International
Macroeconomics
Chapter 6 - The Mundell-Fleming
Model: IS curve -
Summary
- map of the course International Trade
Real side
Financial side
Trade
Balance of Payments
Exports/Imports
Part 2
Chapter 6: IS
Chapter 7: LM
Chapter 8: BP
Chapter 9+10: policies
Open Economy
Part 3
Financial flows
Exchange rates
Part 1
6.1 Plan
Overview
6.2 Quick rehearsal IS LM
6.3 IS curve – ingredients
6.4 IS in an open economy
6.5 Examples - exercises
6.1 Plan: IS >
LM > BP
IS goods
market
Y = C + I + G + NX
LM financial
market
Ms = L(r,Y)
BP Balance of
payments
CA + FA + KA = 0
Chapter 6
Chapter 9 + 10
Chapter 8
An open economy
governm
ent
CB
G T
Financial flows
So-Io
G T
financial market
Sb-Ib
Sg-Ig
S=I
XM
firms
households
C
A financial system with banks
governm
ent
G T
CB
Financial flows
So-Io
G T
Sg-Ig
B
B
B
B
B
Sb-Ib
B
S=I
XM
firms
households
C
The model of aggregate demand (AD) can be split into two parts:
1.IS model of the “goods market”
2.LM model of the “money market”
3. BP model of the Balance of Payments
IS stands for Investment Saving,
Whereas LM stands for Liquidity Money.
BP for Balance of Payments
IS (investment and saving)
model of the
‘goods market’
LM (liquidity and money)
model of the ‘money market
The IS curve (which stands for investment saving)
plots the relationship between the interest rate and the
level of income that arises in the market for goods and
services.
The LM curve (which stands for liquidity and money)
plots the relationship between the interest rate and the
level of income that arises in the money market.
The BP curve plots the relationship between the
interest rate and the exchange rate that ensure
equilibrium on the Balance of Payments
Because the interest rate influences both investment and money demand, it is the
variable that links the two parts of the IS-LM model.
The model shows how interactions between these markets determine the position
and slope of the aggregate demand curve, and therefore, the level of national income
in the short run.
6.2 Quick
rehearsal
• What is the IS curve in a closed economy?
– 6.2.1 The Keynesian cross
• example
– 6.2.2 Components: looks at demand side
– 6.2.3 Equilibrium on goods market
– 6.2.4 Equilibrium for r and Y
6.2.1 The Keynesian Cross
The Keynesian cross shows how income Y is determined for given levels
of planned investment I and fiscal policy G and T. We can use this model to show
how income changes when one of the exogenous
variables change. Actual expenditure is the amount households, firms and the
government spend on goods and services (GDP). Planned expenditure is the amount
households, firms, and the government would like to spend on goods and services.
The economy is in equilibrium : Actual Expenditure = Planned Expenditure or Y = E
Actual expenditure, Y=E
Expenditure, E
Planned expenditure,
E=C+I+G
Y2
Y*
Y1
Income, output, Y
The 45-degree line (Y=E) plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram
becomes the Keynesian cross.
How does the economy get to this equilibrium? Inventories play an
important role in the adjustment process. Whenever the economy is
not in equilibrium, firms experience unplanned changes in inventories,
and this induces them to change production levels. Changes in
production in turn influence total income and expenditure, moving the
economy toward equilibrium.
Actual expenditure, Y = E
Expenditure, E
Planned expenditure,
E=C+I+G
Y2
Y*
Y1
Income, output, Y
Example 1: effect of government purchases on the economy.
Because government purchases are one component of expenditure,
higher government purchases result in higher planned expenditure,
for any given level of income.
Actual expenditure, Y=E
Expenditure, E
B
A
Planned expenditure,
E=C+I+G
ΔG
Income, output, Y
Y* Y1
An increase in government purchases of ΔG raises planned expenditure
by that amount for any given level of income. The equilibrium moves
from A to B and income rises. Note that the increase in income Y
exceeds the increase in government purchases ΔG.
Thus, fiscal policy has a multiplied effect on income.
Example 1: effect of government purchases on the economy.
Ch 9
+ 10
If government spending were to increase by €1, then you might expect equilibrium
output (Y) to also rise by €1.
But it doesn’t!
The multiplier shows that the change in demand for output (Y) will be larger than the
initial change in spending. Here’s why:
When there is an increase in government spending (DG), income rises by DG as well.
The increase in income will raise consumption by MPC ´ DG, where MPC is the
marginal propensity to consume. The increase in consumption raises expenditure and
income again. The second increase in income of MPC ´ DG again raises consumption,
this time by MPC ´ (MPC ´ DG), which again raises income and so on
.
So, the multiplier process helps explain fluctuations in the demand for output. For
example, if something in the economy decreases investment spending, then people
whose incomes have decreased will spend less, thereby driving equilibrium demand
down even further.
Example 1: effect of government purchases on the economy.
The government-purchases multiplier is:
ΔY/ΔG = 1 + MPC + MPC2 + MPC3 + …
ΔY/ΔG = 1 / (1 – MPC)
Do the same reasoning for the effect of a tax increase.
What is the effect on the diagrams? and what is the multiplier?
The tax multiplier is:
ΔY/ΔT = - MPC / (1 - MPC)
Y=C+I+G
Let’s now add the relationship between the interest rate and investment
to our model, writing the level of planned investment as: I = I (r).
On the next slide, the investment function is graphed downward
sloping showing the inverse relationship between investment
and the interest rate. To determine how income changes when the
interest rate changes, we combine the investment function with the
Keynesian-cross diagram.
The IS curve summarizes this relationship between the interest rate
and the level of income. In essence, the IS curve combines the interaction
between I and Y demonstrated by the Keynesian cross. Because an
increase in the interest rate causes planned investment to fall, which in
turn causes income to fall, the IS curve slopes downward.
Suppose further that I is: 𝐼(𝑟) =𝑐−𝑑𝑟
where c,d>0 .
An increase in the interest rate
(in graph a), lowers planned
investment, which shifts
planned expenditure downward
(in graph b) and lowers income
(in graph c).
(a)
investment curve
(b)
E
Keynesian cross
Y=E
Planned expenditure,
E=C+I+G
(c)
Income, output, Y
IS curve
r
r
I(r)
Investment, I
IS
Income, output, Y
Shifts on the curve:
In summary, the IS curve shows the combinations of the interest rate and
the level of income that are consistent with equilibrium in the market for
goods and services.
Shifts of the curve:
The IS curve is drawn for a given situation
1) fiscal policy. Changes in fiscal policy that raise the demand for goods
and services shift the IS curve to the right. Changes in fiscal policy that
reduce the demand for goods and services shift the IS curve to the left.
2) consumption: changes in consumption that raise the demand for goods
and services shift the IS curve to the right.
Y=C+I+G
Exercise 1: increase in G
What is the effect on the IS curve, effect on Y and r? why?
r
IS
r0
Y0
Y
+DG
Consider an increase in government purchases.
This will raise the level of income by DG/(1- MPC).
r
IS
IS´
LM
Y
The IS curve shifts to the right by DG/(1- MPC) which raises income and the interest rate.
What was the multiplier again?
The government-purchases multiplier is:
DY/DG = 1 + MPC + MPC2 + MPC3 + …
DY/DG = 1 / (1 – MPC)
Exercise 2: cut in T
What is the effect on the IS curve, effect on Y and r? why?
-DT
Consider a decrease in taxes of DT.
This will raise the level of income by
DT × MPC/(1- MPC).
r
IS
IS´
Y
The IS curve shifts to the right by DT × MPC/(1- MPC) which raises income and the interest
rate.
Exercise 3: increase in taxes
task: effect on which curve, effect on Y and r? why?
r
IS
r0
Y0
Y
6.3 IS curve ingredients
• 6.3.1 Remember national accounting identity
• 6.3.2 Savings and investment
• 6.3.3 Net foreign investment and the trade
balance
• 6.3.4 The exchange rate and trade
6.3.1. Remember national accounting identity
Y = C + I + G + NX
Total demand
for domestic
output
is composed
of
Consumption
spending by
households
Investment
spending by
businesses and
households
Net exports
or net foreign
demand
Government
purchases of goods
and services
Notice we’ve added net exports, NX, defined as Export - Import. Also, note that
domestic spending on all goods and services is the sum of domestic spending on
domestic goods and services AND on foreign goods and services.
Ch 2
6.3.2 Savings and investment
Start with the national income accounts identity:
Y = C + I + G + NX.
Subtract C and G from both sides
Y – C – G = I + NX.
Let’s call this S, national saving.
So, now we have S = I + NX.
Subtract I from both sides to obtain the new equation
S – I = NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S – I = NX
Net Foreign Investment
Trade Balance
Y = Y = F(K, L)
The economy’s output Y is fixed by the
factors of production and the production
function.
C = C (Y-T)
Consumption is positively related to
disposable income (Y - T).
I = I (r)
Investment is negatively related to the
real interest rate.
NX = (Y-C-G) - I
or NX = S - I
The national income accounts identity,
expressed in terms of saving and investment.
NX = (Y-C-G) - I
NX = Y- C(Y-T) - G - I
NX =
S
- I (r)
This equation tells us that the trade balance is determined by the
difference between saving, and investment
6.3.3. Net foreign investment and the trade balance
Suppose the economy begins in a position of balanced trade. In
other words, investment I equals savings S, and net exports equal zero.
6.3.3.1 Closed economy
Real
interest
rate, r
S
In a closed economy, r adjusts to
equilibrate saving and investment.
rclosed
I(r)
Investment, Saving, I, S
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
6.3.3.2 A small open economy
Real
interest
rate, r*
S
NX
In this case, since r* is
above rclosed and saving
exceeds investment,
there is a trade surplus.
r*
rclosed
I(r)
Investment, Saving, I, S
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
6.3.3.3 Exercise: a rise in r*
Real
interest
rate, r*
S
NX
r*
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
rclosed
I(r)
Investment, Saving, I, S
Hence, starting from balanced trade, an increase
in the world interest rate leads to a trade surplus.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
6.3.3.4 Exercise: a fall in r*
Real
interest
rate, r*
S
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
rclosed
r*'
I(r)
NX
Investment, Saving, I, S
Hence, starting from balanced trade, a fall in the world interest rate leads to a trade deficit.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
6.3.3.5 More exercises
A. Domestic Fiscal Expansion in a Small Open Economy
An increase in government purchases or a cut in taxes decreases national saving and
thus shifts the national saving schedule to the left.
Real
interest
rate, r*
S'
S
NX = (Y - C(Y - T) - G) - I (r*)
NX = S
- I (r*)
The result is a reduction in national
saving which leads to a trade deficit,
where I > S.
r*
NX
I(r)
Investment, Saving, I, S
B. Fiscal Expansion abroad (effects on the Small Open Economy)
A fiscal expansion in a foreign economy large enough to influence world saving and
investment raises the world interest rate from r1* to r2*.
Real
interest
rate, r*
S
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
where S > I.
r 2*
r 1*
NX
I(r)
Investment, Saving, I, S
C. A shift in investment
An outward shift in the investment schedule from I(r)1 to I(r)2 increases the amount of
investment at the world interest rate r*.
Real
interest
rate, r*
As a result, investment now
exceeds saving I > S, which
means the economy is
borrowing from abroad and
running a trade deficit.
S
r 1*
I(r)2
NX
I(r)1
Investment, Saving, I, S
6.3.4. The exchange rate and trade
Remember the current account NX and the REER
What was that relationship?
Remember that S – I = NX
Ch 3
Real
exchange
rate, e
The relationship between the real exchange rate and net
exports is negative: the lower the real exchange rate, the
less expensive are domestic goods relative to foreign
S-I goods, and thus the greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
NX(e)
0
Net Exports, NX
Here the quantity of euros
supplied for net foreign
investment equals the
quantity of euros demanded
for the net exports of goods
and services.
A. Domestic Fiscal Expansion in a Small Open Economy
Real
exchange
rate, e
S2 - I
Expansionary fiscal policy at home, such as an
increase in government purchases G or a cut in
taxes, reduces national saving.
S 1- I
The fall in saving reduces the supply of euros
to be exchanged into foreign currency, from
S1-I to S2-I. This shift raises the equilibrium real
exchange rate from e1 to e2.
e2
e1
NX(e)
NX2
NX1
Net Exports, NX
A reduction in saving reduces
the supply of euros, which
causes the real exchange rate
to rise and causes net exports
to fall.
B. Fiscal Expansion abroad (effects on the Small Open Economy)
Real
exchange
rate, e
S - I(r1*)
S - I (r2*)
Expansionary fiscal policy abroad reduces world
saving and raises the world interest rate from r1* to
r2*.
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of euros to be exchanged into foreign
currencies.
e1
e2
NX(e)
NX1
NX2 Net Exports, NX
As a result, the equilibrium
real exchange rate falls from e1
to e2.
C. A shift in investment
Real
exchange
rate, e
S - I2
S - I1
An increase in investment demand raises the
quantity of domestic investment from I1
to I2.
As a result, the supply of euros to be
exchanged into foreign currencies falls
from S - I1 to S - I2.
e2
e1
NX(e)
NX2
NX1 Net Exports, NX
This fall in supply raises the
equilibrium real exchange rate
from e1 to e2.
6.4 IS curve in an open economy
Net Capital Outflow = Trade Balance
S – I = NX
If S - I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing. Simply put, if Saving > Investment then
Net Capital Outflow > 0.
If S - I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting. Simply put, if Saving < Investment then
Net Capital Outflow < 0.
If S - I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports. Simply put, if Saving = Investment
then Net Capital Outflow = 0.
M(e)….
net exports are just X-M
>> J curve
Marshall Lerner condition
Ch 3
Ch 8
The IS* curve slopes downward because a higher exchange rate
reduces net exports (since a currency appreciation makes domestic goods more
expensive to foreigners), which in turn, lowers aggregate income.
Exchange rate, e
IS*
Income, output, Y
An increase in the exchange rate,
lowers net exports, which shifts
planned expenditure downward
and lowers income. The IS* curve
summarizes these changes in the
goods market equilibrium.
Expenditure, E
(b)
Y=E
Planned expenditure,
E = C + I + G + NX
Income, output, Y
(c)
NX(e)
Net exports, NX
Exchange rate, e
Exchange rate, e,
(a)
IS*
Income, output, Y
6.5 Examples
01
02
03
04
Experiment 1:
increase G
Experiment 2:
twin deficits
US
Experiment 3:
Spain: Plan E
2010
Experiment 4:
export boost
Experiment 1: increase G
What happens in the graphs?
S– I = NX
IS curve
In an open economy ∆G leads to a lower ∆Y than in a closed economy
due to import growth
What does this imply? …
Open economy: smaller multipliers smaller than in a closed
economy, ie, fiscal policy shows a lower effectiveness:
Reason: part of the effects of an expansionary fiscal policy
are felt in the foreign country due to import growth
What happens in the graphs?
S– I = NX
IS curve
Experiment 2: twin deficits
Hence, a decrease in NX. So an expansive fiscal policy
can also create a trade deficit.
This is called the twin deficit
An expansive fiscal policy can also create a trade deficit.
This is called the twin deficit hypothesis.
An expansionary fiscal policy ↑Y REMEMBER M = f (Y)
Thus, ↑Y ↑M ↓ X: TRADE DEFICIT
Does Spain have a twin deficit?
Assignment: upload a page with 2 graphs
and a short explanation why you think there
is (no) twin deficit
Experiment 3: increase G
Plan Español para el Estímulo de la Economía y el Empleo
Plan E
Government Zapatero (2008 – 2011)
Experiment 4: investment boom in housing
Summary
- map of the course International Trade
Real side
Financial side
Trade
Balance of Payments
Exports/Imports
Part 2
Chapter 6: IS
Chapter 7: LM
Chapter 8: BP
Chapter 9+10: policies
Open Economy
Part 3
Financial flows
Exchange rates
Part 1