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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 domestic 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 macroeconomics
- 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
limitations)

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 inflation (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 (MS) so Interest Rates (i)
Expenditure switching (from foreign to domestic) 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 inflation?)
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 combinations 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 sometimes 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 positively 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
Wealth increases: S
Taxes decrease: S
S (if Ricardian equivalence holds.)
Government expenditure increases: S
Net Exports increase: NX
MPK increases: I
Taxes on capital decrease: I

- The IS line shifts left if: Expected future income decreases: S


Wealth decreases: S
Taxes increase: S
S (if Ricardian equivalence holds.)
Government expenditure decreases: S
Net Exports decrease: NX
MPK decreases: I
Taxes on capital increase: I

The IS curve is basically affected by fiscal 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 money demand (Md) 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, independently of real interest rate and real
income.
(Plotting that: see 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: Md.
Inflationary expectations increase: Md.

- The LM line shifts left if: Money supply decreases: M.


Prices increase: Md.
Inflationary expectations decrease: Md.

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 Macroeconomic Analysis with the IS-LM Model


The crossing of the IS and LM curves (YE) will represent simultaneous short-run
equilibrium in the goods and money markets.
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 YE < Y*, and therefore, uE > u*, there is a recessionary gap.
When YE > Y*, and therefore, uE < 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 holds
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 trap 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 the country do not depend on the level of
domestic real income (Y) but do respond to real interest rate (r) differentials.
(Plotting that: Balance of Payments diagram)
The BP curve will then be upward sloping.

Shifts in the BP curve:


- The BP line shifts right with: A positive demand shock on domestic exports: X.
An increase in tariffs: Tariffs.
A lower interest rate in the foreign country: r*.
A depreciation 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.
- This 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 (KIN or KOUT do not react
to small interest rate differentials)
When we allow for increased 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 Balance 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 sectors 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: Reducing Unemployment, Keeping BP=0


The case of developing countries.
Expansionary fiscal policy can achieve internal balance but the resulting domestic interest
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 this level of coordination in macroeconomic policies.)

Fixed ERs, Limited Capital Mobility: Reducing 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 turn 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 increase 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 inflation but made monetary policy
unavailable. Besides, the government can not run larger budget deficits anymore.)

Fixed ERs, Perfect Capital Mobility: Reducing Unemployment, Keeping BP=0


The case of the European Monetary System in 1992.
Expansionary monetary 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 policy 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 capital 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 to maintain the fixed ER arrangement.)
Fixed ERs, Limited Capital Mobility: External shocks and internal effects
Speculation against fixed ERs: EMS (1992), Mexico (1994), 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 must 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 expected to promote international trade and capital flows, expose the
domestic economy to costly external shocks.)

Flexible 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 fight 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 economy from costly external shocks.)

Flexible ERs, Limited Capital Mobility: Reducing 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 resulting 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.)

Flexible ERs, Perfect Capital Mobility: Reducing 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 outflows 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 supply. Inflation is likely to build up in the Canadian economy.
(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.)