Lecture 5 is Lm Bp i 2 6 4
Lecture 5 is Lm Bp i 2 6 4
Lecture 5
Econ 314
The IS Curve
2
Demand + NX
G
I ( r 1) + NX
C + +
G
I ( r 2) + + NX
C + G
I ( r 3) +
C+
O
Y1 Y2 Y3 Y
r
NX rise
r3
r2 IS1
r1 IS
O
Y1 Y2 Y3 Y 3
The LM curve
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.
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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=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.
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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.
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.
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The Asset and Goods Market Equilibrium Process
r
LM
r0 t=0
n
t=
re
IS
Y0 Ye Y
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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.
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An Open Economy
C + I + G + NX
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A BP curve
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
id*↑ → K inflow
id*↓ → K outflow
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Derivation of the BP curve
Start with Y0, at which imports are Mo. The CA balance = X - MO.
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.
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The BP curve
i
BP
i1
i0
O
Y0 Y1 Y
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Slope of the BP curve
The slope of the BP curve has 3 ranges, characterizing
the degree of capital mobility in the economy.
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Substitutability of Assets and the BP curve
i
BP immobile capital
LM
BP mobile capital
O
Y
25
BOP in Surplus
i LM
BP
id
IS
O
Y1 Y
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BOP in Deficit
i
LM
BP
id
IS
O
Y1 Y
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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.
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Adjustment Under Flexible Exchange Rate Regime
The change in e, and its effect on NX, affects both the IS and
the BP curves.
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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.
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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.
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