Week 17 - IS-LM-BP Flashcards
Why is the BP schedule flat?
Because of perfect capital mobility.
- Anywhere above the line, capital will flood into a country until returns are equalised and the interest rate restores to the world rate.
- Anywhere below the line, capital flows out of the country, until eventually the interest rate rises back to the world level.
How does an increase in the demand for goods affect output and e under FIXED exchange rates?
- IS shifts right, however, r has increased.
- CB has to increase money supply (by buying foreign currency with pounds), shifting LM to the right.
- Net effect: r doesn’t change (as required), but output increases. Fiscal policy is effective when exchange rates are fixed.
How does an increase in the rate of return on foreign assets (a financial disturbance) affect e and output under FIXED exchange rates?
- BP line shifts upward. Now the world exchange rate is higher than before.
- To equate domestic interest rates with world interest rates, CB must reduce money supply (shifting LM to the left). They do this by selling foreign currency reserves in exchange for pounds.
- Net effect: Output reduces, r rises.
How does an increase in the rate of return on foreign assets (a financial disturbance) affect e and output under FLOATING exchange rates?
BP line shifts upwards, as before.
- However, now i is below i*. This leads to a depreciation of the exchange rate, making exports seem relatively cheaper. This increases IS until all three curves intersect.
- Net effect: i rises to i* level, and output increases.
What’s the effect of expansionary monetary policy under floating exchange rates?
- Shifts LM to the right. However, now i is lower than i*.
- The exchange rate therefore depreciates, and therefore exports increase and imports decrease.
- IS therefore shifts to the right, increasing output.
- Net effect: i remains unchanged, output increases. Monetary policy is effective under flexible exchange rates.
How does an increase in the demand for goods and services affect e and output under flexible exchange rates?
- IS shifts right. However, now i is above i*.
- Exchange rate therefore appreciates, causing exports to fall and imports to rise.
- IS shifts back to original position, casing r and output to remain unchanged.
What is the IS* curve under the Mundell-Fleming model?
Y = C( Y - T ) + I( r* ) + G + NX(e)
Drawn for a given level of r*. Downward sloping, showing a negative relationship between e and output.
Why? As e falls, NX rises, causing Y to rise.
What is the LM* curve under the Mundell-Fleming model?
Simply, a vertical straight line.
- Drawn for a given level of r*
- Given this, there is only one level of output that creates equilibrium in the money markets, regardless of e.
What is the equilibrium condition in the Mundell-Fleming model?
As usual, it’s where the IS* and LM* curves intersect.
Explain the effect of fiscal expansion in the IS-LM model with flexible exchange rates?
- IS* shifts to the left. LM* remains constant.
- Thus, e rises, but Y stays constant.
Fiscal policy has no effect when exchange rates are allowed to fluctuate. This is due to crowding out. The increase in e crowds out net exports.
What is the effect of expansionary monetary policy in the IS-LM model with flexible exchange rates?
- Shifts LM curve to the right
- Causes e to fall, and Y to rise.
Monetary policy is effective under flexible e rates. Intuition: increase in M, leads to fall in e, leads to rise in NX, leads to rise in Y.
NOTE: AD is unchanged, it’s just demand shifts from foreign to domestic products, causing income at home to increase.
What is the effect of trade policy in the IS-LM model with flexible exchange rates?
For any value of e, the tariffs reduce imports, increases NX and hence shifts IS* to the right.
Net effect: Y is unchanged, but e increases.
What are the drawbacks of trade policy under flexible exchange rates?
- Doesn’t actually reduce a trade deficit. Whilst NX is unchanged, there is less trade.
- Will save jobs in domestic industries, but results in losses of jobs in the export markets.
- Import restrictions can create frictional unemployment due to sectorial shifts.
How does expansionary fiscal policy affect e and output when exchange rates are fixed?
- IS shifts right
- LM also shifts right to keep e constant.
- net effect: e remains constant, but Y increases. Fiscal policy now becomes effective.
How does expansionary monetary policy affect e and output when exchange rates are fixed?
- Ineffective, as money supply must be reduced again to keep e constant.
- net effect: No change in either e or output.
