Free Economics Essays - IS LM CM Model
Norway faced a precipitous drop in the real value of oil exports in 1986. This occurred both because the dollar price of oil declined and because the dollar depreciated. Describe and analyse the impact using the IS/LM/CM model and the policy options available to Norway to counteract the effects of the event. Norway had its exchange rate fixed to a basket of currency.
The standard Keynesian IS-LM framework used to analyse the impact of fiscal and monetary policy can also be extended to the international framework to understand how the dual targets of internal and external balance can be achieved. This essay will first explain the ISLM model before extending it to include concerns over balance of payments, this is the IS-LM-BP or IS-LM-CM model. We will then apply the model to an analysis of Norway’s situation in 1986.
The standard ISLM model identifies the level of interest rates and national income that is consistent with both goods market and money market equilibrium. The goods market equilibrium (with no government) is achieved when planned expenditure equals output:
y = yD
yD = C + I + X – M
yD = C(y) + I(r) + X – M(y)
Note here that we include net exports (X-M) to emphasise that aggregate demand includes demand from overseas (exports) and must subtract demand for overseas goods (imports). The third line also notes that investment is a function of interest rates – in fact as interest rates rise, there will be less investment as investment becomes costly. Also, imports are a function of income – when income rises, consumption of both domestic goods (c) and imports(y) rises.
A downward sloping line in interest rate-income space represents equilibrium in the goods market. This says that for a low interest rate, there needs to be a high level of output for the economy to be in equilibrium since there will be higher investment and thus higher aggregate demand and so output needs to adjust so that we still get y = yD.
We now include an additional line in the diagram, which is the BT line or balance of trade. Note that for the moment we assume that there is no capital mobility. This implies that the capital account on the balance of payments must be zero and the total balance of payments without government intervention equals the balance of trade which is simply X-M. The balance of trade is achieved when X=M(y). We assume that exports are exogenous and fixed – they are determined by demand conditions in other countries outside our model. Imports however increase with income. Thus external balance (a balance of trade) takes place at only one level of income. Interest rates do not affect the equilibrium. Hence the BT line (which is also the balance of payments in the case of zero capital mobility) is a vertical line in the interest rate-income space.
The LM curve represents the set of points at which money market equlibrium is reached. This assumes that money supply is fixed for each LM curve. Money demand responds positively to income, since the higher income, the more money will be held since more transactions are taking place. Money demand responds inversely to interest rates – the higher the interest rates, the more attractive it is to hold bonds instead of money since bonds earn interest whereas money does not. Thus assuming we want to keep money deamand constant at the level of money supply. A higher level of income needs to be accompanied by higher interest rates so that the two effects cancel out.
We represent the curves explained above in the IS-LM-BP diagram below.
r
BT/BP
IS
LM
y
The intersection of all these curves is where we have equilibrium in all 3 markets. Points to the right of the BT line are areas where we have a balance of trade and balance of payments deficit. The level of income (y) is too high in this region which leads to higher imports so X-M is negative and we have a deficit.
Now let us consider the shocks to the Norwegian economy with reference to the ISLM-BP diagram. The first shock is the movement of the BP curve – this is because the value of exports fell, this implies that to get external balance, we need to be at a lower value of imports and hence income. The BP curve is now left of the original one. The fall in exports also shifts the IS curve since it results in lower demand for goods in the economy. This will result in a leftward shift of the IS curve.
BT*
BT
LM*
r
LM
IS*
C
A
B
IS
y
This diagram shows the old curves with dashed lines and a new set of IS and BP curves marked with *s. BT* is left of BT as explained above and IS* is left of IS. Why has the LM curve shifted to the left to LM*? After the IS curve shifts to IS* and the BT curve shifts to BT* we are at point B – we have goods and money market equilibrium but because we are right of BT* we have a balance of trade deficit. What this means is that there is higher imports than exports – there is a greater demand for foreign currency to pay for foreign goods than the amount of foreign currency earned from selling exports. Thus the central bank has to intervene to sell foreign its foreign currency reserves, it does this by buying up some of the domestic currency base. This shrinks money supply and causes a leftward shift of the LM curve. This happens as long as there is a trade deficit so we keep moving the LM curve until IS* and LM* intersect at point C where we also have trade balance since we are on BT*. This analysis occurs because Norway has a fixed exchange rate regime which means that if there is an excess demand for foreign currency, the central bank must make up the shortfall rather than letting the exchange rate fluctuate, this making up of the shortfall affects the domestic money supply.
In this situation, external balance is automatically achieved, however, income is reduced. Note however that external balance is achieved only by running down foreign reserves of the government and this might be problematic if reserves are insufficient. What policy can the Norwegian government take to raise income to its original level? Note that following our analysis, the income level must be at the level that achieves trade balance – we must always be on the BT line, otherwise money supply will shift to bring us there. Thus fiscal and monetary policy are powerless to affect income. Hence to raise income we must move the BT curve rightwards through “expenditure-switching” policies to reduce imports or increase exports. This measure will also shift the IS curve rightwards. Expenditure switching policies could include trade barriers or tariffs to reduce imports or subsidies for exports. It could also explicitly devalue its currency or adjust the weight of the dollar in its basket of currencies downwards to reduce the impact of the dollar depreciation. Shifting the BT curve also has the advantage of reducing the outflow of foreign reserves of the government. However the first measure might result in retaliatory measures from other countries and the second measure effectively undermines Norway’s commitment to a fixed currency.
Alternatively, Norway could engage in “sterilization”. Note that if we tried only monetary policy to push the LM curve rightwards, we would move to point B. However, the automatic adjustment of money supply would shift us to point C again. We would have no increase in income. Could we keep the economy at point B? It is possible through sterilization – we explained above that central bank sales of foreign currency that keep exchange rates fixed also reduce the money supply since the central bank is paid in domestic currency which is withdrawn from circulation. However, if the central bank can at the same time also buy domestic bonds, thus injecting more money into the economy, it can keep the money supply constant and we can stay at point B. Thus with sterilization, monetary policy can be effective.
Now let us consider the situation with perfect capital mobility, also known as the Mundell-Fleming analysis.
r
BT
BP
r*
IS
LM
y
In this situation of perfect capital mobility, the balance of payments is no longer equal to the balance of payments. In fact, a balance of trade deficit can now be financed by a capital account surplus – we no longer need to be on the vertical BT line. The corollary of this is that interest rates in the country must be fixed to be exactly equal to the world interest rate, r*. If interest rates were any higher, there would be an infinite flow of capital into the country and if they were any lower, there would be an infinite outflow. As long as r=r* - any trade deficit will be financed by foreign capital and balance of payments will be in equilibrium at any level of y. Thus the BP line is horizontal. In this equilibrium, balance of trade can be in deficit (as shown above) or in surplus. In such a situation, the government no longer has to worry about a balance of payments deficit that it needs to finance from its reserves as was the case in the no capital mobility situation.
Let us consider the same shock to the Norwegian economy starting from a situation of equlibrium.
LM*
BT*
r
LM
IS*
C
BP
A
B
IS
y
The BT line shifts leftwards as does the IS line. However the BP line remains horizontal – the world interest rate does not shift since it is assumed to be exogenous and not affected by any one economy. Note here that we no longer need to be on the BT line so it is of less significance now (we have excluded the original BT line). However we must be on the BP line.
The impact of the move in the IS curve is that we shift temporarily to point B – at a lower level of income. However at this point interest rates are below world interest rates so there is an outflow of capital from the economy – this is effectively a shrinking of the money supply and so the LM curve is moved to LM* where interest rates equal the world interest rates. This is point C. At point C however income is even lower than at B! The impact of an IS shock is more severe than it first seems due to the capital outflow.
What can the Norwegian government do in this situation? The most obvious solution is to shift the IS curve back to its original position through government expenditure or tax cuts. While this will generate a balance of trade deficit, this is of lesser concern in a situation with capital mobility since the deficit can be financed by capital flows. How about expenditure switching policies? These shift the BT curve and can reduce the trade deficit they also shift the IS curve rightwards and thus can have positive effects on income. However, there is no guarantee that expenditure switching policies will shift the IS and BT curve exactly to the point where we have both internal and external balance. We might achieve trade balance but the level of income might be too low or too high. So what we need in addition, is fiscal policy to adjust the level of income to the desired level. If the Norwegian government is indeed concerned about the trade deficit even though it is financed by foreign investment, then it needs two policy tools to achieve both its desired income level and trade balance.
How about monetary policy that shifts the LM curve? Consider a shift of the LM* curve to LM. This would move us to point B where IS* intersects LM. However the lower interest rates at B will induce a capital outflow and this will reduce money supply shifting LM back to LM*. Monetary policy in this case is powerless! The lesson is that with full capital mobility, monetary policy is powerless, whereas fiscal policy or fiscal shocks are very powerful and have large effects on income. In this analysis interest rates cannot be affected by government.
We have considered two situations – with zero capital mobility and perfect capital mobility each with different implications for what the Norwegian government could do to counteract effects of the shock. In each case the economy is “disciplined” by different constraints – with zero capital mobility, the BT line determines income and policy has to take the form of expenditure switching. Alternatively, sterilization could be used to make monetary policy feasible. With perfect capital mobility, the economy has to have interest rates equal to world interest rates – a horizontal BP line. Here fiscal policy has the most significant effects while monetary policy is useless. In this situation, the targets of the government may also be different – a balance of trade deficit is less of a problem because it does not have to be financed by government reserves. If however, there are concerns about the sustainability of the trade deficit, then in order to target both the trade deficit and income, both fiscal policy and expenditure switching policies need to be used.
References
Carlin, W and Soskice, D. (1990) Macroeconomics and The Wage Bargain. Oxford University Press.
Krugman, P. and M. Obstfeld (2003). International Economics, 6th Edition, Addison-Wesley
Word Count: 2248
