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Building the IS-LM-FX ModelMacroeconomic Policy Analysis
International MacroeconommicsChapter 7. The Open Economy IS-LM Model
Instructor: Yuan Liu
Department of Economics, UCDavis
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Outline
1 Building the IS-LM-FX ModelUnderstand the DemandDerive the IS curveDerive the LM curve
2 Macroeconomic Policy AnalysisMonetary PolicyFiscal Policy
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Outline
1 Building the IS-LM-FX ModelUnderstand the DemandDerive the IS curveDerive the LM curve
2 Macroeconomic Policy AnalysisMonetary PolicyFiscal Policy
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
The Open Economy IS-LM Model
What the model does:Explains the relationship among all the majormacroeconomic variables in an open economy in the shortrun.Why it is useful:How monetary policy and fiscal policy affect the economy.Important conclustions:The feasibiliy and effectiveness of macroeconomic policiesdepend crucially on the type of exchange rate regime inoperation.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Assumptions
A Model can not catch everything in the real world. Extractthe relationship amongs variables of our interests, ignore orsimplify the other non-important, non-related relations.
Two countries: home (the U.S.) and foreign (rest of theworld).Focus on the short run fluctuations: price is sticky.G and T are fixed.Foreign variables are taken as given: Y ∗, i∗.CA = TB and CA = −FA: NUT = 0, NFIA = 0,KA = 0.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Output is driven by demand in the short run.Price is sticky in the short run, so output adjusts tofluctuations in demand to clear the goods market.Components of demand: consumption, investment,government spending, and net exports.
D = C + I + G + TB
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
ConsumptionConsumption is a function of disposable income.
C = C(Y − T )
Example: C = 10 + 0.75(Y − T )
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
InvestmentInvestment is a negative function of nominal interest rate.
I = I(i)nominal interest rate represents the cost of borrowing capital.We expect less investment projects be undertaken.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Government Spending
G , T
Government spending G and taxing income T are exogenous.They are subject only to policy change.
Expansionary fiscal policy: rise in G , and fall in TContractionary fiscal policy: fall in G , and rise in T
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Trade BalanceReal exchange rate
q =EP∗
P =E$/euroPEU
PUS
rise in q means that it takes more home goods basket toexchange for one foreign goods basket.Home goods measured in real term becomes cheaper,foreign goods measured in real term becomes moreexpensive.Exports increases, foreign country demands more homegoods.Imports decreases, home country demands less foreigngoods. TB increases.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Trade Balance
Real exchange rate
q =EP∗
P =E$/euroPEU
PUS
Rise in q leads to a rise in TB.rise in foreign price (P∗)rise in nominal exchange rate (depreciation of homecurrency)fall in home price (P)
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Trade Balance
Income: rise in income raises consumption, some of which isconsumption of goods produced abroad.
MPCH marginal propensity to consumption of homegoodsMPCF marginal propensity to consumption of foreigngoodsMPC = MPCH + MPCF
Example: MPC = 0.75, MPCH = 0.6, MPCF = 0.15.Receive extra $1 of disposable income, spend $0.75. $0.6 isspent on home goods, $0.15 is spent on foreign goods.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Trade BalanceIncome: rise in income raises consumption, some of which isconsumption of goods produced abroad.
Y − T ↑ IM ↑ TB ↓Y ∗ − T ∗ ↑ EX ↑ TB ↑
TB = TB(EP∗
P , Y − T , Y ∗ − T ∗)
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
ShocksShocks are exogenous changes, shifts in functions above,which can affect each part of demand.
Example: rise in wealth shifts the consumption function above.consumption rises at any income level.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Shocks
Example:optimism about investment opportunities.rise in investment at any interest rate level.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Shocks
Example: tasts shifts between home and foreign goods.Trade balance increases at any real exchange rate level.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
The Keynesian CrossGoods market equilibrium:All goods produced must be willingly demanded andpurchased.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
They Keynesian Cross
Thins that shifts the demand line up:rise in Gfall in Tfall in irise in qany exogenous change that shifts up consumption,investment, or trade balance.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
The Keynesian Cross
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Summary Level of output is determined by demand in theshort run. Each component of the demand has itsparticular determinants. Shifts in thesedeterminants, or shifts in other exogenous factors,shift the level of demand, thus change theequilibrium level of output.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
The IS curve shows combinations of output Y and the interestrate i for which the goods and FOREX markets are inequilibrium.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
A fall in i from i1 to i2:leads to a rise of investment. Demand shifts up. Outputin equilibrium rises.leads to a rise of nominal exchange rate (home currencydepreciation). Home goods become cheaper. Demandshifts up. Output in equilibrium rises.
Lower interest rate stimulate the economy (higher outputlevel) via:
investment channelNet exports (TB) channel
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Factors that shift IS curve:
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Any factor which increases demand at a given home interestrate i must cause the demand curve to shift up, leading to ahigher output, and as a result, an outward shift in the IScurve.
a rise in G (Expansionary Fiscal Policy)a fall in T (Expansionary Fiscal Policy)a rise in qany exogenous change that shifts up C, I or TB.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
The LM curve shows the combinations of Y and i at which themoney market is in equilibrium.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
Factors that shift LM curve:a rise in nominal money supply
an exogenous drop in money demand
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Understand the DemandDerive the IS curveDerive the LM curve
At i1, Y1, goods market, FOREX market, money market are allin equilibrium.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Outline
1 Building the IS-LM-FX ModelUnderstand the DemandDerive the IS curveDerive the LM curve
2 Macroeconomic Policy AnalysisMonetary PolicyFiscal Policy
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Monetary Policy under Flexible exchange rateregime
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Monetary Policy under Fixed exchange rate regime
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Fiscal Policy under Flexible exchange rate regime
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Fiscal Policy under Fixed exchange rate regime
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Case Study
Monetary policy is used to stabilize the economy such that itmaintains full employment level.
Shock 1997 Asia financial crisis. Output drops a lot inthese Asia countries. A large proportion ofAustralia’s and New Zealand’s exports werepurchased by these Asia Countries.
Policy Response Both Australia and New Zealand adoptedexpansionary monetary policy to stablize theeconomy against such a negative shock.
Instructor: Yuan Liu CH3
Building the IS-LM-FX ModelMacroeconomic Policy Analysis
Monetary PolicyFiscal Policy
Case Study
Instructor: Yuan Liu CH3