IMT- Lecture 12: Incorporating the International Sector into IS-LM Model

Incorporating the International Sector into IS-LM Model

  • Expansionary Monetary Policy

    • Federal Reserve (Fed) implements expansionary policy:
    • Shifts the LM curve to the right.
    • Initial equilibrium at (r1, y1) adjusts to new equilibrium (r2, y2).
    • Outcomes:
    • Interest rates decrease.
    • Output increases.
    • Stimulates investment and consumption spending.

  • Impact of Decreased Interest Rates on Capital Flows

    • Lower US interest rates make US assets less attractive compared to foreign assets:
    • Causes capital outflow.
    • Leads to a decrease in demand for dollars and an increase in the supply of dollars in the foreign exchange market.
    • Results in a surplus of dollars, affecting exchange rates:
    • Fixed Exchange Rate: Involves buying dollars to maintain the rate, reducing supply.
    • Flexible Exchange Rate: Currency depreciates, causing exports to increase, imports to decrease, shifting IS curve.

  • Exchange Rate Systems

    • Under a fixed exchange rate system:
    • Central bank must buy dollars, which shifts the LM curve left due to reduced money supply.
    • Under a flexible exchange rate system:
    • Currency depreciation leads to increased exports, shifts IS curve to the right.

  • Current Account and Financial Account Dynamics

    • Increase in income typically leads to higher imports, worsening the current account balance.
    • Financial Account:
    • Defined by interest rates and capital mobility:
      • Higher domestic interest rates attract foreign investments and lead to financial account surplus.
    • Important concepts:
    • Balance of Payments = Current Account + Financial Account.
    • At equilibrium, Current Account Surplus = Financial Account Deficit.

  • Graphing the Current Account Balance Against GDP

    • Negative slope: Higher output leads to increased imports and a worse current account balance.
    • Financial account remains flat against GDP as its position is influenced mainly by interest rate changes.

  • Monetary Policy Effectiveness

    • Flexible Exchange Rate System:
    • Expansionary monetary policy effectively raises output due to increased net exports from currency depreciation.
    • Fixed Exchange Rate System:
    • Expansionary monetary policy is ineffective:
      • Interest rate decreases cause capital outflows, leading the central bank to buy dollars, shifting LM curve back to its original position, maintaining initial output.

  • Fiscal Policy Effects

    • Expansionary fiscal policy shifts the IS curve right, initially increasing output.
    • Results in higher interest rates and capital inflows in flexible systems:
    • Currency appreciates, leading to reduced net exports and shifting IS curve back.
    • Fiscal policy is effective in fixed exchange rate systems because:
    • The central bank's commitment to fixed exchange rates diminishes the crowding out effects.
    • Outputs can increase significantly due to the full multiplier effect.

  • Conclusion

    • Incorporating international sectors and understanding different exchange rate systems brings complexity to the IS-LM model:
    • Monetary and fiscal policy outcomes greatly depend on the exchange rate regime and capital mobility.
    • Fundamental understanding of these dynamics is crucial for analyzing impacts on output and interest rates.