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The Open Economy IS-LM Model

The Mundell-Fleming Model

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Learning Objectives

1. Understand how what BOP equilibrium is and how it is represented by BP curve

2. Understand how internal (IS-LM) and external equilibria interact to produce an unique over equilibrium

3. Understand how the fiscal and monetary policy are affected by the exchange rate regime

4. Understand how fiscal and monetary policy are affected by the SOE\LOE assumption

5. Apply it to some real world cases

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Comment on Mankiw’s Presentation

• Mankiw covers this in chapter 13• Different diagrams (more confusing)• I prefer my way which I think is clearer• You can use whichever appeals to you• If you use mine, Mankiw’s text is still

relevant

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Revision of some basics

1. BOP

2. Exchange rates– Fixed vs floating– Real vs nominal

3. Interest rates and capital flows

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• Record of a country’s economic transactions with the rest of the world.

• Rule: receipt = positive (+) , payment = negative (-)– If receipts > payments = surplus.– If receipts < payments = deficit.

• 2 main accounts: current and capital.– Different implications for the economy. The current account

directly affects AD– It is possible to have a current a/c deficit as long as there is

a capital a/c surplus. Example, USA.

BOP

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Exchange Rate

• What is $ price of domestic currency (€)?– Exchange rate: $ price of one €– what we quote in paper– €1=$1.12– Price of 1$ is 1/1.12=0.89– e=1.12

• Depreciation of €– Losses value– Fewer $ per euro– Or e falls

• This or the reciprocal?– Follow the book– I prefer the other way

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Fixed vs Floating

• In a certain trivial sense the BOP always balances– Supply equals demand

• For floating exchange rate this is achieved by the free market• For fixed exchange rates the government makes up the

difference• Current account surplus is counteracted by cap deficit and/or

changes in reserves– US vs China

• Note a bit inconsistent to have e floating but P fixed– As before our excuse is that’s what happens in reality

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Fixed Erates

• Governments may try to fix the exchange rate (why? See later)– Requires supplying foreign currency to market

when there is excess demand– Requires buying foreign currency when there is

excess supply• Mechanism by which an currency crisis can

occur

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Real Exchange Rate• Compare price levels of different countries

– In a common currency (usually US$)• Related to the concept of purchasing power

parity (PPP)• Simple example is the Hamburger index

– What is the US$ price of a Big Mac in various countries

• What is the effect of an increase in R?– our goods more expensive; their’s relatively cheaper– Expect exports to rise and imports to fall– “loss of compteitiveness”

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• What does this tell you?– “competitiveness”– Are one country’s goods cheaper than

another’s?• Do for all goods in a basket and calculate

the ratio– i.e. CPI or GDP or wages

• Look at R for Ireland over time– Level doesn’t tell much– Trend does

US

IRL

US

IRL

P

P*e

$P

$PR

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Competitiveness

0.000

50.000

100.000

150.000

200.000

250.000

NEER

REER

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• What causes R to change?– e changes– Prices change i.e. inflation can erode

competitiveness– Productivity

• These last two factors are “Long Run” and so will be ignored in this model

• Thus changes in the nominal exchange rate (e) will change the real exchange rate (R) in proportion– We will just talk of “exchange rate” to mean both

• Again note the inconsistent treatment of prices and exchange rates.

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e affects the IS Curve

• NX rises following a depreciation (e down)– Price in $ of goods produced in Ireland falls– Example: furry leprechaun €5– e=1.12 (the $ price of 1€)– 1€ gets $1.12– leprechaun costs 5*1.12=$5.6– Depreciation e=0.5 implies €1 get $0.5– Cost is 5*0.5= $ 2.5– Sales rise

• Note this leads to a shift in IS curve– Every r is associated with higher Y

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r

Y

IS2

IS1

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Interest Rates

• Interest rates can be used to influence capital flows and therefore defend a currency.

• reuro > rus Capital inflow e • reuro < rus Capital outflow e• Usually used to prevent depreciation of the

exchange rate.• Sounds like it might affect the LM curve but

we account for it separately

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Taking Stock

• We have from the last section a definition of equilibrium (IS-LM)– We now call this “Internal Equilibrium”

• We have dealt with the prelimaries that enable us to talk about BP equilibrium

• We need to find the combinations of (r,Y) that lead to BOP equilibrium – external equilibrium

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External Balance

• Define external balance to be where BP=0– Net flow of currency between countries is zero– Current account could be in deficit if capital account in surplus

• Why is this an equlibrium?– Plans consistent– See later how BOP not balanced leads to changes– For now think of exporters and importers plans

• Show this on IS-LM framework– (r,Y) that give BP=0– Assume (for now) that e is fixed

• As with any curve we want to know – The slope– What causes it to shift?

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• Start at initial point (A)– assume eqm, BP=0 – Y up,– Imports up (NX falls), – flow out of $– Or increased supply of €– Either way BP<0 : at B– assume e fixed– To restore equilibrium need to encourage

capital inflows (perhaps borrowing)– r up sufficiently to restore equilibrium, – Connect all such points : BP=0 curve

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Y

r

A

B

CBP=0

BP curve is the locus of External equilibrium i.e. the set of (r,Y)combinations which give BOP=0

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Shifts in BP=0

• Points above BP=0 represent BP surplus– Think if r increases beyond C

• Points below BP=0 represent BP deficit• Location of curve depends on e, world income

(Y*) and world interest rates (r*)– Change in any will shift BP=0 (see diagram)– r* rises: BP shifts up, need higher r for all Y– Y* rises: BP shifts right, NX rises, Y rises for all r– e falls: depreciation, NX up, for all r Y up, BP shifts

right

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Y

r

BP=0

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Slope of BP=0

• Slope depends on– Marginal propensity to import– Capital mobility

• Marginal propensity to import– What portion of every increase in GDP is spent

on imports– If high increase in Y leads to a large deficit– need large capital flows to restore equilibrium– Large increase in r– Steep BP curve

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• Capital Mobility– How sensitive are cap flows to interest

differentials?– How free is capital to flow?– Flatter BP=0 curve– Special Case : “Small Open Economy”

• r=r*

• BP=0 flat• Perfect Capital mobility • No influence on world

– Note what happens when BP=0 “shifts” if SOE• e.g. changes in r*

• Changes in Y*

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BP=0

r

Y

r*

Small Open Economy with Perfect Capital Mobility

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PCM & SOE• This is crucial for the effectiveness of policy – as

we will see• You need the two assumptions to get the flat curve• PCM implies your interest rate is the worlds• SOE implies what you do has no effect on the

world• Think of examples• PCM is relatively recent and was very

controversial• Note we also postpone risk until later

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Overall Equilibrium

• We put the three curves together• The intersection is the overall equilibium

– Internal balance– External balance

• As usual we have to show it is stable (why?)

• We already know that internal eqm is stable• So we concentrate on showing how

economy adjusts to external disequilibrium

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Internal and External Balance

• IS-LM give eqm in goods and money market

• Together they give “internal balance”

• Showed it was stable• Add BP to give

external balance• Show stable

BP=0

LM

IS

Y

r

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External Imbalance

• Need to show that if not in external balance, will go there

• A is point of internal balance (what does this mean?)

• A is BP<0: deficit– r is too low to attract

the capital flows– Plans not consistent

• What will happen?– depends on whether e

is free to adjust

A

LM

IS

BP=0

B

r

Y

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• Assume Fixed e• BP deficit means net

outflow of (foreign) currency

• Money supply falls• LM curve shifts up• Interest rate rises until

sufficient to stem the outflow of funds

• New eqm at B• Note Change in money

supply is automatic – not policy

• Mechanism: CB buys € with $ from reserves

BP=0

LM1

LM2

A

B

r

Y

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• Float Exchange rates• BP deficit means net

outflow of (foreign) currency

• Excess demand for $ and excess supply of €

• Price of € falls: e falls• Depreciation• Net exports rise

– IS shifts right: for every r now Y up

– Also BP shifts down• depr until sufficient to

restore balance• New eqm at B

• Note difference in behaviour of central bank in both cases• Note different effect on output and interest rates

BP2

IS2IS1

BP1 B

A

r

Y

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Imbalance with PCM

• Perfect Capital Mobility provides an interesting special case• Flat BP=0 curve

– Interest rate fixed at world levels– No influence on world– Ireland vs. US

• Assume internal equilibrium is BP surplus (point A)• Fixed exchange rates

– Inflow of foreign currency– Or domestic interest rate too high– Money supply rises: LM shifts down– Keeps going until r=r*

– Forex reserves rise

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A

r

Y

B

IS2

IS1

LM1

LM2

BPr* C

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• Floating exchange rates– Inflow of foreign currency–Excess supply of $ causes their price to

fall–Excess demand for €– e rises: appreciation: more $ per €–Exports fall & imports rise– IS shifts left–BP shifts right onto itself–A B

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• Fixed exchange rates– Inflow of foreign currency–Excess supply of $ has to be soaked up

by CB–CB buys $ with € to keep price constant–Money supply up (more € in circulation)–LM curve shifts down–AC–Note: Change in money supply is

automatic – not policy

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Policy In an Open Economy

• Can look at Monetary, Fiscal and Exchange Rate Policy

• If we think of the purpose of policy is to control Y then we get

• The reason is the automatic effects of BP

Fixed e Float eFiscal Effective IneffectiveMonetary Ineffective Effective

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Method

• Now we will assume SOE & PCM as it makes things easier– Drop SOE later

• To analyse any policy1. First look at its effect on internal balance IS-LM

2. Check what sort of BOP disequilibrium that generates (i.e. we will be off BP curve)

3. Apply the rules for adjustment to external balance

4. Remember: These are different depending on exchange rate regime

• Apply 1-4 in exam

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Fiscal Policy with Fixed e

• G up: IS shifts to right (why?)– Internal balance at B

• At B: BP>0, r>r* (why?)• This BP>0 cannot be equilibrium as plans are

changing (whose?)• fixed e: CB must buy excess $ by printing €

– this leads to money supply up– LM shifts down– Interest rate falls

• Balance restored at C• Note contrast with closed economy

– No change in r– Larger change in Y

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A

B

C

r

Y

LM0

LM1 IS0

IS1

Fiscal policy: Fixed e, SOE

r* BP

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Monetary Policy with Fixed e

• Expand money supply– LM shifts down– Internal balance at B

• At B: BP<0, r<r*

• Net currency out flow• CB must sell $ for € (why?)

– Money supply falls back– LM Shifts up

• Return to A• MP is ineffective• Only change is in central banks balance sheet

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A

B

r

Y

LM0

LM1 IS0

Monetary Policy: Fixed e, SOE

BPr*

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Fiscal Policy with Floating e

• G up: IS shifts to right – Internal balance at B

• BP>0, r>r*

– excess supply of $ and/or excess demand for €– Under float e this leads to an appreciation of €– $ price of € rises– Exports fall– IS curve shifts left

• Balance restored at A• Note contrast with closed economy and fixed e

– No change in r– No change Y– Net exports are crowded out

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A

B

LM0

IS0

IS1

Fiscal policy: Float e, SOE

r

Y

BPr*

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Monetary Policy with Float e• Expand the Money supply

– LM shifts down– Internal balance at B

• BP<0, r<r*

– net outflow of funds– Excess demand for $ (or supply of €)

• Price of € falls: e falls; depreciation in the €– Net exports rise– IS curve shifts to the right

• Overall Balance at C• Note contrast with closed economy and fixed e

– No change in r– Larger change in Y– Net exports are “crowded in”

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A

B

C

Y

LM0

LM1IS0

IS1

Monetary policy: Float e, SOE

r

BP

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Policy In an Open Economy

• Can look at Monetary, Fiscal and Exchange Rate Policy

• If we think of the purpose of policy is to control Y then we get

• The reason is the automatic effects of BP

Fixed e Float eFiscal Effective IneffectiveMonetary Ineffective Effective