Download
1 / 127
1.28k likes | 1.76k Views
EC202A Macroeconomics. The IS-LM-BP modelReading material that you may find useful: Abel, Bernanke and McNabb, Chapters 5 and 14. Abel, Bernanke, 5th ed, Chapters 5 and 13. Dornbusch, Fisher and Startz, 9th ed, Chapter 12.Begg, Fischer an Dornbusch, 7th ed, Chapters 28 and 29.. . Outline:The Goods Market Equilibrium in an Open Economy ;The open-economy IS curve ;The Balance of Payments and Capital Flows ;The BP curve ;The Mundell-Fleming model ..
E N D
1. EC202A Macroeconomics
Handout 2
Laura Povoledo
The University of Reading
2. EC202A Macroeconomics
The IS-LM-BP model
Reading material that you may find useful:
Abel, Bernanke and McNabb, Chapters 5 and 14.
Abel, Bernanke, 5th ed, Chapters 5 and 13.
Dornbusch, Fisher and Startz, 9th ed, Chapter 12.
Begg, Fischer an Dornbusch, 7th ed, Chapters 28 and 29.
3. Outline:
The Goods Market Equilibrium in an Open Economy ;
The open-economy IS curve ;
The Balance of Payments and Capital Flows ;
The BP curve ;
The Mundell-Fleming model .
4. The Goods Market Equilibrium in an Open Economy Economies are linked internationally through two main channels:
trade in goods and services;
international financial markets.
First, let’s consider the effects of trade with the rest of the world on the goods market equilibrium and then we’ll understand how to modify the IS curve.
5. The Goods Market Equilibrium in an Open Economy Previously, we have seen that the goods market equilibrium condition can be expressed in two ways:
1) National saving equals investment:
6. The Goods Market Equilibrium in an Open Economy What changes in an open economy?
National saving now has two uses:
increase the nation’s capital stock by domestic investment;
increase the stock of net foreign assets by lending to foreigners.
We capture this by re-writing the equilibrium condition (1) in the following way:
7. The Goods Market Equilibrium in an Open Economy
Eq. (1)’ shows the uses of savings in an open economy. Investment I is accrued to the domestic capital stock. The current account balance CA indicates the amount of funds that the country has available for net foreign lending.
8. The Goods Market Equilibrium in an Open Economy The closed economy equilibrium condition (1) is a special case of the open economy equilibrium condition (1)’, with CA =0.
9. The Goods Market Equilibrium in an Open Economy We can also re-write the equilibrium condition (2) - aggregate supply equals aggregate demand – for an open economy.
The main change is that domestic spending no longer determines domestic output. Instead, spending on domestic goods determines domestic output.
Define:
A = spending by domestic residents
Then:
10. The Goods Market Equilibrium in an Open Economy Spending on domestic goods is total spending by domestic residents less their spending on imports plus foreign demand or exports.
Therefore:
Where:
X = exports;
Q = imports.
11. The Goods Market Equilibrium in an Open Economy In order to obtain an equilibrium condition, we write:
What is an equilibrium condition, and what is an identity?What is an equilibrium condition, and what is an identity?
12. The Goods Market Equilibrium in an Open Economy What affects net exports NX?
Foreign output YF (higher foreign output increases X and NX)
Domestic output Y (higher domestic output increases Q and decreases NX)
The real exchange rate (higher means more exports and less imports)
13. The open-economy IS curve The IS curve shows the possible combinations of the interest rate r and domestic output Y, for which the goods market is in equilibrium.
In the closed economy, the IS curve can be written as:
Meaning: the goods market is in equilibrium when aggregate supply is equal to aggregate demand for goods. Consumption depends on Y, investment depends on r. We draw the IS line (goods market equilibrium condition) in the (r, Y) plane.
14. The open-economy IS curve In the open economy, the goods market equilibrium condition becomes:
Or simply:
15. The open-economy IS curve The IS curve is shifted by changes in G, YF and the real exchange rate (we are assuming that prices are fixed).
16. The open-economy IS curve
17. LM - Money market equilibrium in the open economy
18. The Balance of Payments and Capital Flows The Balance of Payments (from now on, BP) is the record of transactions between one country and the rest of the world.
The two main accounts in the BP are the current account and the capital account:
The current account records trade in goods, services, and transfer payments.
The capital account records the trade in assets.
19. The Balance of Payments and Capital Flows Balance of payments accounts = The record of a country’s international transactions.
Any transaction that involves a flow of money into the UK is a credit item (enters with a plus sign).
Any transaction involving a flow of money out of the UK is a debit item (enters with a minus sign).
20. The Balance of Payments and Capital Flows The overall BP surplus or deficit is the sum of the current and capital account surpluses or deficits:
Since residents of a country must pay for what they buy abroad, any current account deficit must be necessarily financed by an offsetting capital flow:
21. The Balance of Payments and Capital Flows But what are the economic forces that affect the BP? To answer this question we must look at each separate component of the BP.
For convenience we divide the current account into 3 components:
22. The Balance of Payments and Capital Flows In general, NFP and NT are not much affected by current macroeconomic developments. From now on, we assume them to be equal to 0 for simplicity.
We write: CA = X(YF, ) - Q(Y, )
23. The Balance of Payments and Capital Flows A rise in foreign income increases exports:
A real depreciation improves net exports:
A rise in domestic income increases imports:
So the CA is a function of 3 variables:
The real exchange rate measures a country's competitiveness in foreign trade. If prices stay fixed then eR and eNOM (real and nominal exchange rate respectively) always move in the same direction. Why the signs?Why the signs?
24. The Balance of Payments and Capital Flows
Again, we look first at the separate components.
It is often useful to split the capital account into two separate components: (1) the transactions of the country’s private sector and (2) official reserve transactions, which correspond to the central bank activities:
25. The Balance of Payments and Capital Flows The U.S. current account has been consistently in deficit over the last two decades, and in each of these years, the U.S. experienced a net inflow of capital.
Why buy/sell? What happens to reserves?
The U.S. current account has been consistently in deficit over the last two decades, and in each of these years, the U.S. experienced a net inflow of capital.
Why buy/sell? What happens to reserves?
26. The Balance of Payments and Capital Flows
27. The Balance of Payments and Capital Flows The sensitivity of KA to changes in interest rate differentials is a crucial issue, since it depends on the degree of capital mobility.
Three cases are possible (partial derivatives):
Examples of the 3 cases?Examples of the 3 cases?
28. The Balance of Payments and Capital Flows Explanation:
If capital is assumed to be perfectly mobile, investors in one country can trade assets with investors in any other country without restrictions, that is, at low transaction costs and in unlimited amounts, in search of the highest yield or the lowest borrowing costs.
29. We are now ready to write the BP equation:
This equation shows the BP equilibrium condition as a function of 6 macroeconomic variables.
The next task is to obtain a diagram on the (r, Y) plane that represents all the possible combinations of the domestic real interest rate r and domestic output Y, for which the above equation BP = CA + KA = 0. We call this line the BP curve/line. The BP curve
30. The BP curve In the (r, Y) plane the balance of payments becomes a function of the domestic real interest rate r and domestic output Y only:
The slope of the BP line depends on the degree of capital mobility.
31. The BP curve
32. The BP curve Under fixed exchange rates, if CA+NPKI=0, Official Reserve Transactions are 0 and the LM does not move. There cannot be an equilibrium such as CA+NPKI+ORT=0 with ORT different from 0.
Under floating exchange rates (so assume ORT=0), CA+NPKI=0 always since the depreciation/appreciation in the foreign exchange market is immediate.
Also note: the US is on the BP curve, since up to now the CA deficit has been matched by sufficient NPKI. However, a protracted CA<0 is unsustainable.Under fixed exchange rates, if CA+NPKI=0, Official Reserve Transactions are 0 and the LM does not move. There cannot be an equilibrium such as CA+NPKI+ORT=0 with ORT different from 0.
Under floating exchange rates (so assume ORT=0), CA+NPKI=0 always since the depreciation/appreciation in the foreign exchange market is immediate.
Also note: the US is on the BP curve, since up to now the CA deficit has been matched by sufficient NPKI. However, a protracted CA<0 is unsustainable.
33. The BP curve
34. The BP curve
35. The BP curve
36. The Mundell-Fleming model
37. EC202A Macroeconomics
Monetary Policy in the IS-LM-BP model
Reading material that you may find useful:
Dornbusch, Fisher and Startz, Chapter 12 (9th ed).
Begg, Fischer an Dornbusch, Chapter 29 (7th ed).
38. Objective of the lectures
While the IS-LM-BP model still works under the assumption that the price level is given, it nevertheless clearly establishes the key linkages among open economies: trade, the exchange rate and capital flows.
In this lecture, we want to understand how
monetary policy operates in the open economy, under fixed or floating exchange rates.
39. Outline:
Exchange rates and the equilibrium in the Balance of Payments ;
The IS-LM-BP model (revision) ;
Monetary Policy under imperfect capital mobility ;
Monetary Policy under perfect capital mobility ;
Monetary Policy without capital mobility .
40. Exchange rates and the equilibrium in the Balance of Payments Choice of exchange rate regime: Fluctuation band: 2.25%, raised to 15% in 1993.Fluctuation band: 2.25%, raised to 15% in 1993.
41. Exchange rates and the equilibrium in the Balance of Payments
42. Exchange rates and the equilibrium in the Balance of Payments
43. Exchange rates and the equilibrium in the Balance of Payments
44. Exchange rates and the equilibrium in the Balance of Payments
45. Exchange rates and the equilibrium in the Balance of Payments
46. Exchange rates and the equilibrium in the Balance of Payments
47. Exchange rates and the equilibrium in the Balance of Payments
48. The IS-LM-BP model (revision)
49. The IS-LM-BP model (revision)
50. The IS-LM-BP model (revision)
51. The IS-LM-BP model (revision) goods market equilibrium
Or simply:
52. The IS-LM-BP model (revision)
53. The IS-LM-BP model (revision)
54. The IS-LM-BP model (revision)
55. Monetary Policy under imperfect capital mobility
56. Monetary Policy under imperfect capital mobility
57. Monetary Policy under imperfect capital mobility Explanation:
E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase and as interest rates fall capital outflows increase, so BP is in deficit at E1.
58. Monetary Policy under imperfect capital mobility
59. Monetary Policy under imperfect capital mobility Explanation:
E0 to E1 : Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). As output increases imports increase, and as interest rates fall capital outflows increase, so BP0 is in deficit at E1.
60. Monetary Policy under perfect capital mobility
61. Monetary Policy under perfect capital mobility
62. Monetary Policy under perfect capital mobility
63. Monetary Policy under perfect capital mobility Jean-Claude Trichet is now (since 2003) the president of the ECB (the European Central Bank).Jean-Claude Trichet is now (since 2003) the president of the ECB (the European Central Bank).
64. Monetary Policy under perfect capital mobility Explanation:
Expansion of MS determines a decrease in the interest rate, which both stimulates investment and increases output (movement along the IS curve). However, any fall in interest rates will generate a massive capital outflow. The central bank must reduce the domestic money supply, to prevent a change in interest rates. As a result, the economy stays at E0.
65. Monetary Policy under perfect capital mobility
66. Monetary Policy under perfect capital mobility Explanation:
E0 to E2 : An increase in money supply shifts the LM curve to the right, so the interest rate falls while the level of output demanded increases (E1). At E1, the goods and money market are in equilibrium (at the initial exchange rate), but r has fallen below rF . The lower domestic interest rate causes an outflow of capital, which causes a currency depreciation. Because of the depreciation, competitiveness increases and the IS shifts to the right. At point E2, there is no further tendency for exchange rate to change.
67. Monetary Policy under perfect capital mobility We have shown that, under floating exchange rates, a monetary expansion in the home country leads to exchange rate depreciation, increased exports and a higher level of domestic output. But our depreciation shifts demand from foreign goods to home goods. Beggar-thy-neighbor or competitive devaluations is one of the reasons for the EMU.Beggar-thy-neighbor or competitive devaluations is one of the reasons for the EMU.
68. Monetary Policy without capital mobility
69. Monetary Policy without capital mobility
70. Monetary Policy without capital mobility
71. EC202A Macroeconomics
Fiscal Policy in the IS-LM-BP model
Reading material that you may find useful:
Dornbusch, Fisher and Startz, Chapter 12 (9th ed).
Begg, Fischer an Dornbusch, Chapter 29 (7th ed).
72. Objective of the lecture
To understand how fiscal policy operates in the open economy, under fixed or floating exchange rates.
The IS-LM-BP model is our method of analysis.
73. Outline:
The adjustment out of equilibrium ;
Fiscal Policy under imperfect capital mobility;
Fiscal Policy under perfect capital mobility ;
Fiscal Policy without capital mobility ;
Stabilization policy .
74. The adjustment out of equilibrium
75. The adjustment out of equilibrium
76. The adjustment out of equilibrium
77. The adjustment out of equilibrium
78. The adjustment out of equilibrium
79. Fiscal policy (foreword)
80. Fiscal policy (foreword)
81. Fiscal Policy under imperfect capital mobility
82. Fiscal Policy under imperfect capital mobility Explanation:
E0 to E1 : due to the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen.
83. Fiscal Policy under imperfect capital mobility
84. Fiscal Policy under imperfect capital mobility Explanation:
E0 to E1 : after the expansionary fiscal policy IS0 shifts to IS1 . As income increases, so does money demand, and equilibrium in the money market is maintained provided the domestic interest rate r rises. In E1 the BP is now in surplus as r has risen.
85. Fiscal Policy under perfect capital mobility
86. Fiscal Policy under perfect capital mobility
87. Fiscal Policy under perfect capital mobility
88. Fiscal Policy under perfect capital mobility
89. Fiscal Policy under perfect capital mobility Explanation:
After the expansionary fiscal policy, the IS shifts to the right and the domestic interest rate rises above the level of the world interest rate rF. A capital inflow occurs, leading to an appreciation of the domestic currency. The appreciation makes foreign goods cheaper for domestic citizens, and exported goods become relatively more expensive for foreigners. Therefore, net exports decrease and the IS shifts back to its original location.
90. Fiscal Policy without capital mobility
91. Fiscal Policy without capital mobility
92. The effectiveness of monetary/fiscal policies on output depends on the exchange rate regime and on the degree of capital mobility (summary table):
93. Stabilization policy
94. Stabilization policy
95. Stabilization policy Stabilization policy = the use of fiscal/monetary policy to restore internal/external balance.
96. Stabilization policy Example 1: Fixed exchange rates
97. Stabilization policy Example 2: Automatic adjustment of the BP
98. EC202A Macroeconomics
Exchange Rate Policy in the IS-LM-BP model
Recommended reading:
Begg, Fischer an Dornbusch, Chapter 29
Abel, Bernanke and McNabb, Chapter 14
99. Objective of the lecture
To understand exchange rate policy , as one of the tools available to policymakers to influence the level of economic activity in their country.
Monetary and fiscal policy are not the only available tools.
In this lecture we will see how exchange rate policy works.
100. Outline:
Exchange rate policy in the Mundell-Fleming model ;
Are devaluations effective in the long run? ;
How to fix the exchange rate ;
Fixed versus floating exchange rates ;
Exchange rates & monetary policy.
101. Exchange rate policy in the Mundell-Fleming model
102. Exchange rate policy in the Mundell-Fleming model Terminology:
103. Exchange rate policy in the Mundell-Fleming model In order to represent the effects of a devaluation in the Mundell-Fleming model, we must go back to its building blocks:
since the nominal exchange rate only enters the IS and the BP lines, devaluation does not affect the LM.
104. Exchange rate policy in the Mundell-Fleming model
105. Exchange rate policy in the Mundell-Fleming model
106. Exchange rate policy in the Mundell-Fleming model
107. Exchange rate policy in the Mundell-Fleming model In E2, output is above full employment so prices will start rising.In E2, output is above full employment so prices will start rising.
108. Exchange rate policy in the Mundell-Fleming model Explanation:
E0 to E1 : Devaluation means that the balance of payments equilibrium changes - shift from BP0 to BP1 -. Net exports increase – shift of IS0 to IS1 -. As output expands interest rates rise, so there will be a capital inflow. This will result in a balance of payments surplus (point E1), and excess demand of domestic currency.
109. Are devaluations effective in the long run? Q: In the long run can changes in a nominal variable (the nominal exchange rate) ever have any effect on real variables (output, competitiveness)?
A: No, unless there is real change in the economy at the same time. In the absence of this, the eventual effect of devaluation is a rise in all other nominal wages and prices in line with the higher import prices, leaving all real variables unchanged.
110. Are devaluations effective in the long run? Eventually, devaluation has no real effects. Most empirical evidence suggests that the effect of devaluation is completely offset by a rise in domestic wages and prices after 4-5 years. Devaluation leads to a temporary, not a permanent, increase in competitiveness.
In the long run, competitiveness is determined by real factors, and it goes back to its long-run equilibrium level.
However, devaluation is the simplest way to change competitiveness quickly. It may thus be an appropriate response to a real shock which needs a quick change in the equilibrium real exchange rate.
111. Are devaluations effective in the long run?
112. Are devaluations effective in the long run?
113. Fixed exchange rates and macroeconomic policy
114. Fixed exchange rates and macroeconomic policy
115. How to fix the exchange rate It is preferable to use the words “market value” instead of “fundamental value” as in Abel and Bernanke’s book, because the concept of fundamental value (for the nominal exchange rate) can be misleading. There is no reliable, unilaterally accepted model of exchange rates yet, so how can we talk about a fundamental value of the nominal exchange rate? “Market value” is simply what the markets want, the markets’ evaluation of exchange rate. This is what is implied by Abel and Bernanke really.It is preferable to use the words “market value” instead of “fundamental value” as in Abel and Bernanke’s book, because the concept of fundamental value (for the nominal exchange rate) can be misleading. There is no reliable, unilaterally accepted model of exchange rates yet, so how can we talk about a fundamental value of the nominal exchange rate? “Market value” is simply what the markets want, the markets’ evaluation of exchange rate. This is what is implied by Abel and Bernanke really.
116. How to fix the exchange rate How can a country deal with a situation in which its official exchange rate is overvalued?
117. How to fix the exchange rate
118. How to fix the exchange rate
119. How to fix the exchange rate
120. How to fix the exchange rate
121. How to fix the exchange rate
122. Fixed versus floating exchange rates
123. Fixed versus floating exchange rates
124. Fixed versus floating exchange rates
125. Fixed versus floating exchange rates
126. Fixed versus floating exchange rates
127. Exchange rates & monetary policy
128. Exchange rates & monetary policy
