Question

IS-LM-BP Model (Open Economy)

Question 2

Goods Market

C = Co + cYD

YD = Y- T +TR

T = To + tY

I = Io – bi

G = Go, TR = TRo

X = Xo + λθ + γYf

M = IMo + mY – ψθ

Money Market

L = kY - hi

Ms/P = Mo/P + ΔRE/P

Foreign Exchange Market

NX = NXo – mY + vθ + γYf   

CF = CFo + f (i – i_f)   

ΔRE/P = NX + CF

Endogenous Variables: C, YD T, I, X, IM, L, Ms, CF, NX, Y, i and .RES/P

Exogenous Variables: Co, To, Io, Go, TRo, Xo, Yf, IMo, Mo, CFo, NXo, i, i_f and P

Parameters: c, t, b, λ, γ, ψ, m, f, k, h and v

Policy variables: Fiscal policy: (G, t and TR) Monetary policy: (Mo, P) and Exchange Rate: (θ)

1. Explain the general role of parameters λ, γ, ψ, m, f, k, h, v in the algebraic model

2. For the macroeconomic model given, identify the ER (exchange rate) system and the extent of capital mobility (perfect or imperfect) in this economy.

3. Assume that the economy is initially in internal-external equilibrium, show the effects of a devaluation of the real exchange rate (increase in θ), on interest rate i* and output Y*, in an IS-LM-BP space.

4. Provide a brief written description of the adjustment process that occurs in no. 3 above.

5. Use qualitative analysis (state direction of change, do not calculate any values) and clearly describe in words, the ultimate impact of the above policy on the equilibrium level of the following endogenous variables:

• Private Consumption
• Private Savings
• Net Exports
• Money Supply
• Government Revenue
• Investment- Savings balance

6. Explain the costs of devaluation and the ‘J Curve effect’

Answer 1

Ans 1) Endogenous variables are the variable which are given in the model or there is relation with other variable which are given in the model. While exogenous variable which are outside the model , they are not related directly but they have relation with the model which is prescribed. Role of various parameters are described here :

= it is given in the export equation of the model, the relationship with the exchange rate is positive (). The higher the exchange rate higher will be the value of . It is the part of export which depends on exchange rate of the country. It is highly responsive with the exchange rate.

= it is give in export equation, foreign exchange market as well. There is direct relationship between income of foreign and the parameter. In both the equation it is shown that there is direct relationship. The higher the income of foreign higher will be the demand of exports of our country. In foreign exchange equation also higher the income higher will be the role in foreign exchange market of foreign people. So it is highly responsive with foreign income.

= it is given in the import equation of the model. There is negative relationship between the exchange rate and import of the country. Higher the exchange rate lower will be import of the country.

m = it is given foreign exchange market equation of the model. It shows that there is negative relationship between income and foreign exchange market. It is part of equation which depends upon the income of domestic people.

f = it shows the foreign income as it is written with yf. In the model higher the income of foreign people higher will be the demand of our export which directly effect the foreign exchange rate as shown in the foreign exchange market equation also.

k = it is shown in the LM equation of the model. It is part of equation which depends on the income. It response to the income.

h = it is also shown in the LM equation. It is part of equation which depends on the interest rate.

v = it is a part of foreign exchange market which depends on the exchange rate in international market. There is direct relationship between the exchange rate and foreign exchange market.

Ans (2) Exchange rate : There are two types of exchange rate: fixed and floating exchange rate. Under fixed exchange rate and perfect mobility a country can't pursue an independent monetary policy. Interest rate can't move our of line with those prevailing in the world market. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rate are back in line with those in the world market.

With the fixed exchange fiscal expansion under conditions of capital mobility is highly effective in rising equilibrium output. For flexible rates,a fiscal expansion does not change output instead, it produces an offsetting exchange rate appreciation and a shift in the composition of domestic demand towards foreign goods and away from domestic goods.

Under fixed exchange rate, the monetary authority can't control nominal money stock and an attempt to expand money will merely lead to reserve losses and a reversal of the increase in money stock. Under flexible rates by contrast the central bank does not intervene and so the money stock increase is not reversed in the foreign exchange market. The depreciation and expansion in output actually do take place given the assumed fixed prices. The fact that the central bank can control the money stock under flexible rates is a key aspect of that exchange rate system.

Ans 3,4) Internal balance= when output is at full employment. While external balance is the situation when balance of payment is close to balance otherwise central bank is either losing reserve which it cannot keep doing or gaining reserve which it does not want to do forever.

Real exchange rate : It is the ratio of foreign to domestic price, measures in the same currency. It measures a country's competitiveness in international trade. A rise in real exchange rate shows, the country is facing the problem of depreciation , means that goods abroad have become more expensive relative to goods at home. It improves our trade balance as demand shifts from goods produced abroad to those produce at home.

Ans 5) Net export will rise as the demand of our goods is more then the foreign goods. As a result the income of the people who are working in the export sector of the goods will also increase. In relation to income savings as well as consumption of the people will also increase. So private saving , private consumption will increase with the foreign exchange or depreciation. Government revenue will also increase , the income is high in the country so the demand of the money will also increase, the money supply in the country will increase to meet the demand of the people in the country.

The investment will also increase because of decrease in interest rate by increase in the money supply in the economy.

So as a result of depreciation the net effect will be the increase in the saving , investment, consumption, government revenue will not increase as much because of decrease in the import, revenue from tariff will decrease but from direct tax or increase in income of the people the government revenue can increase.

Ans 6) the effect of depreciation that rises the relative price of import short run effects primarily from increased import prices with very few offsetting volume effects. Therefore trade balance initially worsens. Overtime as trade volume adjusts to the the changed relative price, export rises and import volume progressively decline. This show improvement in trade balance in long run. This process is defined as J curve effect explained by prof. Meade.