[TOPIC 6: Practice Qs] IS-LM-FX Model under a Peg

For each of the following situations, use the IS-LM-FX model to illustrate the effects of
the initial shock or policy change. Assume that the central bank responds to maintain

a fixed exchange rate. For each case, state the effect of the shock on the following
variables (increase, decrease, no change, or ambiguous): Y, i, E, Cons., I, and TB. Label

the new equilibrium points under the peg with C.

a. Foreign output decreases (so TB ↓ exogenously to begin with)

IS shifts left, LM shifts left to keep E fixed: Y ↓, i and E no change, C↓, I no change,
TB ↓

Since Y↓ while E is invariant, it is tempting to say TB↑, because Y↓→ IM↓. Again, it
should be noted that there is an initial (exogenous) decrease in TB due to fall in the
foreign income.

Hence, we use the national income identity “Y = C+I+G+TB”, and trace the changes
variables other than TB. As A →C, Y on the LHS decreases (say, by 3) for sure. On the
RHS, C decreases (say, by 1.5), I is invariant, and so is G. Therefore, TB should decrease.

b. Foreign interest rate increases (e.g., MS ↓ in the foreign country)

FR shifts up, IS shifts up, LM shifts in to keep E fixed. Y↓, i↑, E no change, C↓, I
↓, TB↑

Intuitively, the shift in FR is the direct impact of the shock, whereas that in IS is of
secondary importance. Hence, it is more appealing that FR shifts up a lot more than IS
does. Then, Y should decrease.

The above intuition for Y↓can be confirmed via the NII and TB function:

i) it is certain that i increases (a lot!) and hence I falls.

ii) We are also sure that E is fixed.

iii) Now suppose, by way of contradiction, that Y increases as A → C.

iv) With higher income and therefore imports, TB should decrease.

v) This is a contradiction to the NII, because the LHS (i.e., Y) increases whereas the RHS
(i.e., C+I+G+TB)

is likely to decrease (or, increases less than the RHS at the least).

→ So, the correct graph should be as below, with Y1 ↓ Y3.

Now, what about the direction of change in TB? Since Y↓ with E fixed, TB should increase
via IM↓.

c. Money supply increases.

LM shifts right, then LM shifts back left to keep E fixed: No change in Y, i, E, C, I, or

TB

Much ado about nothing!

d. Government spending increases.

IS shifts out, LM shifts right to keep E fixed: Y↑, i and E no change, C ↑, I no

change, TB ↓

National income identity cannot determine whether TB ↓ or ↑. Using the TB

function, however, we can deduce: Y↑ with E fixed → TB↓
e. Devaluation of the home currency (an orderly one!)

Refer to the explanation attached below, taken from the text.

Changes in the Official Exchange Rate

A country that is fixing its exchange rate sometimes decides on a sudden change in the

foreign currency value of the domestic currency. This might happen, for example, if the

country is quickly losing foreign exchange reserves because of a big current account

deficit that far exceeds private financial inflows. A devaluation occurs when the central

bank raises the domestic currency price of foreign currency, E, and a revaluation occurs

when the central bank lowers E. All the central bank has to do to devalue or revalue is

announce its willingness to trade domestic against foreign currency, in unlimited amounts,

at the new exchange rate.

[Figure 6-4C]

Figure 6-4C below shows how a devaluation affects the economy. With fixed prices, a

rise in the level of the fixed exchange rate from  to  (along with Ee ↑ ) implies a

real depreciation making domestic goods and services cheaper relative to foreign goods

and services. Net exports increase at all levels of interest rate, and therefore the IS curve
then shifts out. Output therefore starts to increase.

The new SR eq’m at point ★, however, is not on the initial money market equilibrium

schedule LM1. As income increases following devaluation, there is initially an excess

demand for money due to the rise in transactions accompanying the output increase.

This excess money demand would push the home interest rate above the world interest

rate if the central bank did not intervene in the foreign exchange market. To maintain

the exchange rate at its new fixed level,  , the central bank must therefore buy foreign

assets and expand the money supply until the LM curve reaches LM2 and passes through

point 2. Devaluation therefore causes a rise in output, a rise in official reserves, and an

expansion of the money supply.

The effects of devaluation illustrate the three main reasons why governments sometimes

choose to devalue their currencies. First, devaluation allows the government to fight

domestic unemployment despite the lack of effective monetary policy. If government

spending and budget deficits are politically unpopular (so G↑ or T↓ is not a viable

policy option), for example, or if the legislative process is slow, a government may opt

for devaluation as the most convenient way of boosting aggregate demand. A second

reason for devaluing is the resulting improvement in the current account, a development

the government may believe to be desirable. The third motive behind devaluations, one

we mentioned at the start of this subsection, is their effect on the central bank’s foreign

reserves. If the central bank is running low on reserves, a sudden, one-time devaluation

(one that nobody expects to be repeated) can be used to draw in more reserves.