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Chapter 13. Open Economy Macroeconomics

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Chapter 13. Open Economy Macroeconomics CHAPTER 1313 The IS-LM-BP Approach An economy open to international trade and payments will face different problems than an economy closed to the rest of the world. The typical introductory economics presentation of macroeconomic equilibrium and policy is a closed-economy view. Discussions of economic adjustments required to combat unemployment or inflation do not consider the rest of the world. Clearly, this is no longer an acceptable approach in an increasingly integrated world. In the open economy, we can summarize the desirable economic goals as being the attainment of internal and external balance. Internal balance means a steady growth of the domestic economy consistent with a low unemployment rate. External balance is the achievement of a desired trade balance or desired international capital flows. In principles of economics classes, the emphasis is on internal balance. By concentrating solely on internal goals like inflation, unem- ployment, and economic growth, simpler-model economies may be used for analysis. A consideration of the joint pursuit of internal and external balance calls for a more detailed view of the economy. The slight increase in complexity yields a big payoff in terms of a more realistic view of the problems facing the modern policy maker. It is no longer a question of changing policy to change unemployment or inflation at home. Now the authorities must also consider the impact on the balance of trade, capital flows, and exchange rates. INTERNAL AND EXTERNAL MACROECONOMIC EQUILIBRIUM The major tools of macroeconomic policy are fiscal policy (government spending and taxation) and monetary policy (central bank control of the money supply). These tools are used to achieve macroeconomic equilib- rium. We assume that macroeconomic equilibrium requires equilibrium in three major sectors of the economy: Goods market equilibrium. The quantity of goods and services supplied is equal to the quantity demanded. This is represented by the IS curve. International Money and Finance, Eighth Edition © 2013 Elsevier Inc. DOI: http://dx.doi.org/10.1016/B978-0-12-385247-2.00013-5 All rights reserved. 245 246 International Money and Finance Money market equilibrium. The quantity of money supplied is equal to the quantity demanded. This is represented by the LM curve. Balance of payments equilibrium. The current account deficit is equal to the capital account surplus, so that the official settlements definition of the balance of payments equals zero. This is represented by the BP curve. We will analyze the macroeconomic equilibrium with a graph that summarizes equilibrium in each market. Figure 13.1 displays the IS-LM-BP diagram. This graph illustrates various combinations of the domestic interest rate (i) and domestic national income (Y) that yield equilibrium in the three markets considered here. THE IS CURVE First, let us examine the IS curve, which represents combinations of i and Y that provide equilibrium in the goods market when everything else (like the price level) is held constant. Y refers to the total output as well LM BP ) i ie e Interest rate ( Interest rate IS 0 Ye Income (Y) Figure 13.1 Equilibrium in the goods market (IS), in the money market (LM), and in the balance of payments (BP). The IS-LM-BP Approach 247 as the total income in the economy. Equilibrium occurs when the output of goods and services is equal to the quantity of goods and services demanded. In principles of economics classes, macroeconomic equilib- rium is said to exist when the “leakages equal the injections” of spending in the economy. More precisely, domestic saving (S), taxes (T), and imports (IM) represent income received that is not spent on domestic goods and services—the leakages from spending. The offsetting injections of spending are represented by investment spending (I), government spending (G), and exports (X). Investment spending is the spending of business firms for new plants and equipment. Equilibrium occurs when S 1 T 1 IM 5 I 1 G 1 X ð13:1Þ When the leakages from spending equal the injections, then the value of income received from producing goods and services will be equal to total spending, or the quantity of output demanded. The IS curve in Figure 13.1 depicts the various combinations of i and Y that yield the equality in Equation (13.1). We now consider why the IS curve is downward sloping. We assume that S and IM are both functions of income and that taxes are set by governments independent of income. The higher that domestic income, the more domestic residents want to save. Furthermore, the higher income will also enable domestic residents to spend more on imports. In the bottom panel of Figure 13.2, the S 1 T 1 IM line is upward sloping. This illustrates that the higher domestic income rises, the greater are savings plus taxes plus imports. Investment is assumed to be a function of the domestic interest rate and so does not change as current domestic income changes. Similarly, exports are assumed to be determined by foreign income (they are foreign imports) and so do not change as domestic income changes. Finally, government spending is set independent of income. Since I, G, and X are all independent of current domestic income, the I 1 G 1 X line in the bottom panel of Figure 13.2 is drawn as a horizontal line. Equation (13.1) indicated that equilibrium occurs at that income level where S 1 T 1 IM 5 I 1 G 1 X. In the bottom panel of Figure 13.2, point A represents an equilibrium point with an equilibrium level of income YA. In the upper panel of the figure, YA is shown to be consistent with point A on the IS curve. This point is also associated with a particular interest rate iA. 248 International Money and Finance i C C i A ) A i i B B Interest rate ( Interest rate IS 0 YC YA YB S + T + IM B I' + G + X A I + G + X C I'' + G + X Saving + taxes + imports (S + T + IM) + imports + taxes (S + Saving YC YA YB Invesment + gov. spending + exports (I + G X) + gov. Invesment 0 Income (Y) Figure 13.2 Derivation of the IS curve. To understand why the IS curve slopes downward, consider what happens as the interest rate varies. Suppose the interest rate falls. At the lower interest rate, more potential investment projects become profitable (firms will not require as high a return on investment when the cost of borrowed funds falls), so investment increases as illustrated in the move from I 1 G 1 X to I0 1 G 1 X in Figure 13.2. At this higher level of investment spending, equilibrium income increases to YB. Point B on the IS curve depicts this new goods market equilibrium, with a lower equilibrium interest rate iB and higher equilibrium income YB. Finally, consider what happens when the interest rate rises. Investment spending will fall, because fewer potential projects are profitable as the The IS-LM-BP Approach 249 cost of borrowed funds rises. At the lower level of investment spending, the I 1 G 1 X curve shifts down to Iv 1 G 1 X in Figure 13.2. The new equilibrium point C is consistent with the level of income YC. In the IS diagram in the upper panel we see that point C is consistent with equilibrium income level YC and equilibrium interest rate iC. The other points on the IS curve are consistent with alternative combinations of income and interest rate that yield equilibrium in the goods market. We must remember that the IS curve is drawn holding the domestic price level constant. A change in the domestic price level will change the price of domestic goods relative to foreign goods. If the domestic price level falls with a given interest rate, then investment, government spend- ing, taxes, and saving will not change. However, domestic goods are now cheaper relative to foreign goods, leading to exports increasing and imports falling. The rise in the I 1 G 1 X curve and the fall in the S 1 T 1 IM curve would both increase income. Because income increases with a constant interest rate, the IS curve shifts to the right. A rise in the domestic price level would cause the IS curve to shift left. THE LM CURVE The LM curve in Figure 13.1 displays the alternative combinations of i and Y at which the demand for money equals the supply. Figure 13.3 provides a derivation of the LM curve. The left panel shows a money demand curve labeled Md and a money supply curve labeled Ms. The horizontal axis measures the quantity of money and the vertical axis measures the interest rate. Note that the Ms curve is vertical. This is so because the central bank can choose any money supply it wants, independent of the interest rate. The actual value of the money supply chosen is M0.Themoneydemand shows, for a fixed amount of wealth, how much people are willing to hold in money form, as opposed to interest-bearing assets. The money demand curve slopes downward, indicating that the higher the interest rate, the lower the quantity of money demanded. The inverse relationship between the interest rate and quantity of money demanded is a result of the role of interest as the opportunity cost of holding money. Since money earns no interest, the higher the interest rate, the more you must give up to hold money, so less money is held. The initial money market equilibrium occurs at point A with interest d rate iA.
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