Macro Polixy In An Open Economy Flashcards
What is the Mundell Fleming model
It has three equilibrium conditions:
Goods market equilibrium the IS curve
Money market equilibrium the LM curve
BOP equilibrium the BP curve
What is the IS curve?
Quantity of goods and services supplied = quantity demanded. Leakages = spending injections: S+T+IM=I+G+X. Income received from goods and services = total spendings. S depends on income. T set by gov. IM depends on income. I depends on rate of interest. G is set by gov. X depends on foreign income. Downward sloping. If interest rate falls investment becomes more profitable, increased investment. Generates more income.
What is the LM curve?
Willingness to hold money = quantity of money supply. So Ms=Md. Money supply is fixed by BOE. Vertical curve. Money demand is a function of income (Y) and interest rate (I). People will hold more cash as amount of transactions increases with their income. Increase interest rate decreases quantity demanded for money. Increase income will shift the demand for money to the right. So increase interest rate increases income.
What is the BP curve?
Balance of payments equilibrium. Current account deficit = capital account surplus. Combination of I and Y that yield balance of payments equilibrium. Drawn for give domestic price level, given ER and given net foreign debt. CS=CD because if a country exports more than it imports that income can be used to hold reserves or invest in foreign assets or pay foreign debt. Higher interest rate, attracts foreign investors. Current account able to sustain higher deficit. If capital perfectly mobile BP is horizontal. If not it’s upward sloping.
What is fiscal policy?
Government spending and taxation. If government spent more than the tax received it’s a government run budget deficit otherwise known as expansionary fiscal policy- which aims to boost the coming though AD and economic growth. When there is more taxation than spending it does the opposite in order to cool down the economy. It shifts the IS curve.
What is monetary policy?
Controls the money supply, interest rates and credit available to the economy. To achieve controlled inflation, stabilising currency and econ growth and employment levels. Increase money supply is expansionary monetary policy. It can lowers interest rates also. Boosting consumption, investment and AD. Contractionary does the opposite by decreasing money supply and/or interest rates. Shifts the LM curve.
Monetary expansionary policy under fixed ER?
LM shifts right. Interest rate falls, Y rises. Capital outflow. Official settlements deficit. Pressure domestic currency to depreciate. CB has to buy domestic currency and sell foreign currency to peg. Buying domestic currency decreases money supply. Move LM back to original location.
Expansionary fiscal policy under fixed ER?
IS curve shift right. Income rises and interest rate rises. Large KA surplus. Official settlements become a surplus. Pressure domestic currency to appreciate. To peg CB has to buy foreign currency and sell domestic currency. Increase money supply. LM shift right.
Expansionary monetary policy under floating ER?
Lm shift right. Income rises, interest rate falls. Large CA deficit. Official settlements deficit. Domestic currency depreciates. Currency depreciation makes domestic exports become relatively cheaper. Increase exports shifts IS curve to right.
Expansionary fiscal policy under floating ER?
IS curve shifts right. Income rises and interest rates rise. KA surplus. Official settlements surplus. Domestic currency appreciates. Appreciation of currency shifts IS curve left. Return to original equilibrium.
Fixed ER vs Floating ER
Fixed ER. CB intervention. Monetary policy ineffective, offset by interventions to maintain ER peg.If CB increases MS interest rates fall, leading to capital outflows. CB buys domestic currency, undoing monetary expansion. Fiscal policy effective as capital inflows amplify it. External adjustments are done via reserves or Domestic policies. CB maintains its exchange rate peg.
Floating ER. Market driven. Monetary policy effective as CB has full control over it. Fiscal policy ineffective as it’s offset by exchange rate changes. E.g expansionary raises interest rates, capital inflows and appreciates currency. Reduces net exports, counteracting fiscal expansion. External adjustment via exchange rate movements. CB domestic objectives is priority e.g inflation.
Expansionary fiscal policy IS-LM-BP for UK furlough scheme?
Shifts IS curve to the right due to higher AD. Under floating ER higher Y, raises demand for money, pushing up interest rate (I). Attracts capital inflows, capital account surplus. ER depreciates due to increased demand for domestic currency. Worsens CA. IS curve shifts back to orig equilibrium. Partially effective due to ER offset. Furlough scheme was financed by substantial gov borrowing. Was effective due to unique conditions globally via the pandemic e.g. reduced global capital mobility and ER volatility and coordinated monetary easing. Imports and exports were also affected, limiting offset of ER appreciation on the CA.
What is internal equilibrium?
Where goods market and money market are in equilibrium at full employment output (Y) without inflationary or recessionary pressures. IS curve intersects the LM curve at full employment. Y=Y.
What is external equilibrium?
Condition where BOP is in equilibrium. CA+KA=0. It is achieved when domestic interest rate equals foreign interest rate (I=If) ensuring no net capital inflows or outflows.
Why is internal balance more important than external balance?
Internal affects economic stability and employment. Controlling inflation also protects PPP and economic confidence. External is often less immediately visible. External deficits can be managed more temporarily like the CA deficit can be financed through borrowing on drawing on foreign exchange reserves. In floating economies external imbalances often correct themselves. External balances often require structural changes which only benefit long term. By improving internal balance it can improve external balance over time.
