Macroeconomics Chamberlin and Yueh

1. MacroeconomicsChamberlin and Yueh Chapter 12 Lecture slides

2. The IS-LM-BP Model • Constructing the IS-LM-BP Model • The Open Economy IS Curve (The ISXM Schedule) • The BP curve • The Open Economy LM Curve • Exchange Rate Regimes • Equilibrium in the IS-LM-BP Model • Comparative Statics • The Mundell-Fleming Model

3. Learning objectives • Extend the traditional IS-LM model to incorporate open economy considerations • Understand the open economy version of this model, the IS-LM-BP model. The BP schedule reflects equilibrium in the balance of payments. • Analyse the various applications of this model. • Evaluate a particular version of the IS-LM-BP model, known as the Mundell-Fleming model. • Understand the impact of different exchange rate regimes on the IS-LM-BP model.

4. The IS-LM-BP Model • The open economy version of the IS-LM model is the IS-LM-BP model. • This adds a new line: the BP schedule which reflects equilibrium in the balance of payments. Overall equilibrium will now exist where the economy is in real, monetary and external equilibrium. • There are many different variants of the IS-LM-BP model. Different versions make different assumptions about the degree of capital mobility and the exchange rate regime.

5. The IS-LM-BP Model • A particular version of the IS-LM-BP model which definitely deserves attention is known as the Mundell-Fleming model. This is just the basic IS-LM-BP model with perfect capital mobility. • The second way in which different versions of the model may arise is through the type of exchange rate regime that is assumed. Under a floating regime, the exchange rate is market determined & can fluctuate accordingly. A fixed regimeis where the policy maker acts to maintain the exchange rate at a particular level. It will be seen that the effects of different policies is not independent of the exchange rate regime in place.

6. Constructing the IS-LM-BP Model • Extending the basic IS-LM to the open economy requires two additions. • Firstly, the closed economy IS & LM curves need to be adapted to take into account the foreign influences on the domestic goods and money markets, respectively. • Secondly, the BP schedulerepresents the combination of income & IR where the BOP (or the external part of the economy) is in equilibrium.

7. The open economy IS curve (The ISXM Schedule) • Extending the IS curve to the open economy simply requires the addition of the current account or net exports. • Demand will therefore equal supply when this national income identity holds: C=domestic consumption A=autonomous consumption C=MPC T=size of lump sum taxes Investment is a negative function of the interest rate & also a set of exogenous factors

8. The ISXM Schedule • Government spending is exogenously set: • Real value of net exports or the trade balance given as • Several parameters & factors which determine the size of net exports RER. Providing the Marshall-Lerner condition holds, a depreciation in the RER will lead to an improvement in net exports. • Level of overseas income & the parameter , which is the proportion of foreign income spent on domestic goods. (it will increase export)

9. The ISXM Schedule • The total level of imports is the product of domestic income Y& the MPI. As income rises, consumers will tend to spend more – a proportion of which will be on foreign goods & services.

10. The ISXM Schedule • Rearranging this, derive the equilibrium level of income as a function of all the parameters & variables: • This is the open economy version of the IS curve. To differentiate this from the closed economy version, entitle it as the ISXM schedule. • The ISXM curve also slopes downwards, as a rise in interest rates will lead to a fall in investment, & then a multiplied fall in income.

11. IS vs. ISXM Curves • -downward-sloping curve. • slope of the ISXM curve will be steeper than that of the standard IS curve because the multiplier is now smaller, following the addition of the marginal propensity to import. • -In the closed economy, the multiplier was 1/(1-c) @ 1/s. • -In the open economy, the multiplier is: • -As long as the MPI is positive, the multiplier will be smaller.

12. The ISXM Schedule • Imports are a leakage from the circular flow of income. As the MPI increases, a higher proportion of any additional income will be spent overseas rather than on domestically produced goods & services. the multiplier will be lower. • A change in anything other than the Y or the IR will lead to a shift in the ISXM curve. • If exports rise because foreign income or the proportion dedicated to domestic goods & services increase; or imports fall due to a decline in the MPI, then Y* will rise& the ISXM curve will shift outwards.

13. ISXM curve will shift if there is a change in the RER. • Providing that the Marshall-Lerner condition holds, a real appreciation reduces the competitiveness of domestic goods and services. Exports will fall, and imports will rise and the ISXM curve will shift inwards. • If real depreciation, the improved competitiveness of output produced at home will lead to a fall in imports and a rise in exports, & the ISXM curve will shift outwards. • The ISXM curve should also pivot as the multiplier will change due to the exchange rate effect on the MPI.

14. The BP curve • This represents equilibrium in the BOP. • The BP schedule plots the combinations of income (Y) & interest rates (r) where total inflows & outflows to & from overseas are equal. • The balance of payments consists of two main parts: the current & capital accounts. • The current account is mainly determined by the trade balance or the value of net exports (X-M). • The capital account is largely driven by financial flows, where international investors move funds around the world in search of the highest returns.

15. Versions of the IS-LM-BP Model • Different versions of the IS-LM-BP model make varying assumptions about the degree of capital mobility. • If there is no capital mobility, then finance cannot flow across borders & the capital account doesn’t exist. The entire BOP position is set by the trade balance (CA). • Where there is perfect capital mobility, capital can flow freely with no restrictions. Given that capital flows are large in comparison to trade (exports & imports), the capital account will then tend to dominate the BOP position.

16. Versions of the IS-LM-BP Model • In constructing the BP curve, allow for 3 different levels of capital mobility. • no or zero capital mobility • Perfect capital mobility • capital mobility is neither zero nor perfect

17. No capital mobility • The BOP is represented by only the trade balance or the value of net exports. The BP schedule (equilibrium in the BOP) can therefore be substituted by a BT schedule (equilibrium in the balance of trade). • The BT curve is plotted as the combinations of Y & IR where the trade balance is in equilibrium, BT=0 =X-M.

18. Export function: Depreciation in the real exchange rate -Exports are determined by dm from overseas (horizontal)

19. Import function: Depreciation in the real exchange rate -The import function relates the domestic level of income to the total amount of imports. -Assuming a + & constant MPI, the import function will be an upward sloping function against the domestic level of income. -A real depreciation in the exchange rate will lead to a downward pivot in the import function ( M). As domestic goods become more competitive, consumers will switch their consumption towards them & away from foreign goods; so, the MPI will fall. -The import function will pivot, and the total fall in imports will of course depend on the level of income.

20. No capital mobility • Overall equilibrium in the balance of trade will arise where the export & import functions coincide. This will then determine the BT schedule: A position to the right of the BT schedule indicates a deficit in the BOT. Imports > exports. A position to the left of the BT schedule represents a deficit, exports < imports.

21. Depreciation in the real exchange rate -A change in the RER leads to a shift in the export function & a pivot in the import function. -Following a real depreciation, domestic goods become more competitive vis-à-vis those produced abroad. As a result, the export function will shift upwards & the import function will pivot downwards. -This means that the level of income where the BOT is in equilibrium will increase.

22. Perfect Capital Mobility (no restriction on movement of capital) • Under conditions of perfect capital mobility, if iris the domestic interest rate and ir* is the foreign rate, then the following holds true: • If the ir > ir*, then capital will flow into the country & the BOP will move into surplus. • If the ir < ir*, then capital will flow out of the country & the BOP will move into deficit.

23. BP Schedule: Perfect Capital Mobility BOP equilibrium will be where r=r*. As only a miniscule deviation from the overseas iris required to generate large capital flows, the BP schedule will hence be flat at the ir*.

24. Perfect Capital Mobility • Changes in the ER will not have any impact on this curve. • As the BP schedule is horizontal, a horizontal shift in itself will have no discernable effect. • The other reason is due to the fact that the trade balance is only a small part of the BOP. • Changes in exports & imports have a very small effect on the BOP relative to the scale of capital flows.

25. BP Schedule: Intermediate Capital Mobility -BP curve is upward sloping. -As Y , imports & the BOT deficit become greater. In turn, larger capital account surpluses will be required to offset this deficit. These capital account surpluses can be achieved by offering higher ir. -If a country borrows heavily, however, the increased perception of default is likely to increase the risk premium. -As a result, higher & higher irwould be required in order to attract the required capital inflows to maintain the BOP.

26. Depreciation in the RER -A real depreciation reduce trade deficit ( M) at each Y ( irattract capital inflows).

27. What Shifts the Furthest: The IS or BP Schedules? • Following a change in the RER (Marshall-Lerner condition holds), both the IS & BP schedules will shift horizontally & in the same direction. • The answer to the question as to which one shifts the furthest can be answered by looking at the equations that describe the ISXM & the BT schedules. • What happens following a change in the exchange rate (assumptions to the ISXM equation) as none of these variables depend on the RER.

28. What Shifts the Furthest: The IS or BP Schedules? • The new ISXM schedule is now written as: • Suppose there was a real depreciation in the currency. Exports will rise & produce a multiplier effect on the level of Y where the goods market & the trade balance are in equilibrium.

29. Real depreciation -The only difference between the multipliers is the term 1-c in the IS schedule. As long as this is > zero, the multiplier attached to the ISXM schedule will be smaller. -1-c>0, the ISXM schedule will shift by a smaller amount than the BT schedule.

30. The Open Economy LM Curve -The LM curve in an open economy is same as its closed economy. It defines the combinations of Y & IR where the demand & supply of money are equal to each other. -An upward sloping function. -As Y rises, the demand for money increases due to the transactions motive. -By increasing IR, the excess demand for money is countered, as higher bond yields encourage people to hold less cash & move into bonds.

31. The Open Economy LM Curve • The open economy can exert a powerful effect on the money market. The conventional closed economy LM curve is derived under the assumption that the money supply is fixed. • In a closed economy, the government or the monetary authority is assumed to have complete control over the money supply. • In an open economy, this proposition is less likely. There is a direct relationship between the MS and the BOP position. • The position of the LM curve is therefore linked to that of the BP schedule.

32. The Open Economy LM Curve • The MS is equal to a multiple of the high powered money stock (H), known as the monetary base. The MS including the demand deposits, will be a multiple of the monetary base. • This multiple will be determined by the size of the money multiplier: • In the closed economy, the change in the monetary base is equal to the public sector deficit (PSD) less government sales of bonds. This is essentially the government deficit that is paid for by cash (by printing money) rather than through bond sales:

33. The Open Economy LM Curve • In an open economy, there will a further determinant to the stock of high powered money. This is the net purchase of foreign reserves (R) by the central bank: • Assuming that the public deficit is entirely financed by bond sales, then in the open economy, the MS is driven by central bank changes in reserves (foreign assets). The change in reserves now represents the official financing of the BOP.

34. The Open Economy LM Curve • For the sake of simplicity assume that there is no capital mobility, so that the BOP position & thus the size of official financing or the change in foreign reserves is determined by the trade balance . • In this case, the high powered money stock can be described as follows: • Any discrepancy between exports & imports will see the domestic monetary base rising or falling in line with movements in the foreign exchange reserves of the central bank. The change in the MS is:

35. How the LM and BP (money markets & the balance of payments) interact? • The interaction between the balance of payments & the money supply implies that the central bank, government, or other monetary authority will find it impossible to exert control over the money supply in an open economy. This, though, is not entirely true. • In the above figure, points a& c are not sustainable because adjustments in the money supply will push the economy to a position where the BOP is equilibrated. • In an open economy, the money supply can be expressed as follows:

36. The Open Economy LM Curve • Assumed that the public sector debt was funded entirely by bond sales, leaving the money supply to be driven by the change in foreign reserves. • Bond sales in this case are just sufficient to stop any public sector surplus or deficit from affecting the money supply. However, in the same way, it is possible for bond sales to be used to prevent trade imbalances from affecting the domestic money supply. • In this case, bond sales are set so that: • This process of selling or purchasing excess bonds is known as sterilization.

37. The Open Economy LM Curve • The BOP consists of not only the trade balance (current account) but also the capital account: BP = X – M + net capital inflows. • The change in reserves (R) is determined by the official financing required to achieve BOP equilibrium.

38. Domestic interest rate exceeds foreign interest rate When there is perfect capital mobility, any domestic interest rate above the ir* would produce large-scale capital inflows & lead to an increase in the money supply as foreign reserves accumulate (c to d). When the equilibrium in the money market produces an interest below the foreign rate, large capital flows lead to a deficit on the BOP. The process of official financing will lead to falling foreign reserves and a fall in the money supply, shifting the LM curve upwards – a movement from a to b.

39. The Open Economy LM Curve • An important issue which certainly requires some discussion is the ability of the monetary authorities to control the domestic money supply (the position of the LM schedule) in an open economy. • Since the monetary policy can do this by sterilizing the impact of official financing on the money supply. This was in the case of there being low capital mobility. • Does the result carry over to the case of perfect capital mobility? The conventional wisdom would argue that the answer to this question is no.

40. The Open Economy LM Curve • Where there is no capital mobility, sterilization is only required to offset the effects of the trade balance. • Under perfect capital mobility, only very small differences in home & foreign interest rates are required in order to produce very large flows of capital. Impossible to maintain r>r*, large capital inflow, require large number of bond sales. • Therefore, comes down to a question of scale. • Sterilization is more realistic when dealing with relatively smaller levels of official financing. For this reason, it has become a well-established phenomenon that policy makers cannot hope to have high capital mobility and also the power to control the money supply (set the position of the LM curve). • Where capital is perfectly mobile, the LM curve effectively disappears, and the money supply is automatically determined so that r*=r.

41. Equilibrium in the IS-LM-BP Model -The point where the three schedules intersect represents the combination of Y & IR where the goods market, the money market & the balance of payments are all in equilibrium. -Having established this model, it can now be applied in a number of ways. Fiscal policy will shift the IS schedule, monetary policy the LM schedule, and exchange rate policy the BP schedule.

42. Comparative Statics • A fiscal expansion under a floating exchange rate regime. • A monetary expansion under a floating exchange rate regime. • A fiscal expansion under a fixed exchange rate regime. • A monetary expansion under a fixed exchange rate regime. • An exchange rate devaluation in a fixed exchange rate regime.

43. Comparative Statics-policy with zero @ low capital mobility • Pages 419-426

44. Comparative Statics-policy with high capital mobility • Pages 426-431

45. Equilibrium in the Mundell-Fleming model -The Mundell-Fleming model is the IS-LM-BP model under the conditions of perfect capital mobility. -The IS-LM-BP model is a fixed price model; there is nothing that explains or accounts for price changes. It is assumed that prices are determined implicitly in this model. -There is a full employment/natural level of output such that: -Prices will change in the same direction as the deviation of output from its natural level, and  determines the speed at which prices change in this case.

46. The Mundell-Fleming modelcan be used to analyse the effect of MP and FP in an open economy & the effect of policy depend on the type of the exchange rate that is implemented.

47. Monetary & Fiscal Policy under Floating Exchange Rates • An expansionary MPimplies path a-b-c-a, whereas expansionary FP implies path a-d-a. • Monetary expansion shifts LM1LM2, ir<ir*, er will depreciate indusing a rise in competitiveness, shift the ISXM1ISXM2, Y1>Yhat. Y>FE level, price  --LM2LM1, ISXM2ISXM1(P), then return the economy back to FE level of output.

48. A fiscal expansion, ISXM1ISXM2, r2<r*, er appreciates, as competitiveness falls, ISXM2ISXM1.

49. Monetary & Fiscal Policy under Fixed Exchange Rates • An expansionary MP will imply path a-b-a, whereas an expansionary FPwill move the economy along the path a-d-c-a. • Monetary expansion shifts LM1LM2, ir<ir*, policy must restore r=r* by contracting MS, LM2LM1,, will no effect on output.

50. A fiscal expansion, ISXM1ISXM2, r2>r*, MP must expand (LM1LM2) to r=r*. Y1>Yhat & above natural level, P will , so LM2LM1, IS2IS1 (to reduce competitiveness) & return to FE level of output.