IS-LM-BP model of Ireland, as a country receiving financial assistance

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Oct 28, 2013 (3 years and 10 months ago)

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IS
-
LM
-
BP model of Ireland, as a country receiving financial assistance


Viliam Páleník

Institute of Economic Research SA
S
, Bratislava, Slovakia

European Economic and Social Committee, Brussels, Belgium

Introduction

Ireland is currently receiving financial

help from the European Union and International
Monetar
y Fund.
1

The condition for doing so is having accepted recommendations from joint
experts of European Commission, European Central Bank and International Monetary Fund.
Macroeconomic stabilization toge
ther with fiscal restriction are also part of those. As it often
happens, these recommendations are being criticized because of its need for expansive fiscal
policy in the periods of recession. The aim of this article is to contribute to this discussion by

constructing macroeconomic model of Ireland and present its quantitative and qualitative
analysis.

The article contains macroeconomic mathematical analysis of Ireland on the basis of
macroeconomic model IS
-
LM
-
BP. It discusses its validity in the period be
tween 1999 and
2011. We also consider the period before beginning of the crisis, depending on how the
parameters of the model have changed since then and also whether it was possible to detect
the potential problems even at the time. The imbalances of prin
cipal economic indicators are
discussed as well.

Basic macroeconomic indicators of Ireland

Irish macroeconomic indicators had developed in very positive way in previous decades,
country was considered to be economically successful and was fulfilling Maast
richt criteria as
a difference to Portugal or Greece. They obliged the pact of stability and growth:

-
inflation lowered under 5% at the end of 80s

-
government debt was less than 40% at the beginning of new millennium

-
the unemployment rate dropped from 15
% in 80s to 5% in new millennium

-
economic growth measured by annual GDP growth was on 10% and never below 5%.
2

Since the beginning of the crisis in autumn 2008 the situation in Ireland has changed
dramatically. It was surprising that this country got itse
lf to serious economic difficulties
which even lead it to apply for foreign support. Here the question has to be asked, are usual
basic macroeconomic indicators accurate enough to indicate the imbalances of economy? Was



1

European Union, Economic and Financial Affairs

2

GRACZOVÁ, D.
-

PÁLENÍK, V.,
2012, pp.
14
-
18

the crisis all about the “bad” finan
cial institutions and stock markets or was it only a logical
consequence of wrong economy policy? To answer these questions, it is insufficient to only
discuss the timeline of the indicators, therefore we have constructed the macroeconomic
model.

Models
3

Speaking of economic model we understand clear, simplified view of reality with ambition of
capturing the important and influential aspects of it, neglecting all the others. Given the aim
of this article, we concentrate on Keynesian theory, as this theory

was based on the 30s
economic crisis with the goal of restructuring and highering employment and growth. Since
then however, the theory has spread to various interpretations and studies, although the
national economies have changed as well. In the case of

Ireland we consider following
relevant: it has opened itself for international trade and financial transactions and is a member
of monetary union. We will use IS
-
LM
-
BP model as interpretation of Keynes in the
conditions of open economy.

In order to imply

the method of lowering abstraction it is necessary to mention another two
models, which are considered to be the forerunners of IS
-
LM
-
BP. Standard IS
-
LM model
acknowledges closed economy, it gives balance on the market of goods and on this of money.
Mund
ell
-
Fleming model is an expansion of IS
-
LM model, it takes into account also
international trade as well as the exchange rate, therefore it is more appropriate model for
countries with open economies. We estimate the linear regressions using the least squa
re
method and test the null hypothesis of given linear regression and its parameters. The
benchmark for being statistically significant we take as 5%, marked with *. If the tested
element is significant even for the benchmark 1%, we call it highly signific
ant and mark with
**.

IS
-
LM Model

This model illustrates the balance of money and capital market in closed economies. It is
related to Hicks interpretation of Keynes theory (R.Parke), (B.Felderer, S. Homburg 1995).
Model consists of two equations, containi
ng two endogenous variables, pension and interest
rate. In normal conditions there is only one solution to this problem, which lies on the
intersection of two curves.

(IS)


Y

= C(Y
-
T) + I(r,Y) + G


(1)

(LM)

M/P

= L(Y,i)


(2)


r

= i
-

π



(3)

Model is graphically clear and mathematically very simple. In macroeconomic studies it is
often discussed very broadly, including specific scenarios such as investment trap and
liquidity trap. It is also frequently criticized. In the light of our purpose,

it is important that



3

GRACZOVÁ, D.
-

PÁLENÍK, V.,
2012, pp.
18
-
30

IS
-
LM model abstracts the outside economic relations, which in the case of Ireland is in our
opinion relevant factor. Although we believe this model is clear and simple, for our research
needs it doesn’t enclose factors which are rele
vant at the place.

Mundell
-
Fleming Model

Mundell
-
Fleming model is modified IS
-
LM model for analysis of open economies. The
equation of the goods market is therefore enriched by net export
NX

being depending on
exchange rate and outside demand (R. Parke),
(
B. Felderer, S. H
omberg 1995), (M. Luptáčik
et al. 2006), (K. Morvay et al
. 2005)
.

The system of equations takes following form

(IS)


Y

= C(Y
-
T) + I(r,Y) + G +
NX(ε,FD,Y)


(4)

(LM)

M/P

= L(Y,i)


(2)


r

= i
-

π


(3)

For constructing this model, Mundell and Fleming were awarded Nobel prize for economy. It
illustrates a logical reaction of rising volume of international goods and trade of services.
Model itself is widespread around the globe, has few different vers
ions and extensions. It is in
part more sophisticated than IS
-
LM model, but is still clear, graphically viewable and
mathematicaly simple.

In this model we only take into consideration international trade of goods. Nowadays
however, countries are mainly ha
ving problems with financial flows, therefore we do not
consider this model to be suitable either.

IS
-
LM
-
BP Model

As difference to previous projections, IS
-
LM
-
BP model takes into consideration balance of
capital and financial account for given country. Th
is is done through the inflow of net capital.
The principle of equality in payment balance from definition is approximated by zero sum of
net export and net inflow of capital. This model offers us perspective of exchange rate being
endogenous variable. We
discuss following form of the model
(M. P
áleník, 2004) , (V.
Kvetan et al
. 2007):

(IS)


0

= C(Y
-

T) + I(r,Y) + G +
NX(ε,FD,Y)
-

Y

(5)

(LM)

0

= L(Y,i)
-

M/P

(6)

(BP)

0

= NX(ε,FD,Y) + NK(ud)

(7)

where





r

= i
-

π

(8)


ud

= i + E(de)


if
-

RP

(9)


IS curve states the balance in the goods market. The first part is private consumption given as
increasing function of disponible income
(Y
-
T),
where exogenous variable
T
indicates the
amount of taxes. Then we have investments, increasing together with
Y

and decreasing with
growing interest rate. As third come government expenses, in this model being exogenous
variable. Fourth component represents the connection with foreign countries via net export,
which is given by the difference of export and import.
It is function of real exchange rate, real
pension
Y

and foreign demand. Rate depreciation leads to increase in export and decrease in
import. Growing foreign demand
FD

leads to increased export and hence to increase in net
export
NX.

This particle also sh
ows as exogenous variable. The last component defines the
condition of balance, stating that sum of individual parts of income has to be equal to its level.

LM curve shows us balance on domestic money market. In general, the rule is that total
money suppl
y, generated by national bank and banking sector has to be equal to demand for
money, generated by households, companies and government. The supply is represented by
M/P
, where
M

is total nominal money supply generated by banking sector and
P

(CPI) is a
price index. Both of these variables are exogenous in the model.

BP curve expresses balance on the foreign exchange market. The payment balance consists of
common, capital and financial account, where common account will be represented by net
export in the model, which is already defined in IS curve. It moves positively with foreign
demand, opposite to total
Y

and exchange rate
e
. capital and financial accounts are represented
by inflow of net capital
NK
, which is increasing function of interes
t differential, given by
relation (9). Interest differential is the difference between domestic and foreign exchange rate,
corrected by expected change in exchange rate
E(de)
and risk premium
RP
.

Components of given curves are modeled as lineary dependent

given by following formulas:

C(Y)

= a + b(Y


T)

(10)

I(r,Y)

= c


d
1
r + d
2
Y

(11)

NX(ε,FD,Y)

= EX(ε,FD)
-

IM(ε,Y)

(12)

EX(ε,FD)

= l
1



l
2
ε + l
3
FD

(13)

IM(ε,Y)

= m
1

+ m
2
ε + m
3
Y

(14)

L(Y,i)

= h + gY
-

fi

(15)

NK(ud)

= k
1

+ k
2
ud

(16)


Endogenous variables in the model are
Y

as total product,

i

as domestic interest rate,
e

as
nominal exchange rate given as the amount of foreign units for one domestic unit,
ε

is

real
exchange rate.

IS
-
LM
-
BP can be considered as Hick’s interpretation of Keynes for an open economy. It is
also a

model, which is acceptable in its cleariness and mathematical simplicity, though not
trivial. Model can be standard and expanded, nevertheless in critical and s
pecial scenarios it is
less discussed than IS
-
LM. The reason for this might be relatively new composition, together
with more complexity and less visibility.

Model works with real effective exchange rate which brings an obstacle in the case of Ireland
as
for choosing the right statistical indicator. In accordance with our hypothesis IS
-
LM
-
BP is
suitable for analysis of the situation in Ireland and for creating economic and political
implications.

IS
-
LM
-
BP Model of Ireland

In Table 1 we can see that marginal propensity to consume
b

in ireland is 0,64, and is even
lower than in the years before crisis. In equation (15) for LM curve the nominal short
-
term
interest rate is shown only in period 1999
-
2011, but it bears opposite m
ark compared with
expectations (
f
). In this period also the statistical significance of interest rate in equation (11)
for investment (
d
1

) is shown. Until 2008 there was no proven interest rate to fit into equation
(11). Purchasing power parity
(
l
2
) is s
hown in export equation (14), hence with increasing
value of
PPP

export is decreasing and vice versa. In import equation purchasing power parity
(
m
2
)
was not proved. Ireland model includes following:

(IS)


0

= C(Y
-

T) + I(r,Y) + G + NX(ε,FD,Y)
-

Y

(5I)

(
LM)

0

= L(Y,i)
-

M/P

(6I)

(BP)

0

= NX(ε,FD,Y) + NK(ud)

(7I)


Table 1

Parameters of the model for Ireland
4



1999q1


2011q2


1999q1


2007q4



a

1 061,81



416,3



b

0,64

**

0,66

**

c

968,18



-
1 963,54

*

d1

408,3

**

0



d2

0,23

**

0,3

**

h

-
536,14



-
789,32

**

g

0.05

**

0,05

**

f

-
35,15

*





k1

-
5

497,79

**





k2

-
1

379,72

*





PPP









l1

54

882,64

**

48

926,22

**

l2

50

129,92

**

45

557,82

**

l3

0,12

**

0,13

**

m1

-
6

080,35

**

-
5

093,96

**

m2









m3

0,85

**

0,82

**



With IS
-
LM
-
BP model of Ireland we get the results shown in Table 2. This is obtained
through real exchange rat
e defined as ratio of production and consumption

price index and
purchase power parity. For equations (13) and (14), ratio
PPI/CPI

has proved not

to be
significant on required significance level, although for benchamrk set on 7%, it has come as
significant in equation (14), and therefore was included in model. We can compare results
with those obtained by choosing
PPP
. Outputs which came out other
that expected, are



4

GRACZOVÁ, D.
-

PÁLENÍK, V.,
2012, p
. 51

highlighted. Those are clear to influence nominal interest rate, which is caused by adversive
relation of liquidity from interest rate.

Restrictive fiscal policy has negative impact on GDP, hence 1 billion euro cutback in
government cos
ts will cause drop 0,72 billion euro in GDP. Furthermore, 1 billion increase in
tax revenues will lead to 0,46 billion euro drop in GDP. In adddition, restrictive fiscal policy
will higher interest rates.

Increase in risk premium causes decline in GDP. Dir
ect foreign loan of 1 billion euro will
result in 0,7 billion GDP downfall, on the contrary sterilized direct investment of 1 billion
euro will lead to 0,92 billion increase in GDP.


T able 2

IS
-
LM
-
BP model of Ireland results for period 1999q1
-
2011q2
5


Y

i

e (PPI/CPI)

e (PPP)

Fiscal policy

G

0,72224

-
0,00093

0,00001

0,00004

T

-
0,45979

0,00059

-
0,00001

-
0,00002

Monetary policy

M

0,20209

0,00021

0

-
0,00001

Fiscal and monetary policy

G, M

>0

<0

>0

>0



(t1,t2)
6

(t1,t2>0)

(t1>2*t2
-
0,1)


(t1>
2*t2
-
0,1)

RP

-
996,49436

1,27876

0,00928

0,03126

Foreign demand

FD, if

>0

<0

<0

<0



(t1,t2)

(t1,t2)

(t1,t2)

(t1,t2)

FD

0

0

0,000004

0,00001

Direct loan

PP

-
0,72224

0,00093

0,00001

0,00002

Direct investment







PI

0

0

0,00002

0,00006

Sterilized direct investment

SPI

0,92433

-
0,0009

0,00001

0,00002


For period prior crisis, nominal interest rate in LM equation (15) has not proved to be
significant, therefore the fiscal policy was shown to be ineffective.

Conclusion

Ireland used to be country known as “The Celtic Tiger”. GDP growth set on high level,
government debt was reducing, unemployment dropped in large in 2000 and until the crisis
held under 5%. The economic indicators were very optimistic for this country, eve
n showing



5

GRACZOVÁ, D.
-

PÁLENÍK, V.,
2012, p
. 52

6

Coefficients by which government spending G and money supply M is multiplied. If greater than 1, expansive
policy takes place,
if less than 1, restriction is set. Thus, t1, t2 represent intensity of either restrictive or
expansive policy.

overheating of economy (real estate boom). Hence Ireland suffered considerably from the
crisis, with consequences apparent throughout all sectors of economy.

For small, open economy, we get very similar results from IS
-
LM
-
BP model and Mundell
-
Fl
eming model. During the analysis, we observed balanced situation for different values of
,
both in the period prior and after beginning of crisis. IS
-
LM
-
BP model has furthermore
verified and precised its results.

In the case of Ireland, we rec
ognise little changes while
lowering the abstraction of analysed models. Therefore, we can imply that real influence of
exogenous variables will be close to those obtained in our model.

IS
-
LM
-
BP model or Ireland is rather similar to the basic one, economy

is not in fiscal trap and
foreign investment in combination with monetary sterilization seem to be appr
opriate and
rewarded
.


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-

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-

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ÁLENÍK, V.,
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-
LM
-
BP modelu”, in P
áleník, V.
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,
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