ECON 671 International Economics

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ECON 671 International Economics

• Exchange Rate Regimes and the
• IS-LM-BP Model

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IS-LM-BP under a Flexible Exchange Rate Regime
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IS-LM-BP Model with Flexible EXR

• IS-LM-BP Model described by 3 equations
• (IS) Y C (Y-T, W) I(i) G NX(e, Y,
  YROW, W)
• (LM) Ms/P a(DR IR)/P f(Y, i, W, E(p))
• (BP) BOP0 NX(e, Y, YROW, W) j(i, i xa)
• IS-LM-BP with Flexible Exchange Rate Regime
• Endogenous Variables Y, i, e
• Exogenous Variables G, T, DR, W, P, M
• In a Flexible Exchange Rate Regime, adjustment to
  FX market equilibrium occurs through changes in
  exchange rate, e.
• Changes in e will shift both IS and BP Curves in
  adjustment to equilib.
• No Changes in LM Curve to changes in e.

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IS-LM-BP Model
Interest
Rate
BOP Surplus Currency appn, e falls
BOP Deficit Currency depn, e rises
Income, Output
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Fiscal Policy under a Flexible Exchange Rate
Regime
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Fiscal Policy with Flexible EXR

• Look at effects of increase in govt spending, G.
• Direct Effect
• Increase in G will shift IS Curve outwards.
• No Direct effect on either BP or LM Curves.
• New internal equilibrium where LM and new IS
  intersect.
• Both Y and i increase at new intersection. This
  is not overall equilib.!!
• What is status of BoP at this point?
• Depends on capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• If capital is relatively immobile
• BOP lt 0, resulting incipient BOP deficit causes
  EXR to depreciate, e rises.
• This shifts the IS and BP Curves outwards until
  IS-BP-LM all intersect.
• If capital is relatively mobile
• BOP gt 0, resulting incipient BOP surplus causes
  EXR to appreciate, e falls.
• This shifts the IS and BP Curves inwards until
  IS-BP-LM all intersect.

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Fiscal Policy with Flexible EXR
Interest
Rate
LM0
BP(e0, i, Y)
i0
A
IS(e0, G0, T0)
Income, Output
Y0
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Fiscal Policy Capital Mobility
Capital Perfectly Mobile
Capital Completely Immobile
i
i
BP0
LM0
IS0
LM0
IS0
BP0
i0
i
Y0
Y0
Y
Y
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Fiscal Policy Capital Mobility
Capital Relatively Mobile
Capital Relatively Immobile
i
i
BP0
IS0
LM0
IS0
LM0
BP0
i0
i0
Y0
Y0
Y
Y
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Monetary Policy under a Flexible Exchange Rate
Regime
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Monetary Policy with Flexible EXR

• Look at effects of increase in money supply
  through higher DR.
• Direct Effect
• Increase in Ms shift LM Curve outwards.
• No Direct effect on either BP or IS Curves.
• New internal equilibrium where LM and new IS
  intersect.
• Rise in Y and i falls at new intersection. This
  is not overall equilib.!!
• BoP at this point is always in deficit regardless
  of capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• Incipient BoP deficit means that home currency
  will depreciate, e rises.
• This shifts both IS and BP Curves out until get
  to new IS-LM-BP equilibrium.
• Monetary policy is very effective under Flexible
  Exchange rate Regime
• Independent monetary policy is possible as
  Central Bank is not forced to intervene in FX
  market to keep EXR at set level.

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Monetary Policy Capital Mobility
Capital Perfectly Mobile
Capital Completely Immobile
i
i
BP0
LM0
LM0
BP0
i0
i
IS0
IS0
Y0
Y0
Y
Y
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Monetary Policy Capital Mobility
Capital Relatively Mobile
Capital Relatively Immobile
i
i
BP0
LM0
LM0
IS0
BP0
i0
i0
IS0
Y0
Y0
Y
Y
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Effects of Foreign Events under a Flexible
Exchange Rate Regime
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Effect of Foreign Income and Prices

• Look at effects of rise in ROW incomes, Y or
  foreign prices, P.
• Direct Effects
• Rise in Y or P raises NX which shifts IS and
  BP Curves outwards.
• No Direct effect on LM Curve.
• New internal equilibrium where LM and new IS
  Curves intersect.
• Both Y and i rise in new at new intersection.
  This is not overall equilib.!!
• BoP at this point is always in surplus regardless
  of capital mobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• Incipient BoP surplus means that e will fall,
  appreciation of currency.
• This shifts the IS and BP Curves backs until get
  to original equilibrium.
• Rise in ROW Incomes or Prices does not increase
  domestic output.
• Appreciation of the currency will offset effects
  of change in ROW variables.

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Effects of Increase in Y or P
Interest
BP(e0, i, Y0)
Rate
LM(Ms/P)
IS(e0, Y0)
Income, Output
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Effect of Foreign Interest Rate

• Look at effects of rise in ROW interest rate i.
• Direct Effects
• Rise in i raises capital outflows which shifts
  BP Curve upwards.
• No Direct effect on IS or LM Curves.
• Internal equilibrium unchanged but new external
  equilibrium.
• BoP in deficit except for perfect capital
  immobility.
• Indirect Effects (Automatic Adjustment to New
  Equilibrium)
• If capital is perfectly immobile
• No change at all , either directly or indirect
  adjustment.
• If capital is mobile
• BOP lt 0, resulting incipient BOP deficit causes
  EXR to depreciate, e rises.
• This shifts the IS and BP Curves outwards until
  IS-BP-LM all intersect.
• Rise in Domestic GDP and domestic interest rate.

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Effects of Increase in i
Interest
LM(Ms/P)
Rate
BP(e0, i0)
i0
IS(e0)
Y0
Income, Output
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Effect of Domestic Price Level

• Look at effects of rise in domestic prices, P.
• Direct Effects
• Rise in P lowers NX which shifts IS and BP
  Curves inwards.
• Also lowers real money supply so LM Curve shifts
  back.
• New internal equilibrium where new IS, BP, and LM
  Curves intersect.
• Y decreases at new intersection. This is new
  overall equilib.!!
• BoP at this point is always in surplus regardless
  of capital mobility or EXR regime for that
  matter.

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Increase in Domestic Prices
Interest
Rate
BP(e0, P0)
LM(Ms/P0)
i0
IS(e0, P0)
Y0
Income, Output
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Summary of Policy Effects under a Flexible
Exchange Rate Regime
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Policy Effects with Flexible EXR

• Fiscal Policy
• Directly affects only the IS Curve.
• Adjustments to equilibrium depend on degree of
  capital mobility.
• Higher the degree of capital mobility, the less
  effective is fiscal policy.
• When capital immobile, EXR adjustment mostly
  shifts BP increases Y.
• When capital mobile, EXR adjustment mostly shifts
  IS decreases Y.
• Monetary Policy
• Directly affects only the LM Curve.
• Adjustments to equilibrium does not depend on
  degree of capital mobility.
• Monetary policy is very effective in changing Y.
• Most effective when capital perfectly mobile,
  keeps domestic i i.
• Effect on interest rate uncertain in most cases,
  depends on relative shifts and slopes of IS and
  BP curves.