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Lecture 5 is Lm Bp i 2 6 4

The document discusses the IS-LM-BP model, which illustrates the equilibrium in goods and money markets through the IS and LM curves, as well as the balance of payments (BP) curve in an open economy. It describes the processes of adjustment to equilibrium, including the cobweb and asset market equilibration processes, and how changes in interest rates and output affect investment and net exports. The document also outlines the impact of fixed and flexible exchange rate regimes on the balance of payments and overall economic equilibrium.
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0% found this document useful (0 votes)
6 views31 pages

Lecture 5 is Lm Bp i 2 6 4

The document discusses the IS-LM-BP model, which illustrates the equilibrium in goods and money markets through the IS and LM curves, as well as the balance of payments (BP) curve in an open economy. It describes the processes of adjustment to equilibrium, including the cobweb and asset market equilibration processes, and how changes in interest rates and output affect investment and net exports. The document also outlines the impact of fixed and flexible exchange rate regimes on the balance of payments and overall economic equilibrium.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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The IS-LM-BP Model - I

Lecture 5
Econ 314
The IS Curve

A locus of those combinations of output Y


and rate of interest r, such that the goods
market is in equilibrium.

2
Demand + NX
G
I ( r 1) + NX
C + +
G
I ( r 2) + + NX
C + G
I ( r 3) +
C+

Derivation of the IS curve

O
Y1 Y2 Y3 Y
r

NX rise
r3

r2 IS1
r1 IS
O
Y1 Y2 Y3 Y 3
The LM curve

A locus of those combinations of output Y


and rate of interest r, such that the money
market is in equilibrium.

4
Money Supply
Interest Rate
Derivation of the LM curve

r3
L(Y3)
r2 L(Y2)
r1
L(Y1)
O
Quantity of Real Money
r
LM
r3

r2
Shift due to an increase in Money Supply

r1

O
Y1 Y2 Y3 Y 5
Point of Disequilibrium
r LM
r0

IS

O
Y0 Y

r r AD

r0 r0

O Y O I0 I O Y0 Y 6
Process of Adjustment to an Equilibrium.

The existing values of i and Y will have a tendency to change.


The interest rate will fall because there is a shortage of bonds
and as the price of bonds rises to drive the bond market to
equilibrium, the interest rate will fall. The equilibrium interest rate,
of course, will be found at the intersection of the Ms and Md
schedules. Output will increase because a falling interest rate will
trigger higher investment expenditures by firms. The increased I
will increase AD and, therefore, Ye will increase. But then the
higher income will shift money demand up, which will increase
the equilibrium interest rate, and the same chain will be triggered
leading to a decrease in the equilibrium level of output.

7
The Cobweb equilibrium process

r
LM
r0

IS
O
Y0 Y
8
r t=0 LM
r0 t=4
r2 t=3

t=1
r1 t=2

IS

O
Y0 Y2 Y1 Y
G
r r AD
AD
=C
+I 1
+

t=0 t=0
t=2
r0 r0 +I 2
+ G
t=3 =C
t=3 t=4 AD
r2 I0 +
G
C+
t=4 AD
=

r1 t=2
t=1 t=1 t=0

O Ms M O I0 I2 I1 I O Y0 Y2 Y1 Y 9
The Cobweb equilibrium process
At t=0, the interest rate above the equilibrium interest rate and the goods
market in equilibrium for the given interest rate, r0.

At t=1, the bond market clears so that the interest rate = the equilibrium
interest rate. This means that the interest rate falls to r 1 in the IS/LM graph
and in the money market graph. We are on the LM curve and off the IS
curve. At t=1, the low interest rate, r1, does not correspond with the low
level of investment, I0. Therefore, AD is "wrong" and so is the ruling level
of output, Y0.

At t=2, we allow the lower interest rate, r1, to increase investment


expenditures to I1. This increases AD and yields an equilibrium Y1. On the
IS/LM graph, we have moved back on the IS curve because the goods
market is once again in equilibrium. At t=2 we are off LM, because the
higher level of income, Y1, increases Md and this will require a higher
equilibrium interest rate.
10
The Cobweb equilibrium process
At t=3, the interest rate is driven to its new equilibrium position. Higher
money demand (because Y increase to Y1) establishes a new equilibrium
interest rate r2. In the IS/LM graph, we are back on the LM curve because
the money market is in equilibrium; but off the IS curve because the
goods market is in disequilibrium. The higher interest rate at r2 changes
the level of investment and thus AD and Y.

At t=4, we return to the goods market in order to allow the forces in the
model to determine the equilibrium level of output. The higher interest
rate, r2, determines a lower level of investment, I2, which leads, through
AD, to lower equilibrium level of output, Y2. In the IS/LM graph, the
economy is now at r2 and Y1 in goods market equilibrium, but in money
market disequilibrium.

This continues till we reach an equilibrium at the intersection between the


IS and the LM curves.

11
The Asset Market Equilibrium Process

r
LM
r0 t=0
n
t=

re

IS

Y0 Ye Y
12
r t=0 LM
r0

r3
r2
r1 t=3
t=2
t=1
IS

O
Y0 Y 1 Y2 Y

r r AD
t=3 + G
+I 2
=C
t=0 t=0 AD
r0 r0 +I 1 +
G
t=2 C
t=3 AD =
r3 t=3
t=2
I0 +
G
r2 = C+
t=2 AD
Md(Y2)
r1
Md(Y1) t=0
t=1 Md(Y0)

O Ms M O I0 I1 I2 I O Y0 Y1 Y2 Y 13
The Asset Market Equilibrium Process
At t=0, the interest rate is above the equilibrium interest rate and the goods
market is in equilibrium for the given (or old equilibrium) interest rate, r 0.

At t=1, the bond market clears so that the interest rate equals the
equilibrium interest rate. This means that the interest rate falls to r 1 in the
IS/LM graph and in the money market graph. We are on the LM curve but
off the IS curve!
At t=1, the low interest rate, r1, does not correspond with the low
level of investment, I0. Therefore, AD is "wrong" and so is the ruling level of
output, Y0.

At t=2, firms increase investment expenditures. As investment increases to


I1, AD increases and output increases to Y1. Output does not increase
enough to clear the goods market because r does not correspond to r1. So,
we are still off the IS curve. At t=2, the Y increase raises M d resulting in an
upward shift.
14
The Asset Market Equilibrium Process

The interest rate responds and rises to its new equilibrium level, r 2.
Graphically, this means we stay on the LM curve. We will never be
off
the LM curve because the interest rate will always instantly adjust to
any shock.

We are still off the IS curve in t=2 because the equilibrium interest
rate, r2 still does not correspond to the level of investment.

Consequently, in time period t=3, investment will increase further,


triggering the same process as in the previous period. Y will increase
and this will shift up Md which will force an increase in the interest
rate to r3. This process will continue until the economy reaches a
state of rest at re, Ye in time period t=n.

15
The Asset and Goods Market Equilibrium Process

r
LM
r0 t=0
n
t=

re

IS

Y0 Ye Y
16
The Cobweb equilibration process is not, however, widely accepted. Most
economists feel that the sequential market clearing assumption is incorrect.
After all, there is no reason why the money and goods market must clear in
alternating order.

Many macroeconomists believe that asset markets clear faster than goods
markets. A strong version of this story would have the asset market always in
equilibrium because it is assumed that the asset market can immediately
adjust itself to a given shock. Such a view is called the Asset Market
Equilibration Process.

The final equilibration process we have considered is a hybrid. It is used to


show that we can order the steps in the equilibrating process however we
want. Instead of jumping immediately down to the LM curve as the asset
market clears while the goods market stays fixed, the figure depicts an
equilibration process where both markets clear simultaneously. Some
economists argue that this Assets and Goods Market Equilibrium process
best matches empirical reality.

17
An Open Economy

Total expenditure in an open economy is,

C + I + G + NX

To analyze the effect of exports and imports on the equilibrium


level of output, the various factors which determine the levels of
exports and imports, need to be understood.

C = consumption expenditure, I = investment expenditure,


G = government expenditure, NX = net exports

18
A BP curve

 depicts the various combinations of interest rates


and income levels for which the Current Account and
the Capital Account offset each other, such that the
Balance of Payments is in equilibrium.

 helps examine the effect of trade in financial assets


(i.e. capital flows).

19
Current Account Balance
The Current Account (CA) balance, is equivalent to the level of
net
exports. Here, YD / YF = domestic / foreign income; M = imports;
X = exports

It is determined by i) YD, which affects M,


ii) YF which affects X
iii) the exchange rate which affects
M and X.

As YD ↑ → M↑ while X remains constant (YF constant).


Therefore, YD ↑ → NX ↓ → CA ↓
20
Capital Account Balance

The Capital Account is determined by the factors that affect


capital flows between countries. Here, if* = foreign equilibrium
interest rate; id* = domestic equilibrium interest rate

Assuming : i) if* is constant


ii) there are no expectations that the
exchange rate will change

id*↑ → K inflow
id*↓ → K outflow

21
Derivation of the BP curve

 Assume given “e” and a given if.

 Start with Y0, at which imports are Mo. The CA balance = X - MO.

 X - MO < 0 → a deficit in the CA. To offset the deficit, there has


to be a A surplus (i.e. K inflows).

 Assume that domestic interest rate i0 , attracts sufficient capital


inflows K0 to exactly offset the CA deficit.

 Thus, at the interest rate i0 and the income level Y0 the Current
and the Capital Accounts offset each other. These represent a
point on the BP curve.
22
The BP curve
i

BP
i1

i0

O
Y0 Y1 Y
23
Slope of the BP curve
The slope of the BP curve has 3 ranges, characterizing
the degree of capital mobility in the economy.

(i) Horizontal when capital is perfectly mobile. This


situation occurs when financial assets are perfect
substitutes across countries.

(ii) Not perfectly horizontal, but flatter than the LM curve,


when capital is mobile. Assets are not perfect
substitutes across countries.

(iii) Steeper than the LM curve, when capital is immobile.

24
Substitutability of Assets and the BP curve
i
BP immobile capital
LM

BP mobile capital

BP perfect capital mobility

O
Y
25
BOP in Surplus
i LM

BP
id

IS

O
Y1 Y
26
BOP in Deficit
i

LM

BP

id

IS

O
Y1 Y
27
The Adjustment to an Overall Equilibrium
 Under a fixed exchange rate regime, the Central
Bank buys and sells sufficient quantities of the
domestic currency to keep the exchange rate fixed
at given level. Thus, the BP curve does not move
under fixed exchange rates. The adjustment
happens done through monetary policy.

 Under a flexible exchange rate regime, the price of


foreign exchange is allowed to adjust, such that the
economy adjusts simultaneously to an internal and
external equilibrium.

28
Adjustment Under Flexible Exchange Rate Regime

As e↑ (i.e. the domestic currency depreciates), NX ↑.

The change in e, and its effect on NX, affects both the IS and
the BP curves.

(i) As NX↑ → total expenditure ↑ → IS curve shifts to the right.

(ii) As NX rises → CA rises (becomes less negative) → the CA


improves → the economy does not need as high a level of
capital inflows at each income level as it did before → the BP
curve shifts to the right*.

29
Case of perfect capital mobility
When capital is perfectly mobile and the internal equilibrium
Is below the BP curve, there is pressure on the exchange
rate to depreciate (i.e., there is an infinite amount of capital
outflows).

As e ↑ (depreciates) → NX ↑ → CA improves.

The improvement in the CA is a finite number, whereas the


capital outflows infinitely large. Thus, under the case of
perfect capital mobility, the BP does not shift when the
exchange rate changes.

30
Summing Up
1. Fixed Exchange Rate Regime: The BP does not shift,
regardless of the degree of capital mobility. The Central Bank
increases /decreases MS to counter a surplus / deficit in the
BOP.

2. Flexible Exchange Rate Regime:


a) Perfectly Mobile Capital - BP does not shift. The change in
the exchange rate affects Net Exports and thus, the IS curve.

b) Mobile / Immobile Capital – Change in the exchange rate


affects NX and therefore the Current Account. IS and the BP
shift in the same direction.

31

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