open economy IS schedule is also downward sloping, as shown in the Figure.
result in high levels of investment, goods market equilibrium requires that saving and
imports must be high; therefore, Y, must be high.

• In constructing the open economy IS schedule
in the Figure, we hold four variables constant:
taxes, government spending, foreign income,
and the exchange rate. These are variables that
shift the schedule.
• Expansionary shocks, such as an increase in
government spending, a cut in taxes, an
increase in foreign income, or a rise in the
exchange rate, shift the schedule to the right.

•A rise in foreign income is expansionary because it
increases demand for our exports.
• A rise in the exchange rate is expansionary both
because it increases exports and because it reduces
imports for a given level of income; it shifts demand
from foreign to domestic products.
•An autonomous fall in import demand is
expansionary for the same reason.
•Changes in the opposite direction in these variables
shift the IS schedule to the left.

• In addition to the IS and LM schedules, our
open economy model contains a balance of
payments equilibrium schedule, the BP
schedule in the Figure.
• This schedule plots all interest rate–income
combinations that result in balance of
payments equilibrium at a given exchange rate.
• Balance of payments equilibrium means that
the official reserve transaction balance is zero.
• The equation for the BP schedule can be
written as:
X( , π) — Z(Y, π) + F(r -- ) = 0

• The first two terms in equation
X( , π) — Z(Y, π) + F(r -- ) = 0
constitute the trade balance (net exports).
• The third item ( F ) is the net capital inflow (the surplus
or deficit in the financial account in the balance of
payments. The net capital inflow depends positively on
the domestic interest rate minus the foreign interest
rate ( r − ).
• A rise in the U.S. interest rate relative to the foreign
interest rate leads to an increased demand for U.S.
financial assets (e.g., bonds) at the expense of foreign assets; the net capital inflow
increases.
• A rise in the foreign interest rate has the opposite effect. The foreign interest rate is
assumed to be exogenous.

• The BP schedule is positively sloped, as shown in the
Figure.
• As income rises, import demand increases, whereas
export demand does not. To maintain balance of
payments equilibrium, the capital inflow must increase,
which will happen if the interest rate is higher.
Factors shifting the BP schedule:
• An increase in π will shift the schedule horizontally to the
right. For a given level of the interest rate, which fixes the
capital flow, at a higher exchange rate, a higher level of
income will be required for balance of payments equilibrium.
• The reason is that the higher exchange rate encourages exports and discourages
imports; thus, a higher level of income that will stimulate import demand is needed
for balance of payments equilibrium. 14
MOOCS by Dr. Subir Maitra, Associate Professor of Economics, HCC, Guest Faculty, Department of Commerce, University of Calcutta, subirmaitra.wixsite.com/moocs

• Similarly, an exogenous rise in export demand (due to a rise
in ) or a fall in import demand will shift the BP schedule to
the right.
• If exports rise—for example, at a given interest rate that
again fixes the capital flow—a higher level of income and
therefore of imports is required to restore the balance of
payments equilibrium.The BP schedule shifts to the right.
• A fall in the foreign interest rate would also shift the BP
schedule to the right; at a given domestic interest rate ( r )
the fall in the foreign interest rate increases the capital inflow. For equilibrium in the
balance of payments, imports and therefore income must be higher.

Imperfect capital mobility:
• The BP schedule will be upward sloping in the case of
imperfect capital mobility . For this case, domestic and
foreign assets (e.g., bonds) are substitutes, but they are
not perfect ones.
• If assets are less than perfect substitutes, their interest
rates need not be equal.
• Factors that might make assets in foreign countries less than perfect substitutes for
a country’s assets include differential risk on the assets of different countries, risks
due to exchange rate changes, transaction costs, and lack of information on
properties of foreign assets.
• Such factors are sufficient to make foreign and domestic assets less than perfect
substitutes.

Perfect capital mobility:
• If domestic and foreign assets were perfect
substitutes, a situation called perfect capital mobility,
investors would move to equalize interest rates among
countries. If one type of asset had a slightly higher
interest rate temporarily, investors would switch to that
asset until its rate was driven down to restore equality.
• In the context of our model, perfect capital mobility
implies that r = . This equality implies a horizontal BP
schedule.

Monetary Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• We now consider the effects of an increase in
the money supply from M0 to M1. The increase
in the money supply shifts the LM schedule to
the right, from LM(M0) to LM(M1).
• The equilibrium point shifts from E0 to E1, with
a fall in the interest rate from r0 to r1 and an
increase in income from Y0 to Y1 .
• We know that all points below the BP
schedule are points of balance of payments
deficit, whereas all points above the schedule
are points of surplus.
18

• As we move from an equilibrium point on the BP
schedule to points below the schedule—for example,
increasing income or reducing the interest rate, or
both—we are causing a deficit in the balance of
payments.
• Consequently, as we move from point E0 to point E1
after the increase in the money supply, the balance
of payments also moves into deficit.
• The expansionary monetary policy increases income,
stimulating imports and lowers the interest rate
thereby causing a capital outflow (F declines).
19

• Thus, when an economy is in equilibrium, an
expansionary monetary policy leads to a balance of
payments deficit. This raises potential conflicts
between domestic policy goals and external balance.
• If at point E0 in the Figure, the level of income, Y0, is low
relative to full employment, then the move to point E1
and income level Y1 may well be preferable on domestic
grounds. But at point E1 there will be a deficit in the
balance of payments, and with limited foreign exchange
reserves, such a situation cannot be maintained
indefinitely.

Fiscal Policy under Fixed Exchange Rates with Imperfect Capital Mobility
• The effects of an increase in government spending
from G0 to G1 are illustrated in the Figure.
• The increase in government spending shifts the IS
schedule to the right from IS(G0) to IS(G1), moving the
equilibrium point from E0 to E1. Income rises from Y0
to Y1 , and the interest rate rises from r0 to r1 .
• At the new equilibrium point we are above the BP
schedule; there is a balance of payments surplus.
• We get this result because in the Figure the BP
schedule is flatter than the LM schedule.
21

• If the BP schedule were steeper than the LM schedule,
an expansionary fiscal policy action would lead to a
balance of payments deficit, as can be seen in this
Figure.
• The BP schedule will be steeper, the less responsive
capital flows are to the rate of interest. The smaller the
increase in the capital inflow for a given increase in the
interest rate (given the fixed value of ), the larger will
be the rise in the interest rate required to maintain
balance of payments equilibrium as we go to a higher
income (and hence import) level; that is, the steeper
will be the BP schedule.
22

• The BP schedule will also be steeper the larger
the marginal propensity to import.
• With a higher marginal propensity to import, a
given increase in income will produce a larger
increase in imports.
• For equilibrium in the balance of payments, a
larger compensatory increase in the capital
inflow and consequently a larger rise in the
interest rate will be required.
23

• The expansionary fiscal policy action depicted in above two Figures causes income to increase.
Increased income leads to a deterioration in the trade balance and causes the interest rate to
rise, resulting in an improvement in the financial account.
• The steeper the BP schedule, the larger the unfavorable effect on imports and the trade balance
and the smaller the favorable effect on capital flows. Therefore, the steeper the BP schedule,
the more likely it becomes that an expansionary fiscal policy action will lead to a balance of
payments deficit.
24

• Thus, the slope of the BP schedule relative to the slope of the LM schedule determines whether
an expansionary fiscal policy action will result in a balance of payments surplus or deficit.
• Given the slope of the BP schedule, the steeper the LM schedule, the more likely it is that the
LM schedule will be steeper than the BP schedule, the condition required for a surplus to result
from an expansionary fiscal policy action.
• This result follows because, other things being equal, the steeper the LM schedule, the larger
the increase in the interest rate (which produces the favorable capital inflow) and the smaller
the increase in income (which produces the unfavorable effect on the trade balance).
25

Monetary Policy under Flexible Exchange Rates with Imperfect Capital Mobility
• When the exchange rate is completely flexible,
exchange rate adjusts to equate supply and demand in
the foreign exchange market.
• Now, suppose, there is an increase in the quantity of
money from M0 to M1 . The effects of this expansionary
monetary policy action in the flexible exchange rate
case are illustrated in the Figure.
• The initial effect of the increase in the money supply—
the effect before an adjustment in the exchange rate—
is to move the economy from point E0 to point E1.
• The interest rate falls from r0 to r1 . Income rises from
Y0 to Y1, and we move to a point below the BP
schedule where there is an incipient balance of
payments deficit.
26

• In a flexible exchange rate system, the exchange
rate will rise (from to ) to clear the foreign
exchange market.
• The rise in the exchange rate will shift the BP
schedule to the right; in the Figure, BP schedule
shifts from BP ( ) to BP ( ).
• The rise in the exchange rate also causes the IS
schedule to shift to the right, from IS ( ) to
IS( ) in the Figure, because exports rise and
imports fall with an increase in the exchange rate.
• The new equilibrium is shown at point E2 , with
the interest rate at r2 and income atY2 .
27

• The exchange rate adjustment re-equilibrates the
balance of payments after the expansionary monetary
policy and eliminates the potential conflict between
internal and external balance.
• The rise in income as a result of the expansionary
monetary policy action is greater in the flexible rate
case than in the fixed rate case.
• With a fixed exchange rate, income would rise only to
Y1. With a flexible exchange rate, the rise in the
exchange rate would further stimulate income by
increasing exports and reducing import demand (for a
given income level).
• Monetary policy is therefore a more potent
stabilization tool in a flexible exchange rate regime
than in a fixed rate regime.
28

Fiscal Policy under Flexible Exchange Rates with Imperfect Capital Mobility
• Figure illustrates the effects of an increase in government
spending from G0 to G1 with a flexible exchange rate.
• The initial effect i.e. the effect before the adjustment in the
exchange rate, is to shift the IS schedule from IS(G0, ) to
IS( G1, ) and move the economy from E0 to E1.
• The interest rate rises (from r0 to r1), and income increases
(from Y0 to Y1). With the slopes of the BP and LM
schedules as drawn in this Figure (with the BP schedule
flatter than the LM schedule), an incipient balance of
payments surplus results from this expansionary policy
action.
• In this case, the exchange rate must fall (from to )
to clear the foreign exchange market. A fall in the exchange
rate will shift the BP schedule to the left in the Figure, from
BP ( ) to BP ( ).
29

• The IS schedule will also shift left, from
IS(G1, ) to IS(G1, , ), because the fall in
the exchange rate will lower exports and
stimulate imports. The exchange rate
adjustment will partially offset the
expansionary effect of the fiscal policy
action.
• The new equilibrium point will be at Y2,
which is above Y0 but below Y1, the level
that would have resulted with the fixed
exchange rate.
30

• There is not, however, a definite relationship
between the potency of fiscal policy and the
type of exchange rate regime, as there is with
monetary policy.
• Had the BP schedule been steeper than the
LM schedule, an expansionary fiscal policy
would, for a given exchange rate, have caused
a balance of payments deficit.
• With an incipient balance of payments deficit
in the flexible exchange rate regime, the
exchange rate must rise to restore equilibrium
in the foreign exchange market.

• The BP schedule and the IS schedule will shift to the
right and reinforce the initial expansionary effect of the
increase in government spending. In this case, the
expansionary fiscal policy action would have a larger
effect on income than it would in the fixed exchange
rate case.
• Although this alternative outcome is possible in theory,
most economists think the outcome in this Figure is
more likely. They believe an expansionary fiscal policy
will lower the exchange rate (raise the value of the
domestic currency).
• This belief follows from the view that there is a
relatively high degree of international capital mobility,
so the BP schedule is relatively flat and therefore likely
to be flatter than the LM schedule, as in this Figure.

IS LM Model 5

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