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
· 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 = NX0 - b1 Y – b2 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 – rf) 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.