General Equilibrium, the IS-LM Model, and International
Influences

The
IS Curve:

·
Aggregate
expenditure depends on real income and the real interest rate, as well as other
autonomous influences (including the price level)

·
The
combination of real interest rates and real income levels that result in
equilibrium in the goods market is called the IS curve

·
The
demand for real money balances depends on real income and the real interest
rate

·
The
real money supply depends on the nominal money supply and the price level

·
The
combination of real interest rates and real income levels that result in
equilibrium in the money market is called the LM curve

IS-LM
Equilibrium

·
Equilibrium
income and the real interest rate is determined by simultaneous equilibrium in
the goods market and the money market

·
Change
in autonomous forces and the price level will lead to a shift in the IS or LM
curve leading to a change in equilibrium income

Fiscal
Policy and the IS Curve

·
Higher
expenditure or lower taxes shift the IS curve and AD curve to the right

·
The
impact of the shift depends in part on the slope of the LM curve

Monetary
policy and the LM Curve

·
More
money shifts the LM curve and the AD curve to the right

·
The
impact of the shift depends in part on the slope of the IS curve

·
Effect
of real income

·
Effect
of the real foreign exchange rate

·
NX
= NX_{0 } - b_{1} Y – b_{2}
e

The
Real Exchange Rate and the Interest Rate Differential

·
The
mechanism by which a real interest rate differential affects the real exchange
rate involves the flow of capital between countries

·
If
perfect capital mobility the flow of capital will soon eliminate the real
interest rate differential

·
Free
capital mobility is most relevant for a small open economy

The
IS-LM Model in a Small Open Economy with Perfect Capital Mobility

·
The
differential between domestic and foreign interest rates (r – r^{f})
must remain at zero

·
Any
shift in the domestic IS or LM curve will generate capital flows that will
quickly bring the domestic interest rate into line with the unchanged foreign
interest rate.

The
IS-LM Analysis of a Change in Policy in a Small Open Economy with Fixed
Exchange Rates

·
Monetary
expansion shifts the LM curve outward, initially lowering interest rates, but
this generates huge capital outflows and losses of international reserves. To prevent this the central bank must boost
the interest rate to its original level by reducing the money supply. Hence, monetary policy is completely
ineffective.

·
Fiscal
expansion shifts the IS curve outward, initially increasing the real interest
rate, generating capital inflows, swamping the central bank with reserves. Under a fixed system, the central bank must
respond by increasing the money supply, shifting the LM curve outward, until
interest rates return to their original level.
This makes fiscal policy even more effective.

·
*Perfect capital mobility with fixed exchange rates forces monetary
policy to be accommodative; in effect fiscal policy gains control of monetary
policy*.

The IS-LM Analysis of a Change in Policy in a Small
Open Economy with Flexible Exchange Rates

·
When
exchange rates are flexible, the central bank does nothing to prevent an
exchange rate appreciation or depreciation

·
A
change in the real interest rate differential will cause a change in the real
exchange rate

·
Monetary
expansion shifts the LM curve to the right, lowering the real interest rate and
depreciating the real exchange rate as capital leaves the country. The lower real exchange rate increases net
exports and shifts the IS curve to the right until the economy reaches
equilibrium at the former real interest rate.
At that point the currency stops depreciating and the economy reaches
full equilibrium with a boost in real income and net exports.

·
If
real income is beyond the economy’s potential, then the combination of higher
income that increases net imports and higher prices that lower net exports
results in no permanent change in real income.

·
Fiscal
expansion shifts the IS curve to the right, increasing the real interest rate
and appreciating the real exchange rate as capital enters the country. The higher exchange rate (and initially
higher domestic income) causes net exports to fall until the IS curve shifts
back to its original position and equilibrium income is unchanged.

Domestic crowding out is replaced by international crowding out unless
there is a change in the LM curve.

· *In a small open economy with
flexible exchange rates, monetary policy is highly effective. The central bank can control the money
supply and can stimulate the economy by causing the exchange rate to
depreciate. But, with flexible exchange
rates fiscal policy is impotent and international crowding out is complete.*

Capital
Mobility and Exchange Rates in a Large Open Economy

·
A
large open economy (like the U.S.), unlike a small open economy has substantial
control over its domestic interest rate.

·
The
reason is that its large size compared to the rest of the world means that capital
flows are not sufficiently powerful to push its domestic interest rate into
exact equality with the world interest rate.