IS LM Model in Open Economy

It is time to relax the closed economy assumption and understand the impact & design of Macro economic policy in an open economy. We first introduce the foreign balance constraint into IS-LM framework and then consider the design of optimal policies under fixed and flexible exchange rates. Foreign Balance & IS-LM analysis: With an open economy, the notion of Macro economic equilibrium has to be reinterpreted. In the IS-LM frame work, full macro economic equilibrium is established when there is simulateneous equilibrium in the BOP accounts and the Goods & Money Markets. We write the Goods Market equilibrium as ( IS Equation): I (r)+G+X = S (y) + T + Z Where I = investment, G= exogeneous Govt Expenditure, X= exports, S=Savings, T=Taxes and Z= Imports. As par as I,G,S,T we has a detailed discussion but regarding X & Z we should know: Exports depend on the real exchange rate = ep*/p i.e., X = f (ep*/p) P= domestic price level and p*= foreign price level. Imports are a function of real income and the real exchange rate, so that Z = f (Y, ep*/p) BOP Equilinrium itself occurs when the net surplus on the current and capital accounts sum to zero. i.e., X-Z+K =O, K = Net inflow of capital.

The foreign balance equilibrium: X (ep*/p ) Z (Y, ep*/p) + K (r) = O Therefore, in figure, we drawn FB (foreign Balance) curve /schedule is as follows:

Point A is BOP Equilibrium, if real income is higher than Yo. Imports are higher and cause to deficit. (Equil at point C). if the r was permitted to rise from ro to more, more capital would be attracted and the payments deficit would be eliminated. So r and y combination above the FB schedule denote BOP surplus and below is BOP deficits and the slope of FB schedule depends on degree of International capital mobility.

Macro Policy with Fixed Exchange Rates and Perfect Capital Mobility: Monetary Policy (Increase in MS): In this figure, Interest rate fixed at the international level i.e., ro. Domestic Y =Yo. Monetary authorities conduct an open market purchases to increase in MS result in the LM schedule shifts out to LM and equilibrium at point b. however, point b is shows deficit in BOP. Since we are living in a fixed exchange rates, Monetary authorities are obliged to support the legal value of

the Rupee. Hence, the Monetary authority sell dollors at fixed exchange rate so

The LM curve must go all the way back and the old equilibrium at point a restored. Hence, MP is that Monetary policy is ineffective. Fiscal Policy ( Increase in Investment): Increase in Government Investment leads in shift in IS to IS than Equil at b which leads to surplus in BOP. As a result capital inflows into economy. To prevent appreciation of domestic currency by buying dollars at the old rates. Subsequently money supply increases, so that there will be a shift in LM to LM again have ro so that BOP surplus eliminated and Y increases.

Macro economic policy with Fixed Exchange Rates and Perfect Immobility: When capital is completely immobile internationally, the FB schedule becomes vertical. Monetary policy ( increase in MS): Increase in Money supply leads to a shift in LM curve to LM than equil at point b---Deficit in BOP---Central Bank sells Foregin exchange at the existing rate --declines in money supply, therefore, LM move way back to point a so that earlier equil will be restored.

Fiscal Policy ( Increase in Investment): Increase in Governement investment leads to shift in IS to IS and equil at point b so that there will be deficit in BOP. To maintain value of rupee, RBI sells

foreign exchange at existing rate, result in decline in money supply. Therefore, shift in LM to LM so that final equil at point c where compared to a the interest rate is higher but the level of Y is the same. Macro Policy with Flexible Exchange Rates and Perfect Capital Mobility: Monetary policy ( Increase in Money Supply): Increase in Money supply leads to shift in LM to LM which lead to equil at point b so that therewill be defict in BOP. This beginning level of deficit cannot last long under flexible exchange rates. However, the rate of interest at pointb is lower than the international interest rate. Therefore, capital outflows leads to the deprecation of rupee causes increase in exports and increase in aggregate demand, so that there will be a shift in IS to IS. this will continue still domestic r is equal to International r so that final equil at point c and income increases and monetary policy is effective.

Fiscal Policy ( Increase in Investment): When government investment increases, there will be a shift in IS to IS so that equil at point d result in domestic r increases, therefore, inflow of capital result in current account surplus. Which leads to an appreciation in domestic currency and decline in exports and aggregate demand. Subsequently shift in IS back, income remains same, so that fiscal policy is powerful. Macro economic policy with flexible exchange rate with perfect capital immobility: Monetary policy ( Increase in Money supply): When there is an increase in money supply which leads to a shift in LM to LM and equil at point b causes deficit in BOP. Because of capital immobility deficit

appears totally in current account and exchange rate depreciates so that FB shifts as FB and equil at point b than exports= imports and AD = IS so that final equil at b.

Fiscal policy ( Increase in Investment): When there is an increase in Investment which leads to a shift in IS to IS and equil at b causes deficit BOP only in current account and exchange rate depreciates result in a shift in FB and equil will be restored.