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## ECON 671 – International Economics

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**ECON 671 – International Economics**Exchange Rate Regimes and the IS-LM-BP Model**Open Economy SR Equilibrium:IS-LM-BP Model**• IS-LM-BP Model described by 3 equations (IS)Y = C (Y-T, W) + I(i) + G + NX(e, Y, YROW, W) (LM)Ms/P= a(DR + IR)/P= f(Y, i, W, E(p)) (BP)BOP0 = NX(e, Y, YROW, W) + j(i, i*+ xa) • IS-LM-BP with Fixed Exchange Rate Regime: • Endogenous Variables: Y, i, M(BOP=DIR) • Exogenous Variables: G, T, DR, W, P, e • In a Fixed Exchange Rate Regime, adjustment to FX market equilibrium occurs through changes in Int’l Reserves, IR. • Changes in IR will shift LM Curve Only • No Changes in IS or BP Curves to changes in IR.**Reach equilibrium by**changes in all 3 endog. variables: i, Y, e or M LM Curve - shifts with DM or DP BP Curve LM([DR+IR]/P) - shifts with De or DROW variables BP(e0, i*, Y*) i1 IS Curve - shifts with De, DG or DT IS(e0, G0, T0) Y1 IS-LM-BP Model Interest Rate Income, Output**Types of Fixed EXR Regimes**• Traditional Fixed Exchange Rate Regime: • Gov’t sets a fixed level for the exchange rate. • Central bank intervenes in FX market to maintain EXR fix. • Requires Central bank to hold credible levl of Int’l Reserves. • Exchange Rate Bands: • Gov’t sets a “band” around a fixed level for exchange rate. • Central bank intervenes if EXR moves outside bands. • Requires Central bank to hold credible level of Int’l Reserves. • Currency Board: • Gov’t sets a fixed level for exchange rate. • Currency Board issues domestic currency only to extent it can be backed 100% by Int’l Reserves. • Currency Board conducts no independent monetary policy.**Fiscal Policy with Fixed EXR**• Look at effects of increase in gov’t spending, G. • Direct Effect • Increase in G will shift IS Curve outwards. • No Direct effect on either BP or LM Curves. • New internal equilibrium where LM and new IS intersect. • Both Y and i increase at new intersection. This is not overall equilib.!! • What is status of BoP at this point? • Depends on capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • If capital is relatively immobile • BOP < 0, Int’l Reserves fall as Central Bank tries to keep EXR fixed • This shifts the LM Curve backwards until IS-BP-LM all intersect. • If capital is relatively mobile • BOP > 0, Int’l Reserves rise as Central Bank tries to keep EXR fixed • This shifts the LM Curve outwards until IS-BP-LM all intersect.**1. Rise in Gov’t spending shifts IS Curve out**2. BOP surplus at B leads to increase in IR at fixed e. 3. Rise in IR, raises Ms, which shifts LM out to pt. C. 1. LM1 DG > 0 2. B i1 C IS(e0, G1, T0) Y1 Fiscal Policy under Fixed EXR Interest Rate LM0 BP(e0, i*, Y*) i0 A IS(e0, G0, T0) Y0 Income, Output**LM1**IS1 IS1 LM1 i1 Y1 Fiscal Policy & Capital Mobility Capital Completely Immobile Capital Perfectly Mobile i i BP0 IS0 LM0 LM0 IS0 BP0 i0 i* Y0 Y Y Y0**IS1**LM1 IS1 LM1 i1 i1 Y1 Y1 Fiscal Policy & Capital Mobility Capital Relatively Immobile Capital Relatively Mobile i i BP0 IS0 IS0 LM0 LM0 BP0 i0 i0 Y0 Y0 Y Y**Monetary Policy with Fixed EXR**• Look at effects of decrease in money supply through lower DR. • Direct Effect • Decrease in Ms shift LM Curve inwards. • No Direct effect on either BP or IS Curves. • New internal equilibrium where new LM and IS Curves intersect. • Both Y and i increase at new intersection. This is not overall equilib.!! • BoP at this point is always in surplus regardless of capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • BoP surplus means that IR will increase, results in increase in Ms. • This shifts the LM Curve outwards until get back to original equilibrium. • Monetary policy is ineffective under Fixed Exchange rate Regime • Independent monetary policy is not possible as Central Bank must intervene to keep EXR at set level.**LM1**LM1 DDR<0 DDR<0 DIR>0 DIR>0 Monetary Policy & Capital Mobility Capital Completely Immobile Capital Perfectly Mobile i i BP0 LM0 LM0 BP0 i1 = i0 i* IS0 IS0 Y0 Y0 = Y1 Y Y**LM1**LM1 DDR<0 DDR<0 DIR>0 DIR>0 i1 = i1 = = Y1 = Y1 Monetary Policy & Capital Mobility Capital Relatively Immobile Capital Relatively Mobile BP0 i i LM0 LM0 BP0 i0 i0 IS0 IS0 Y0 Y0 Y Y**EXR Policy with Fixed EXR**• Look at effects of devaluation in domestic currency, (rise in e). • Direct Effects • Depreciation raises NX which shifts IS and BP Curves outwards. • No Direct effect on LM Curve. • New internal equilibrium where LM and new IS Curves intersect. • Both Y and i increase at new intersection. This is not overall equilib.!! • BoP at this point is always in surplus regardless of capital mobility. • Indirect Effects (Automatic Adjustment to New Equilibrium) • BoP surplus means that IR will increase, results in increase in Ms. • This shifts the LM Curve outwards until get to IS-BP-LM equilibrium. • Exchange Rate policy is effective. • A Devaluation of the Exchange Rate is expected to increase the level of GDP in the country, i.e. its an expansionary policy.**1. Depreciation in EXR shifts IS Curve out.**2. Depreciation in EXR shifts BP Curve out. 3. BOP surplus at B leads to increase in IR at fixed e. 4. Rise in IR, raises Ms, which shifts LM out to pt. C. LM1 1. De > 0 3. B De > 0 2. BP(e1, i*, Y*) i1 C IS(e0, G1, T0) Y1 EXR Policy under Fixed EXR Interest Rate LM0 BP(e0, i*, Y*) i0 A IS(e0, G0, T0) Y0 Income, Output**BP1**IS1 De>0 LM1 LM1 De>0 i1 De>0 IS1 Y1 Y1 EXR Policy & Capital Mobility Capital Completely Immobile Capital Perfectly Mobile i i BP0 LM0 LM0 BP0 i0 i* =BP1 IS0 IS0 Y0 Y0 Y Y**BP1**IS1 IS1 De>0 De>0 LM1 LM1 i1 i1 BP1 De>0 Y1 Y1 EXR Policy & Capital Mobility Capital Relatively Immobile Capital Relatively Mobile i i BP0 IS0 LM0 IS0 LM0 De>0 i0 i0 BP0 Y0 Y0 Y Y**Summary of Policy Effects under a Fixed Exchange Rate Regime****Policy Effects with Fixed EXR**• Fiscal Policy • Directly affects only the IS Curve. • Adjustments to equilibrium depend on degree of capital mobility. • Higher the degree of capital mobility, the more effective is fiscal policy. • When capital immobile, IR adjustment shifts LM in & increases i, Y fixed. • When capital mobile, IR adjustment shifts LM out & increases Y, i fixed. • Monetary Policy • Directly affects only the LM Curve. • Adjustment to equilibrium does not depend on degree of capital mobility. • Monetary policy is not effective in changing Y. • Change in Domestic Reserves brings changes in i & Y affecting FX market. • FX market disequilibrium, requires Central Bank to change Int’l Reserves by amount exactly offsetting original change in Domestic Reserves. • Exchange Rate Policy • Devaluation affects both IS & BP curves, increasing Y. • Central Bank intervention to achieve new fixed EXR brings about change.