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IF TUTE 3 TUTE NOTES 1) a. The IS Curve is the locus of combinations of Y and r satisfying the goods market equilibrium condition, expenditure = income, or I+G+X = S+T+M, or I+G+B = S+T (where B = balance of trade). Ignoring the impact of Y on M, S depends positively on Y and I depends negatively on r. Therefore, a decrease in r (which increases I) must be combined with an increase in Y (which increases S) for the equilibrium condition to be maintained. This implies the IS curve must have a negative slope. Put more simply, the downward slope of the curve indicates that a decrease in the rate of interest will stimulate an increase in the demand for goods. The LM curve is the locus of combinations of Y and r satisfying the money market equilibrium con dition, supply of money = demand for money, where the demand for money depends positively on Y (transactions demand for money) and negatively on r (speculative demand for money), and the money supply is held constant. An increase in Y would increase the d emand for money, so for a constant money supply it must be offset by an increase in r, for the money market to remain in equilibrium. This implies the LM curve must have a positive slope, when drawn for a constant money supply. Put more simply, the upwar d slope of the curve indicates that an increase in income, which increases the demand for money, will cause an increase in interest rates if the money supply is held constant. If the central bank varies the money supply to hold the interest rate constant, then the LM curve must be replaced by a horizontal line, at the central bank’s interest rate target. b. The FE Curve is the combinations of Y and r leading to equilibrium on the foreign exchange market, where the demand for domestic currency due to trad e and capital flows is equal to its supply. A trade surplus would go with a net capital outflow, and a trade deficit with a net capital inflow. i. Under perfect capital mobility, any differences in interest rates between countries lead to limitless capital f lows, and so are immediately eliminated. The FE curve is then horizontal. ii. Under imperfect capital flows, net capital inflows depend on the gap between domestic and foreign interest rates, but are not infinite. An increase in income leads to an increase in imports and so a trade deficit, which must be offset by an increase in domestic interest rates, to attract a net capital inflow, for foreign exchange market equilibrium. The FE curve is then upward sloping ( like the LM curve). It is usually assumed that t he FE curve is more elastic than the LM curve, and this assumption is hardly discussed, but it turns out to be an important assumption. c. i. One issue with this model is that it ignores exchange rate expectations (or assumes that no -one expects a change in exchange rates in advance). ii. Another issue is that the model holds the price level constant. The Dornbusch Model offers a solution to both these weaknesses. 2) a.

i. Under fixed exchange rates, IS shifts from IS1 to IS2. In a closed economy, there would be a shift from 1 to 2. With perfect capital mobility, any increase in interest rates leads to an excess demand for domestic currency on the foreign exchange market. To hold the exchange rate fixed, the central bank must sell domestic currency on the foreign exchange market, increasing the domestic monetary base. This shifts the LM curve to the right. With perfect capital mobility, this must continue until r=r* once again , at point 3 . The rate of interest must return to its initial level, whic h is equal to the foreign interest rate. A fiscal expansion is highly expansionary under fixed exchange rates and perfect capital mobility. ii. Under floating exchange rates and a perfect capital market , the shift in IS from IS1 to IS2 (at point 2) leads to a currency apprecation, due to the domestic interest rate rising above the foreign interest rate. This currency appreciation must continue until it has caused a sufficient deterioration in the trade balance to offset the impact of the fiscal expan sion on the IS curve (point 3 is the same as point 1) . A fiscal expansion is completely ineffective, under these circumstances, as it is predicted to cause 100% crowding out of net exports, due to a currency appreciation. b) Under imperfect capita l mobility, a fiscal expansion does have an effect on national income. The shift from 1 to 2 again leads to a currency appreciation. However, the currency appreciation, while it shifts the IS curve back to the left again, also shifts the FE curve upward s. This is because of the need for higher interest rates and a bigger net capital inflow than before at any level of national income, due to the negative impact of the currency appreciation on the trade balance. The final general equilibrium point 3 i s the point where the shifting FE and IS curves (FE2 and IS3) intersect along the LM curve. The LM curve is static c. An interest rate target means the central bank varies the monetary base to fix the interest rate. This implies that a fiscal expansion leads to an excess supply of domestic currency on the foreign exchange market (point 2). The increase in income causes a deterioration in the trade balance, and there has been no increase in interest r ates. The domestic currency depreciates, shifting the FE curve down and the IS curve further to the right. The fiscal expansion is highly effective, as there is crowding in of net exports due to the impact on the trade balance of the currency deprecia tion. d. This time, we come up against the impossible trinity problem. The fiscal expansion moves the closed economy equilibrium below the FE curve, leading to pressure for a currency depreciation. Either the central bank must allow the currency to depreciate – giving up on the fixed exchange rate – or the central bank must use its foreign exchange reserves to buy domestic currency and defend the fixed exchange rate. This wo uld decrease the domestic monetary base and increase the rate of interest. The central bank can ‘sterilise’ the impact of its foreign exchange market intervention on the monetary base and the rate of interest, by purchasing bonds from domestic banks. Ho wever, it cannot do this indefinitely, as it will run out of foreign exchange reserves. The central bank must eventually either allow the domestic monetary base to fall and interest rates to rise to defend the fixed exchange rate, or must allow the curr ency to depreciate and retain its interest rate target. There is no final equilibrium point 3 under this scenario. Point 2 is not a new general equilibrium, as it is not on the FE curve.