Macroeconomics

Session 17
Dr. Jithin P
IIM Raipur
Output Determination (IS-LM Model) in an Open Economy

• The effects of policies (adjustment process)

depend on exchange rates regime, ie
whether the country has a fixed or a
flexible exchange rate regime.
• Let us consider some countries where the
exchange rate is fixed (Hong Kong, Oman,
Qatar etc).
Monetary Policy is Ineffective under a Fixed Exchange Rate System

• Consider a monetary expansion that starts from

point E shifts LM down and to the right to E’
• At E’ there is a large payments deficit, and
pressure for the exchange rate to depreciate
• Central bank must intervene, selling foreign
money, and receiving domestic money in
exchange
• Supply of money falls, pushing up interest rates
as LM moves back to original position
• Conclusion: When there is a fixed exchange rate
system and perfect capital mobility, central bank
cannot conduct an independent monetary policy. The
home country’s interest rate is determined by foreign
(US) interest rate.
Changes in Demand and Supply: Exchange
Rate fluctuations in a Fixed Exchange Rate System
• Implications: In a fixed exchange rate system, the Central Bank loses
control over money supply.
• When the Central Bank buys dollar, it increases money supply (and
when it sells foreign currency, it decreases money supply).
• In a pegged exchange rate system, if the Central bank decides to
decrease exchange rate from $1=Rs 50 to $1=Rs 55: devaluation.
• On the contrary, if the Central bank decides to increase the exchange
rate from $1=Rs 50 to $1=Rs 45: revaluation.
Fiscal Policy is Effective under a Fixed Exchange
Rate System
• A fiscal expansion shifts the IS curve up and to the
right- increases interest rates and output
• The higher interest rates creates a capital inflow with
the tendency to appreciate the exchange rate
• To manage the exchange rate, the central bank buys
foreign exchange.
• This expands the money supply- shifting the LM curve
to the right
• Pushes interest rates back to their initial level, but
output increases yet again
Fiscal Policy is Ineffective under a
Flexible Exchange Rate System
• Suppose the economy is in equilibrium at point E.
• Now there is an increase in government
expenditure (G)
• An increase in G leads to an increase in interest
rate and GDP
• IS curve shifts to right
• As domestic interest rate is higher than world
interest rate, it would attract capital inflows
• Exchange rate will appreciate.
• Real exchange rate will appreciate ─ Exports will
fall, Imports will rise ─ Net export will decrease
Fiscal Policy is Ineffective under a
Flexible Exchange Rate System
• A decrease in net export will decrease
aggregate demand for domestically
produced goods and services
• IS curve shifts back to left An increase in G
leads to an exchange rate appreciation,
worsening of trade deficit, a little or no
increase in domestic real GDP.
• An increase in government spending
crowds out foreign demand due to
exchange rate appreciation
Monetary Policy is effective under a
Flexible Exchange Rate System
• Suppose the economy is in equilibrium at
point E initially.
• Now there is an increase in the nominal
money supply: ─ The real stock of money,
M/P, increases since P is fixed
• This leads to a decrease in domestic interest
rate
• LM shifts to the right ─ At point E’, goods and
money markets are in equilibrium, but
i(domestic interest rate) is below if (the world
level) ─ This leads to an increase capital
outflows and depreciation of the nominal
exchange rate (ER)
Monetary Policy is effective under a
Flexible Exchange Rate System
• A nominal exchange rate depreciation leads to
an increase in real exchange rate (R).
• An increase in real exchange rate increases
exports (X) and reduces imports (M) and
improves the trade balance.
• This can be shown by the rightward shift of the
IS curve. So the economy moves from point E to
E’’.
• An expansionary monetary policy leads to a
depreciation nominal and real exchange rate,
improvement in trade deficit, and increase in
aggregate demand and real GDP.
Aggregate Demand and Aggregate Supply
 Introduction
• We have seen how IS-LM-BP model can be used to explain the effects of
autonomous spending on domestic real GDP and interest rate.
• We have also seen how this model can be used to analyze the effects of
changes in monetary policy, fiscal policy, foreign interest rate on domestic
interest rate, exchange rate, trade deficit, GDP and so on.
• There is an alternative framework. It is AD-AS model. Both IS-LM-BP and AD-
AS model are based on same assumptions.
• However, the AD-AS model is useful in explaining the impact of autonomous
spending, monetary and fiscal policy on inflation. IS-LM-BP does not explain
inflation as it is useful for short-run analysis and inflation is assumed to be
relatively stable in short-run.
• Inflation is variable in medium and long-run. AD-AS model is appropriate
model for inflation as it explains the fluctuations of inflation.
Derivation of AD curve

• The aggregate supply–aggregate demand model is the basic

macroeconomic tool for studying output fluctuations and the
determination of the price level and the inflation rate.
• The aggregate demand schedule maps out the IS-LM
equilibrium holding autonomous spending and the nominal
money supply constant and allowing prices to vary.
• A higher price level means a lower real money supply, an LM
curve shifted to the left, and lower aggregate demand.
Derivation of AD curve

• Suppose the price level in the economy is P1 . Panel ( a ) of

Figure shows the IS-LM equilibrium. Note that the real
money supply, which determines the position of the LM1
curve, is M /P1. The intersection of the IS and LM1 curves
gives the level of aggregate demand corresponding to price
P1 and is so marked in the lower panel ( b ).
• Suppose, instead, that the price is higher, say P2 . The curve
LM 2 shows the LM curve based on the real money supply
M/P2.
• Point E2 shows the corresponding point on the aggregate
demand curve. Repeat this operation for a variety of price
levels and connect the points to derive the aggregate
demand schedule.
Aggregate Demand and Aggregate Supply
• Aggregate demand curve shows the combinations of the price level and the level of output at
which the goods and money markets are simultaneously in equilibrium
• Downward sloping since higher prices reduce the real money supply, which reduces the demand
for output.
• Aggregate supply curve describes, for each given price level, the quantity of output firms are
willing to supply.
• Short-run-Horizontal/relatively flatter since firms are willing to supply more output at same
prices ( prices are fixed in short-run/rate of inflation is zero/low and stable, say 2%)
• Medium run-Upward sloping since firms are willing to supply more output at higher prices
• Long-run-Vertical since output is determined by productive capacity.
• Intersection of AS and AD curves determines the equilibrium level of output and price level.
Short run(Keynesian) and long-run(Classical)
AS Curve

• The classical supply curve is vertical,

indicating that the same amount of goods will
be supplied, regardless of price [Figure 5-4
(b)]
• Based upon the assumption that the labor
market is in equilibrium with full employment
of the labor force
• The level of output corresponding to full
employment of the labor force = potential
GDP, Y*
 Short run(Keynesian) and long-run(Classical) AS
Curve
• The Keynesian supply curve is horizontal, indicating firms will supply whatever amount of
goods is demanded at the existing price level [Figure 5- 4 (a)]
• Since unemployment exists, firms can obtain any amount of labor at the going wage rate
• Since average cost of production does not change as output changes, firms willing to supply
as much as is demanded at the existing price level.
• Intellectual genesis of the Keynesian AS curve is found in the Great Depression, when it
seemed firms could increase production without increasing P by putting idle capital and
labor to work
• Additionally, prices are viewed as “sticky” in the short run → firms reluctant to change
prices and wages when demand shifts
• Instead firms increase/decrease output in response to demand shift → flat AS curve in the
short run