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ECON 671 – International Economics

ECON 671 – International Economics. Exchange Rate Regimes and the IS-LM-BP Model. IS-LM-BP under a Flexible Exchange Rate Regime. IS-LM-BP Model with Flexible EXR. IS-LM-BP Model described by 3 equations (IS) Y = C (Y-T, W) + I(i) + G + NX(e, Y, Y ROW , W)

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ECON 671 – International Economics

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  1. ECON 671 – International Economics Exchange Rate Regimes and the IS-LM-BP Model

  2. IS-LM-BP under a Flexible Exchange Rate Regime

  3. IS-LM-BP Model with Flexible EXR • IS-LM-BP Model described by 3 equations (IS)Y = C (Y-T, W) + I(i) + G + NX(e, Y, YROW, W) (LM)Ms/P= a(DR + IR)/P= f(Y, i, W, E(p)) (BP)BOP0 = NX(e, Y, YROW, W) + j(i, i*+ xa) • IS-LM-BP with Flexible Exchange Rate Regime: • Endogenous Variables: Y, i, e • Exogenous Variables: G, T, DR, W, P, M • In a Flexible Exchange Rate Regime, adjustment to FX market equilibrium occurs through changes in exchange rate, e. • Changes in e will shift both IS and BP Curves in adjustment to equilib. • No Changes in LM Curve to changes in e.

  4. BP(e0, i*, Y*) BP Curve - shifts with De or DROW variables LM(Ms/P) IS(e0, G0, T0) IS-LM-BP Model Interest Rate BOP Surplus Currency app’n, e falls BOP Deficit Currency dep’n, e rises Income, Output

  5. Fiscal Policy under a Flexible Exchange Rate Regime

  6. Fiscal Policy with Flexible EXR • Look at effects of increase in gov’t spending, G. • Direct Effect • Increase in G will shift IS Curve outwards. • No Direct effect on either BP or LM Curves. • New internal equilibrium where LM and new IS intersect. • Both Y and i increase at new intersection. This is not overall equilib.!! • What is status of BoP at this point? • Depends on capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • If capital is relatively immobile • BOP < 0, resulting incipient BOP deficit causes EXR to depreciate, e rises. • This shifts the IS and BP Curves outwards until IS-BP-LM all intersect. • If capital is relatively mobile • BOP > 0, resulting incipient BOP surplus causes EXR to appreciate, e falls. • This shifts the IS and BP Curves inwards until IS-BP-LM all intersect.

  7. 1. Rise in Gov’t spending shifts IS Curve out 2. Incipient BOP surplus at B leads to decrease in e. 3. Currency appreciation shifts BP & IS in. 4. New equilibrium at C. 1. BP(e1, i*, Y*) DG > 0 B C 3. i1 3. IS(e0, G1, T0) IS(e1, G0, T0) Y1 Fiscal Policy with Flexible EXR Interest Rate LM0 BP(e0, i*, Y*) i0 A IS(e0, G0, T0) Y0 Income, Output

  8. BP1 IS1 IS1 De >0 DG > 0 i1 De < 0 IS2 DG > 0 Y1 Fiscal Policy & Capital Mobility Capital Completely Immobile Capital Perfectly Mobile i i BP0 IS0 LM0 LM0 IS0 BP0 i0 i* Y0 Y0 Y Y

  9. BP1 IS1 IS1 i1 BP1 i1 IS2 IS2 Y1 Y1 Fiscal Policy & Capital Mobility Capital Relatively Immobile Capital Relatively Mobile i i BP0 IS0 IS0 LM0 LM0 BP0 i0 i0 Y0 Y0 Y Y

  10. Monetary Policy under a Flexible Exchange Rate Regime

  11. Monetary Policy with Flexible EXR • Look at effects of increase in money supply through higher DR. • Direct Effect • Increase in Ms shift LM Curve outwards. • No Direct effect on either BP or IS Curves. • New internal equilibrium where LM and new IS intersect. • Rise in Y and i falls at new intersection. This is not overall equilib.!! • BoP at this point is always in deficit regardless of capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • Incipient BoP deficit means that home currency will depreciate, e rises. • This shifts both IS and BP Curves out until get to new IS-LM-BP equilibrium. • Monetary policy is very effective under Flexible Exchange rate Regime • Independent monetary policy is possible as Central Bank is not forced to intervene in FX market to keep EXR at set level.

  12. BP1 LM1 LM1 De >0 DDR>0 De >0 DDR>0 De >0 i1 IS1 IS1 Y1 Y1 Monetary Policy & Capital Mobility Capital Completely Immobile Capital Perfectly Mobile i i BP0 LM0 LM0 BP0 i0 i* IS0 IS0 Y0 Y0 Y Y

  13. BP1 IS1 LM1 LM1 BP1 i1 i1 IS1 Y1 Y1 Monetary Policy & Capital Mobility Capital Relatively Immobile Capital Relatively Mobile i i BP0 LM0 LM0 IS0 BP0 i0 i0 IS0 Y0 Y0 Y Y

  14. Effects of Foreign Events under a Flexible Exchange Rate Regime

  15. Effect of Foreign Income and Prices • Look at effects of rise in ROW incomes, Y* or foreign prices, P*. • Direct Effects • Rise in Y* or P* raises NX which shifts IS and BP Curves outwards. • No Direct effect on LM Curve. • New internal equilibrium where LM and new IS Curves intersect. • Both Y and i rise in new at new intersection. This is not overall equilib.!! • BoP at this point is always in surplus regardless of capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • Incipient BoP surplus means that e will fall, appreciation of currency. • This shifts the IS and BP Curves backs until get to original equilibrium. • Rise in ROW Incomes or Prices does not increase domestic output. • Appreciation of the currency will offset effects of change in ROW variables.

  16. BP(e1, i*, Y1*) = BP(e0, i*, Y1*) DY*>0 De <0 De <0 DY*>0 IS(e0, Y1*) = IS(e1, Y1*) Effects of Increase in Y* or P* Interest BP(e0, i*, Y0*) Rate LM(Ms/P) IS(e0, Y0*) Income, Output

  17. Effect of Foreign Interest Rate • Look at effects of rise in ROW interest rate i*. • Direct Effects • Rise in i* raises capital outflows which shifts BP Curve upwards. • No Direct effect on IS or LM Curves. • Internal equilibrium unchanged but new external equilibrium. • BoP in deficit except for perfect capital immobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • If capital is perfectly immobile • No change at all , either directly or indirect adjustment. • If capital is mobile • BOP < 0, resulting incipient BOP deficit causes EXR to depreciate, e rises. • This shifts the IS and BP Curves outwards until IS-BP-LM all intersect. • Rise in Domestic GDP and domestic interest rate.

  18. BP(e0, i1*) BP(e1, i1*) De >0 Di* >0 i1 De >0 IS(e1) Y1 Effects of Increase in i* Interest LM(Ms/P) Rate BP(e0, i0*) i0 IS(e0) Y0 Income, Output

  19. Effect of Domestic Price Level • Look at effects of rise in domestic prices, P. • Direct Effects • Rise in P lowers NX which shifts IS and BP Curves inwards. • Also lowers real money supply so LM Curve shifts back. • New internal equilibrium where new IS, BP, and LM Curves intersect. • Y decreases at new intersection. This is new overall equilib.!! • BoP at this point is always in surplus regardless of capital mobility or EXR regime for that matter.

  20. BP(e1, P1) DP >0 LM(Ms/P1) DP >0 DP >0 IS(e1, P1) Y1 Increase in Domestic Prices Interest Rate BP(e0, P0) LM(Ms/P0) i0 IS(e0, P0) Y0 Income, Output

  21. Summary of Policy Effects under a Flexible Exchange Rate Regime

  22. Policy Effects with Flexible EXR • Fiscal Policy • Directly affects only the IS Curve. • Adjustments to equilibrium depend on degree of capital mobility. • Higher the degree of capital mobility, the less effective is fiscal policy. • When capital immobile, EXR adjustment mostly shifts BP & increases Y. • When capital mobile, EXR adjustment mostly shifts IS & decreases Y. • Monetary Policy • Directly affects only the LM Curve. • Adjustments to equilibrium does not depend on degree of capital mobility. • Monetary policy is very effective in changing Y. • Most effective when capital perfectly mobile, keeps domestic i = i*. • Effect on interest rate uncertain in most cases, depends on relative shifts and slopes of IS and BP curves.

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