Macroeconomics Essay, Research Paper

Module 7525 Macroeconomics II

Essay Coursework.

“Many economic forecasters are suggesting that the US economy is about to enter into recession. Using IS/LM/BP analysis and assuming perfect capital mobility, suggest how the US could use its exchange rate policy to counter this movement but also highlight the potential problems of using such a policy to the US government”.

History Background: The US Economy.

There are increasing signs that the US economy is heading towards a recession as major corporations (from the auto industry, to banking, to technology, to consumer goods) have announced far weaker than expected sales and earnings and a new round of mass layoffs and plant closings.

While most pundits still maintain that the US will sustain a decline in growth without a recession, the Financial Times noted that “a growing number of economists now believe that the US is well on the way to recession in 2001” with some arguing that it has already arrived. While that assessment may be “too pessimistic”, it continued, the “threat of a serious downturn for the US is as great as it has been at any time in the past decade.”

The IS, LM, BP Model.

When we open the economy to international transactions we have to take into account the effects of trade in goods and services (i.e. items in the current account) as well as trade in assets (i.e. items in the capital account). Opening the economy to international trade in goods and services means that we have to take into account the increased demand for our goods by foreigners (our exports), as well as the decreased demand for our goods that occurs because we purchase foreign goods (i.e. our imports).

The effect of opening the economy to trade in goods and services, is that the IS curve needs to be specified for a given exchange rate. The IS curve still depicts the combinations of I and Y for which the level of total expenditures equals the level of production, but now, in addition to being determined by the interest rate, total expenditures are also determined by the exchange rate. Under a fixed exchange rate regime, the IS curve is fixed (unless there is a change in government spending or tax rates, or the government devalues or revalues the currency). Under a flexible exchange rate regime, the price of foreign exchange fluctuates to equate the demand and supply of foreign exchange. Thus, e (domestic price of foreign currency) changes on a frequent basis.

Whenever e changes, the IS curve shifts. If e increases (the domestic currency depreciates), X increases, V falls, thus, NX increases, which means total expenditures have risen, therefore the IS curve shifts to the right. If e falls (the domestic currency appreciates), X falls, V rises, thus NX falls and the IS curve shifts to the left. When discussing the effects of various policies (fiscal and monetary), we must be certain of the exchange rate regime: we will get different answers with a flexible regime than with a fixed regime.

To examine the effect of trade in financial assets (i.e. capital flows) we need to construct a BP curve. The BP curve shows the various combinations of interest rates and income levels for which the Current Account (CA) and the Capital Account (KA) offset each other (i.e. the Balance of Payments is in equilibrium). The Current Account (CA) is equivalent to the level of net exports and is determined by the domestic level of income (which affects V), the (constant) foreign level of income (which affects X), and the exchange rate (which affects both V and X). As the domestic level of income rises, imports rise while exports stay constant. Thus, as income rises (with e remaining unchanged) NX falls, therefore the CA falls. The Capital Account is determined by the factors that affect capital flows between countries: the rate of return on comparable assets. By assuming that foreign interest rates (i*) are constant and that there are no expectations that the exchange rate will change, a rise in domestic interest rates will attract capital here (K inflow) while a fall in domestic interest rates will attract capital to foreign countries (K outflow).

The BP curve is drawn for a given exchange rate and a given foreign interest rate. (Diagram 1, Appendix 1)

The slope of the BP curve (Diagram 2, Appendix 1) has 3 ranges, characterizing the degree of capital mobility in the economy. The BP is perfectly horizontal when capital is perfectly mobile. This situation occurs when financial assets are perfect substitute across countries. Any small deviation in the domestic interest rate from the foreign interest rate results in an infinite amount of capital flows. If the domestic interest rate is lower than the foreign interest rate, there are an infinite amount of capital outflows. If the domestic interest rate is higher than the foreign interest rate, there are an infinite amount of capital inflows.

Obviously, whenever there are an infinite amount of capital flows, there is very strong pressure on the exchange rate to change. Under a fixed exchange rate regime, the Central Bank will have to buy or sell sufficient quantities of domestic currency to counteract this pressure on the exchange rate. Under a flexible exchange rate regime, the price of foreign exchange will adjust.

When capital is mobile (but not perfectly mobile) the BP curve is not perfectly horizontal, but is flatter than the LM curve. Assets are not perfect substitutes across countries. Immobile capital occurs when the BP curve is steeper than the LM curve. As we will see below, the degree of capital mobility has a bearing on the outcome of various fiscal and monetary policies.

To sum up, the rules for shifts in the curves are as follows:

The IS Curve.

The IS shifts right when there is an increase in G or the exchange rate depreciates (i.e. e increases). The IS curve shifts left when there is an increase in the proportional tax (note that the IS curve does not shift in a parallel fashion in this case) or when the exchange rate appreciates (it shifts in a parallel fashion in this case).

The LM Curve.

The LM shifts right when there is an increase in the money supply.

The BP Curve.

? Fixed: The BP does not shift, regardless of the degree of capital mobility. The government must increase or decrease the money supply to counter any surplus or deficit in the Balance of Payments.

? Flexible:

ό Perfect: The BP does not shift (Capital flows overwhelm the change in the Current Account). The change in the exchange rate affects Net Exports and therefore the IS curve.

ό Mobile: The change in the exchange rate affects NX, and therefore the Current Account. The IS and the BP both shift (in the same direction).

ό Immobile: Same as for mobile.

Cases of Fiscal And Monetary Policies.

Fixed Exchange Rates, Perfect Capital Mobility, Increase in Money Supply

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there are infinite capital outflows as domestic investors seek to purchase higher returning foreign assets. These investors are exchanging their unwanted dollars for foreign exchange. The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted dollars and sells foreign exchange. As the Federal Reserve buys the dollars, the money supply is decreased: the LM curve moves to the left, coming to rest at its initial position. The economy moves back to A. There is no change in Y or I from this monetary policy.

Moral: Monetary policy is ineffective in altering the level of domestic output under fixed exchange rates and perfect capital mobility.

(Diagram 3, Appendix 1)

Fixed Exchange Rates, Perfect Capital Mobility, Increase in G.

The increase in G means an increase in Total Expenditures, therefore the IS curve shifts to the right and the economy goes from point A to point B. At B, there are infinite capital inflows as foreign investors seek to purchase higher returning domestic assets. These investors are exchanging their foreign currency for dollars. The Federal Reserve has agreed to maintain the exchange rate at e0, and therefore buys up the unwanted foreign exchange and sells dollars. As the Federal Reserve sells the dollars, the Money supply is increased: the LM curve moves to the right and the economy goes from point B to point C. There is a large change in Y from this fiscal expansion.

Moral: Fiscal policy is extremely effective in altering the level of domestic output under fixed exchange rates and perfect capital mobility.

(Diagram 4, Appendix 1)

Flexible Exchange Rates, Perfect Capital Mobility, Increase in Money Supply.

The increase in the Money supply shifts the LM curve to the right, the economy goes from point A to point B. At B, there are infinite capital outflows as domestic investors seek to purchase higher returning foreign assets. These investors are exchanging their unwanted dollars for foreign exchange. This decreased demand for dollars causes the value of the dollar to fall on foreign exchange markets (i.e. the dollar depreciates, e increases). As e increases, Net Exports increase as domestic goods become relatively cheaper on international markets. As NX increases, Total Expenditures rise and the IS curve shifts to the right. The exchange rate will continue to depreciate, and the IS curve will continue to shift to the right until the capital outflow is halted (i.e. until the domestic interest rate equals the foreign interest rate). The new equilibrium is at C, where domestic output has increased.

Moral: Monetary policy is extremely effective in altering the level of domestic output under flexible exchange rates and perfect capital mobility.

(Diagram 5, Appendix 1)

Flexible Exchange Rates, Perfect Capital Mobility, Increase in G.

The increase in Government spending means there’s an increase in Total Expenditures, therefore the IS curve shifts to the right and the economy goes from point A to point B. At B, there are infinite capital inflows as foreign investors seek to purchase higher returning domestic assets. These investors are exchanging their currency for the more desirable dollar. This increased demand for dollars causes the value of the dollar to rise on foreign exchange markets (i.e. the dollar appreciates, e decreases). As e decreases, Net Exports decrease as domestic goods become relatively more expensive on international markets. As NX decreases, Total Expenditures fall and the IS curve shifts to the left. The exchange rate will continue to appreciate, and the IS curve will continue to shift to the left until the capital inflow is halted (i.e. until the domestic interest rate equals the foreign interest rate). The new equilibrium is at the same level of output as the initial level: the economy moves back to A.

Moral: Fiscal policy is ineffective in altering the level of domestic output under flexible exchange rates and perfect capital mobility.

(Diagram 6, Appendix 1)

Appendix 1

Diagram 1

Diagram 2

Diagram 3

Diagram 4

Diagram 5

Diagram 6