as below

IF TUTE 3 TUTE NOTES

1) a. The IS Curve is the locus of combinations of Y and r satisfying the goods market

equilibrium condition, expenditure = income, or I+G+X = S+T+M, or I+G+B = S+T (where B =

balance of trade).

Ignoring the impact of Y on M, S depends positively on Y and I depends negatively on r.

Therefore, a decrease in r (which increases I) must be combined with an increase in Y (which

increases S) for the equilibrium condition to be maintained. This implies the IS curve must

have a negative slope.

Put more simply, the downward slope of the curve indicates that a decrease in the rate of

interest will stimulate an increase in the demand for goods.

The LM curve is the locus of combinations of Y and r satisfying the money market

equilibrium condition, supply of money = demand for money, where the demand for money

depends positively on Y (transactions demand for money) and negatively on r (speculative

demand for money), and the money supply is held constant.

An increase in Y would increase the demand for money, so for a constant money supply it

must be offset by an increase in r, for the money market to remain in equilibrium. This

implies the LM curve must have a positive slope, when drawn for a constant money supply.

Put more simply, the upward slope of the curve indicates that an increase in income, which

increases the demand for money, will cause an increase in interest rates if the money supply

is held constant.

If the central bank varies the money supply to hold the interest rate constant, then the LM

curve must be replaced by a horizontal line, at the central bank’s interest rate target.

b. The FE Curve is the combinations of Y and r leading to equilibrium on the foreign

exchange market, where the demand for domestic currency due to trade and capital flows is

equal to its supply. A trade surplus would go with a net capital outflow, and a trade deficit

with a net capital inflow.

i. Under perfect capital mobility, any differences in interest rates between countries

lead to limitless capital flows, and so are immediately eliminated. The FE curve is

then horizontal.

ii. Under imperfect capital flows, net capital inflows depend on the gap between

domestic and foreign interest rates, but are not infinite. An increase in income leads

to an increase in imports and so a trade deficit, which must be offset by an increase

in domestic interest rates, to attract a net capital inflow, for foreign exchange

market equilibrium. The FE curve is then upward sloping (like the LM curve). It is

usually assumed that the FE curve is more elastic than the LM curve, and this

assumption is hardly discussed, but it turns out to be an important assumption.

c.

i. One issue with this model is that it ignores exchange rate expectations (or assumes

that no-one expects a change in exchange rates in advance).

ii. Another issue is that the model holds the price level constant.

The Dornbusch Model offers a solution to both these weaknesses.

2) a.

i. Under fixed exchange rates, IS shifts from IS1 to IS2. In a closed economy, there

would be a shift from 1 to 2. With perfect capital mobility, any increase in interest

rates leads to an excess demand for domestic currency on the foreign exchange

market. To hold the exchange rate fixed, the central bank must sell domestic

currency on the foreign exchange market, increasing the domestic monetary base.

This shifts the LM curve to the right.

With perfect capital mobility, this must continue until r=r* once again, at point 3.

The rate of interest must return to its initial level, which is equal to the foreign

interest rate.

A fiscal expansion is highly expansionary under fixed exchange rates and perfect

capital mobility.

ii. Under floating exchange rates and a perfect capital market, the shift in IS from IS1 to

IS2 (at point 2) leads to a currency apprecation, due to the domestic interest rate

rising above the foreign interest rate. This currency appreciation must continue until

it has caused a sufficient deterioration in the trade balance to offset the impact of

the fiscal expansion on the IS curve (point 3 is the same as point 1).

A fiscal expansion is completely ineffective, under these circumstances, as it is

predicted to cause 100% crowding out of net exports, due to a currency

appreciation.

b) Under imperfect capital mobility, a fiscal expansion does have an effect on national

income. The shift from 1 to 2 again leads to a currency appreciation. However, the

currency appreciation, while it shifts the IS curve back to the left again, also shifts

the FE curve upwards. This is because of the need for higher interest rates and a

bigger net capital inflow than before at any level of national income, due to the

negative impact of the currency appreciation on the trade balance.

The final general equilibrium point 3 is the point where the shifting FE and IS curves

(FE2 and IS3) intersect along the LM curve. The LM curve is static

c. An interest rate target means the central bank varies the monetary base to fix the

interest rate. This implies that a fiscal expansion leads to an excess supply of

domestic currency on the foreign exchange market (point 2). The increase in income

causes a deterioration in the trade balance, and there has been no increase in

interest rates.

The domestic currency depreciates, shifting the FE curve down and the IS curve

further to the right. The fiscal expansion is highly effective, as there is crowding in of

net exports due to the impact on the trade balance of the currency depreciation.

d. This time, we come up against the impossible trinity problem. The fiscal expansion

moves the closed economy equilibrium below the FE curve, leading to pressure for a

currency depreciation. Either the central bank must allow the currency to depreciate

– giving up on the fixed exchange rate – or the central bank must use its foreign

exchange reserves to buy domestic currency and defend the fixed exchange rate.

This would decrease the domestic monetary base and increase the rate of interest.

The central bank can ‘sterilise’ the impact of its foreign exchange market

intervention on the monetary base and the rate of interest, by purchasing bonds

from domestic banks. However, it cannot do this indefinitely, as it will run out of

foreign exchange reserves. The central bank must eventually either allow the

domestic monetary base to fall and interest rates to rise to defend the fixed

exchange rate, or must allow the currency to depreciate and retain its interest rate

target.

There is no final equilibrium point 3 under this scenario. Point 2 is not a new general

equilibrium, as it is not on the FE curve.