CHAPTER 21

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CHAPTER 18

OPEN
ECONOMY MACROECONOMICS: IS
-
LM
-
BP MODEL


Introduction



Everybody talks about the global economy but very few seem to understand how
external
factors

affect the
internal economy
:

-

Why does a financial crisis in Thailand affect the unemployment
rate in Mexico?

-

Why does a competitive devaluation of the Brazilian Real threaten the future expansion of
Mercosur?

How important is the “tequila effect”?

-

Why imposing a fixed ER with respect to the US dollar (
e
.
g.

Ecuador, Argentina) imposes
such high dom
estic costs? Why do countries do it, then?



We are going to develop the connections between the internal and external sides of the
economy, we are going to study how international factors affect domestic realities:

-

We will start with some basic notions of m
acroeconomics

-

We will continue by constructing some basic models (IS
-
LM
-
BP
,
open
AS
-
AD) to capture
the workings of the economy in a simplified and compact way.

-

We will finish by using those models to explain real
-
life economic policies (and their
limitatio
ns)


Macroeconomic Goals



At any given moment in time, economic policymakers are trying to achieve two
simultaneous goals:

-

Internal
balance
: full employment of resources (low unemployment

rate (4%
-
5%)
,
moderate
GDP
growth

(3%
-
4%)
) and price control (low inf
lation

(2%
-
3%)
)

-

External equilibrium
: this is difficult to define, since it does not necessarily imply a
balanced CA or KA, it depends on the country and their level of economic development.


Economic Policy Options



What are the economic policies available

to governments to achieve those objectives?



Expenditure changing policies (demand policies)
:

-

Fiscal Policy:


Taxes (
T
) or


Government Expenditure (
G
).

-

Monetary Policy:


Money Supply (
M
S
) so


Interest Rates (
i
)



Expenditure switching (from foreign to do
mestic) policies
:

-


ER, devaluation:

Exports and

Imports

-


ER, revaluation:

Exports and

Imports



Direct controls
:

-

Tariffs, to make imports more expensive.

-

Quotas, to limit the quantity of imports.

-

Capital controls (to block or facilitate capital mobility.
)


The IS
-
LM Model



The IS
-
LM model

is the basic framework that economic policy makers employ to analyze
the implications of alternative economic policies used to solve different economic
problems.

(e.
g.
: how can unemployment be reduced? how can we fight in
flation?)



This model represents the workings of the economy as the interaction between two curves:

-

The
IS

curve, showing the different combinations of real interest rates (
r
) and real output
(
Y
) that result in
equilibrium in the goods market
.

-

The
LM

curve,

showing the different combinations of real interest rates (
r
) and real output
(
Y
) that result in
equilibrium in the money market
.



Since we are dealing with an open economy, the external sector will be represented by:

-

The
BP

curve, showing the different co
mbinations of real interest rates (
r
) and real output
(
Y
) that result in
equilibrium in the balance of payments
.




This model is
based on Keynesian economic premises translated into graphs
and theories
by
1999
Nobel prize laureate

Robert A. Mundell
.

It is s
ometimes referred to as the
Mundell
-
Fleming model
.



There are some excellent on
-
line resources to review the workings of the model:

http://www.fgn.unisg.ch/eumacro/tutor/map.htm

as well as to practice with different policy scenarios on
-
line:

http://www.fgn.
unisg.ch/eumacro/IntrTutor/SGE02.html




Although this particular model faces the basic shortcoming of considering prices as being
fixed, we will adapt it later on to incorporate that price flexibility.



The IS Curve



The
IS

curve represents the equilibrium
points in the goods market: the combinations of
r

and
Y

for which investment (
I
) is equal to saving (
S
).



Remember that:

-

Investment is negatively related to the real interest rate and does not depend on the level
of real output / income.

-

Saving is positivel
y related to the real interest rate and also increases with income.

(Plotting that: see Saving
-
Investment diagram
)



The
IS

curve will then be downward sloping.




Shifts in the IS curve
:

-

The
IS

line shifts
right

if:




Expected future income increases:

S



W
ealth increases:

S



Taxes decrease:

S





S
(if Ricardian equivalence holds.)



Government expenditure increases:

S



Net Exports inc
rease
:

NX



MPK
increases:

I



Taxes on capital decrease:

I


-

The
IS

line shifts
left

if:




Expected future income d
ecreases:

S



Wealth decreases:

S



Taxes increase:

S





S
(if Ricardian equivalence holds.)



Government expenditure decreases:

S



Net
Exports
de
crease
:

NX



MPK
decreases:

I



Taxes on capital increase:

I




The IS curve is basically affected by
f
iscal policy

(



in
T

and
G
)

-

Expansionary

fiscal policy shifts the
IS

line
right

-

Contractionary

fiscal policy shifts the
IS

line
left

The LM Curve



The
LM

curve represents the equilibrium points in the money market: the combinations of
r

and
Y

for which mon
ey demand (
M
d
) is equal to money supply (
M
).



Remember that:

-

Money demand is negatively related to the real interest rate and depends on the level of
real output / income (because we use money for transaction purposes.)

-

Money supply is determined by the Fed
,
independent
ly

of real interest rate and real
income.

(Plotting that
:

s
ee
Money
market
diagram
)



The
LM

curve will then be upward sloping.




Shifts in the LM curve
:

-

The
LM

line shifts
right

if:



Money supply increases:

M.



Prices decrease:

M
d
.



Inflat
ionary expectations increase:

M
d
.


-

The
LM

line shifts
left

if:




Money supply decreases:

M.



Prices increase:

M
d
.



Inflationary expectations decrease:

M
d
.




The
LM

curve is basically affected by
monetary policy

(



in
M
)

-

Expansionary

monetary policy
shifts the
LM

line
right

-

Contractionary

monetary policy shifts the
LM

line
left



Internal
Macroeconomi
c Analysis with the IS
-
LM Model



The crossing of the
IS

and
LM

curves (
Y
E
) will represent simultaneous short
-
run
equilibrium in the goods and money market
s.



Whether or not that short
-
run equilibrium represents the full employment (
Y
*
) of all
factors of production (
K

and
N
) can be seen on the graph:



When
Y
E

<
Y
*
, and therefore,
u
E

>
u
*
, there is a

recessionary gap
.



When
Y
E

>
Y
*
, and therefore,
u
E

<
u
*
, there

is an expansion, and an
inflationary gap
.




Two different types of economic policies can be applied to close a recessionary gap:

-

Expansionary

fiscal policy:

T

or

G
(at the new equilibrium

Y

but also

r
)




T

may be ineffective if Ricardian equivalence hol
ds




G

may cause some
crowding out

of private investment


-

Expansionary

monetary policy:

M
(at the new equilibrium

Y

and also

r
)




M
causes other problems, such as high inflation, not captured by this model.




M

may be ineffective if there is a
liquidity tr
ap

or inflationary expectations by
households.


The BP Curve



The
BP

curve represents the equilibrium points in the foreign exchange market: the
combinations of
r

and
Y

for which the balance of payments (
BP
) is zero. That is, where
the Current Account (
CA
)
is equal to the Capital Account (
KA
)



Remember that:

-

Exports (
X
) are determined by exogenous factors
(e.g.: foreign GDP)
and that imports (
M
)
are a function of the domestic level of real income (
Y
).
CA = X
-

M (Y)

-

The volumes of capital coming and out of th
e country do not depend on the level of
domestic real income (
Y
) but do respond to real interest rate (
r
) differentials.

(Plotting that
: B
alance of
P
ayments

diagram
)



The
BP

curve will then be upward sloping.




Shifts in the BP curve
:

-

The
BP

line shifts
righ
t

with
:



A positive demand shock on domestic exports:

X.



An increase in tariffs:

Tariffs.



A lower interest rate in the foreign country:

r*.



A de
preciation of the domestic currency
:

ER.


-

The
BP

line shifts
left

with
:



A negative demand shock on
domestic exports:

X.



A decrease in tariffs:

Tariffs.



A higher interest rate in the foreign country:

r*.



An appreciation of the domestic currency:

ER.




Why do we draw the
BP

line
as being
steeper

than the
LM

line?

-

The
BP

line is relatively steeper

to capture the idea that a small change in
r

does not
greatly affect
Y
, or that only large changes in
Y

will affect the
BP

through
r
.

-

Th
is

is
the case when we have a high propensity to import (large changes in
M

when
Y

increases) or when there is limited
international capital mobility (
K
IN

or
K
OUT

do not react
to small interest rate differentials)



When we allow for increas
ed

capital mobility the
BP

line will be
flatter

than the
LM

line
(capital flows will be more responsive to interest rate differentials.)



When there is perfect capital mobility the
BP

line will be
perfectly elastic
with respect to
r

(it will be completely flat)

-

Whenever
r>r*

we will experience a large
CA

deficit.

-

Whenever
r*>r

we will experience a large
CA

surplus


Internal and External Bal
ance

with the Mundell
-
Fleming Model



If we put together the
IS
-
LM

curves we can determine how close the economy is to the
goal of internal equilibrium (low unemployment)



If we include in the graph the
BP

curve we can connect the internal and external secto
rs of
the economy and study the economic policy options available to the government:

-

Fiscal policy: changes in taxes (
T
) and/or the level of government expenditure (
G
)

-

Monetary policy: changes in the level of the money supply (
M
)



A new battery of questions

is thus presented to us:

-

How are economic policies going to affect the achievement of domestic equilibrium?

-

What are the repercussions to the external sector?

-

How do external shocks affect the internal economy?



The answers to these questions depend on the

type of ER system (fixed or flexible) that
the country adopts
:


Fixed ERs, Low Capital Mobility: Redu
cing Unemployment, Keeping BP=0

The
case of developing countries
.



Expansionary fiscal policy can achieve internal balance but the resulting domestic inter
est
rate is not high enough to achieve external balance (the
BP

is in deficit.)



Expansionary monetary policy can achieve internal balance but the resulting domestic
interest rate is not high enough to achieve external balance (there is a larger
BP

deficit.
)



We need to implement contradictory fiscal (expansionary) and monetary (contractionary)
policies to achieve simultaneous internal and external balance.

(
It
is very unlikely

to achieve

t
his
level of coordination in macroeconomic policies
.
)


Fixed ERs,
Limi
ted

Capital Mobility: Redu
cing Unemployment, Keeping BP=0

The
case of Argentina in late 2001.



Expansionary monetary policy does not achieve internal balance because the resulting low
domestic interest rate will promote large capital outflows that will in t
urn reduce the
domestic money supply and so return the
LM

curve to its initial position.



Expansionary fiscal policy can achieve internal balance because the resulting higher
domestic interest rate will attract large capital inflows
that will in turn increa
se the
domestic money supply and so shift the
LM

curve to the right
.



Monetary policy is ineffective in this scenario and will place devaluating pressure on the
fixed ERs. Only fiscal policy is available
.

(
The parity with the US dollar served to control inf
lation but made monetary policy
unavailable. Besides, the government can not run larger budget deficits anymore
.
)


Fixed ERs,
Perfect

Capital Mobility: Redu
cing Unemployment, Keeping BP=0

The
case of the European Monetary System in 1992.



Expansionary monet
ary policy does not achieve internal balance because the resulting low
domestic interest rate will promote large capital outflows that will in turn reduce the
domestic money supply and so return the
LM

curve to its initial position.



Expansionary fiscal pol
icy can achieve internal balance because the resulting higher
domestic interest rate will attract large capital inflows that will in turn increase the
domestic money supply and so shift the
LM

curve to the right.



Higher domestic interest rates attract capi
tal flows from other partners in the EMS and so
reduce their money supplies, imposing recessionary forces on their economies
.

(
Coordination of macroeconomic policies among economic union members is required in
order to promote general economic growth and t
o maintain the fixed ER arrangement
.
)


Fixed ERs,
Limited

Capital Mobility:
External shocks and internal effects

Speculation against fixed ERs: EMS (1992), Mexico (199
4
), Thailand (1997).



Foreign investors liquidate their assets denominated in the domestic

currency and transfer
them out of the country by first purchasing a foreign currency
.

This places devaluating
pressures on the fixed
ER
. The domestic Central Bank will try to fight them.



When reserves are exhausted in the defense of the fixed
ER

the CB mu
st choose between
rising domestic interest rates (
LM

shifts left)
,

or devaluating (
BP

shifts right
.
)



Extending the defense with higher interest rates or giving up the defense and devaluating
are both costly decisions for the country
.

(
Fixed ERs, that are

e
xpected to promote international trade and capital flows, expose the
domestic economy to costly external shocks
.
)


F
lexible
ERs,
Limited

Capital Mobility:
External shocks and internal effects

Speculation against flexible ERs: developed industrial economies
.



Foreign investors liquidate their assets denominated in the domestic currency and transfer
them out of the country by first purchasing a foreign currency. This places depreciating
pressures on the flexible
ER
. The domestic Central Bank does not need to f
ight them.



A depreciated domestic currency promotes exports and reduces imports. The
BP

shifts
right. Relatively higher domestic interest rates attract foreign capital and so demand for
the domestic currency increases. The
ER

rises,
BP

shifts left

returns

to initial point.



The
BP

curve adjusts itself (through the changes in the
ER
) and the Central Bank does not
need to intervene at all.

(
Flexible ERs, that are very volatile due to the large number of factors that affect them,
in
turn
protect the domestic e
conomy from costly external shocks
.
)


F
lexible
ERs,
Limited

Capital Mobility: Redu
cing Unemployment, Keeping BP=0

Mexican macroeconomic policies after 1994.



Expansionary fiscal policy does not achieve internal balance because the resulting higher
domestic
interest rate will attract large capital inflows that will in turn lower the
ER

(
BP

shifts left), lowering
X

and promoting
M
. The
IS

curve, then, returns to its initial position.



Expansionary monetary policy
can
achieve internal balance because the resulti
ng low
domestic interest rate will promote large capital outflows that will
raise the
ER

(
BP

shifts
right), promoting
X

and lowering
M
. The
IS

curve, then, shifts to the right.



Fiscal policy is ineffective in this scenario because it will place revaluating

pressure on the
flexible ERs. Only monetary policy is available.


(
Mexico has to exercise precise fiscal discipline in order to avoid pressures on ERs that
will cause a domestic recession
.

Only fine
-
tuning with monetary policy is possible.
)


F
lexible
ERs,

Perfect
Capital Mobility: Redu
cing Unemployment, Keeping BP=0

The case of the USA and Canada.



Expansionary fiscal policy does not achieve internal balance because the resulting higher
domestic interest rate will attract large capital inflows that will in
turn lower the
ER

(
BP

shifts left), lowering
X

and promoting
M
. The
IS

curve, then, returns to its initial position.



Expansionary monetary policy can achieve internal balance because the resulting low
domestic interest rate will promote large capital outfl
ows that will raise the
ER

(
BP

shifts
right), promoting
X

and lowering
M
. The
IS

curve, then, shifts to the right.



Lower
domestic interest rates
re
-
direct
capital flows
towards
this NAFTA partner and so
increase

its

money suppl
y. Inflation is likely to bui
ld up in
the

Canadian

econom
y
.

(
Coordination of macroeconomic policies is required in order to

avoid a situation where
USA exports overrun Canadian goods, or the USA “exports” inflation to Canada
.
)