Building the IS-LM-FX Model Macroeconomic Policy …yyliu.weebly.com/uploads/1/5/5/7/15579332/chapter7.pdfBuilding the IS-LM-FX Model Macroeconomic Policy Analysis Understand the Demand

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


Outline

1 Building the IS-LM-FX ModelUnderstand the DemandDerive the IS curveDerive the LM curve

2 Macroeconomic Policy AnalysisMonetary PolicyFiscal Policy



Understand the DemandDerive the IS curveDerive the LM curve

Outline






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.




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.




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




ConsumptionConsumption is a function of disposable income.

C = C(Y − T )

Example: C = 10 + 0.75(Y − T )




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.




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




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.




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)




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.




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 ∗)




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.




Shocks

Example:optimism about investment opportunities.rise in investment at any interest rate level.




Shocks

Example: tasts shifts between home and foreign goods.Trade balance increases at any real exchange rate level.




The Keynesian CrossGoods market equilibrium:All goods produced must be willingly demanded andpurchased.




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.




The Keynesian Cross




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.




The IS curve shows combinations of output Y and the interestrate i for which the goods and FOREX markets are inequilibrium.




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




Factors that shift IS 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.




The LM curve shows the combinations of Y and i at which themoney market is in equilibrium.




Factors that shift LM curve:a rise in nominal money supply

an exogenous drop in money demand




At i1, Y1, goods market, FOREX market, money market are allin equilibrium.



Monetary PolicyFiscal Policy

Outline






Monetary Policy under Flexible exchange rateregime




Monetary Policy under Fixed exchange rate regime




Fiscal Policy under Flexible exchange rate regime




Fiscal Policy under Fixed exchange rate regime




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.




Case Study


Documents

Building the IS-LM-FX Model Macroeconomic Policy …yyliu.weebly.com/uploads/1/5/5/7/15579332/chapter7.pdfBuilding the IS-LM-FX Model Macroeconomic Policy Analysis Understand the Demand