Macroeconomics
is based on models that describe aggregate economic behavior and the response
of the economy to shocks from energy prices, financial system failures, foreign
recessions, exchange rate shocks, and government monetary and fiscal policies. The ISLM model is the workhorse macro model
and this introduction focuses on the small economy open to international trade
and investment. IS indicates investment
and saving on the real side of the economy and LM stands for liquidity and
money on the monetary or financial side of the economy.
The main advantage of the ISLM model
is that it includes consumption, investment, government spending, taxes,
exports, imports, the interest rate, exchange rate, and national output in a
single framework. Unemployment and
inflation, the two major policy targets of macroeconomics, are indirectly
linked to the ISLM model. The ISLM model
does not include optimal decision making by households, firms, and government,
and does not include the production and distribution of output, the labor
market, or economic growth. Although the
ISLM model has shortcomings, its appeal is the overall description of how the
major macroeconomic variables in an economy react over time periods of a few
quarters or a year. The ISLM model is
also worth studying because it remains the primary model used by government
policy makers, financial commentators, and macroeconomic consultants.
This
introduction examines the open economy ISLM model, focusing on the role of
government policy to influence output and unemployment. A mix of government policies are considered,
fiscal policy in government spending and taxation, monetary policy in control
of the money supply, and exchange rate policy in the central bank choice of a
fixed or floating exchange rate.
Inflation is anticipated in the ISLM model. The small open economy is assumed to be a
price taker for the global interest rate in the international credit
market. The balance of trade and
international investment in the capital account are included in the adjustment
process. For the small open macroeconomy
the exchange rate, trade, and international investment prove critical to the
adjustment process.
A. Production, absorption, and trade along the
IS curve
Three groups inside the economy
(consumers, firms, government) consume aggregate output Y. The three types of spending are
C household consumption
I firm investment
G government spending.
Y = A + BOT = C + I + G + X M,
where
X export
revenue
M import
spending
Short of changing inventories, everything that is produced on
the left side of the equation is absorbed by the economy or exported. Imports are consumed but not produced and
included on the right hand side. When
BOT > 0 there is a trade surplus with the economy producing more than
it absorbs, lending to other countries and accumulating wealth, and when BOT
< 0 there is a trade deficit with the economy borrowing and spending
wealth.
The national accounting scheme says
nothing about how economic agents in the economy behave and behavioral
assumptions are required to build a macro model. The IS curve summarizes these behavioral
assumptions and shows combinations of output and the interest rate that balance
spending and production.
Consumer spending depends on income Y
after taxes T and the interest rate,
C = C( Y T , r ) .
An increase in disposable income Y T leads to an
increase consumer spending. Consumers
typically save a only fixed portion of disposable income.
Taxes are exogenous to the ISLM
model. While taxes are not explained by
the model, it can analyze the effects of exogenous changes in fiscal policy
variables T or government spending G.
The motivation for government spending and taxes is based on economic
and political decisions.
Consumption spending also depends on
the real interest rate r. A higher
interest rate induces consumers to save more as indicated by the (-) sign. Bonds pay a rate of return equal to the nominal
interest rate R on the single riskless bond issued by firms or the
government to borrow.
The Fischer equation relates the real interest rate r to the nominal
interest rate R and expected inflation π,
r = R π.
Expected inflation and the real interest rate are critical
variables. The ISLM model keeps the
price level P fixed making inflation π equal to zero and implying r =
R. Over long time periods, however, the
government controls the money supply and by implication the price level P. A higher growth rate in the money supply
leads to a higher price level P.
Inflation π = ΔP/P is determined by money supply policy,
complicating the macro adjustment.
Consumption in fact also depends on
expectations about future income and prices, average age of the population,
changes in the propensity to save, changes in trade protection, and so on. This introduction sticks with the simplest
assumptions. If a macro model proves
capable of predicting aggregate behavior, it is useful regardless of its
assumptions and the ISLM model has proven useful.
Investment
spending I by firms depends on the interest
rate r. Firms consider the
opportunity cost of buying bonds when making investment decisions. Firms with retained earnings have the option
of investing in an array of projects such as a new assembly line or new
delivery trucks, and rank these investment projects according to their rates
of return. The most attractive
investment projects are those with the highest rates of return, and they are
the first ones done subject to liquidity constraints.
Any investment project has to offer a
higher rate of return than the market interest rate r to be considered. Firms with retained earnings have the option to buy bonds or invest in internal
projects, and would invest in any project with a rate of return higher than
r. Firms without retained earnings could
possibly borrow by selling bonds to raise funds to invest in projects with
rates of return higher than r.
Investment spending declines with an increase in the real interest rate
r since fewer investment projects would be profitable. The investment function is then
I = I( r ).
The ISLM model does not explain
government spending G but examines the effects of fiscal policy when G
changes. The basic government budget is
tax income less spending, T G. The
government also has to pay the interest expense rB on its outstanding bonds B
but can print money ΔMs or sell bonds ΔB to finance a deficit if T
< G + rB where Δ means change in.
The government budget constraint is
G + rB = T + ΔMs + ΔB.
The money supply Ms plays an important role and the
government is responsible for controlling it through the Central Bank. The government also sets taxes T and
determines whether to sell or buy bonds B.
A drawback from raising funds by selling government bonds ΔB > 0
is the higher spending rB in the future.
The next term in the national income
expenditure equation is export revenue.
The exchange rate plays a role in determining export revenue and import
spending as do changing price levels at home and abroad. Suppose there is a single foreign
country. The real exchange rate
eP*/P is the relative price of imports, or in units
eP*/P = ($/)(/m) χ ($/x) = ($/m) χ
($/x),
where the exchange rate is the price of foreign currency e =
$/, P* = /m is the foreign euro currency price of imports m, and P = $/x is
the home dollar currency price of exported products x. This relative price of imports is the price
of a unit of imports m in terms of a unit of exports x.
Depreciation
refers to a higher exchange rate eP*/P that raises the home currency price of
imports. Depreciation may be due to a
higher e, an increase in P*, or a decrease in P. The resulting change in export revenue
depends on the import elasticity.
Export revenue also increases with
foreign income Y* since foreign purchases of home products increase with higher
income. The export revenue function is
X = X( eP*/P, Y* ).
Depreciation raises export revenue X. A higher foreign price level P* raises export
revenue since the foreign country would substitute toward cheaper imports. A higher home price level P induces foreign
consumers to substitute away from home goods, lowering X. Higher foreign income Y* causes an increase
in foreign spending on home exports.
Import
spending is the mirror image of export revenue,
M = M( eP*/P, Y ) .
An increase in national income increases import spending M
and lowers the BOT = X = M. Depreciation
raises the BOT with an increase in X and a decrease in M. Depreciation raises the BOT if exports plus
imports are elastic, the Marshall-Lerner condition.
Adjustment to depreciation can lead
to a J-curve in the BOT. Traders
do not immediately respond to the exchange rate since trade contracts are set
in advance. The BOT falls with
depreciation before rising as traders adjust to the higher price of foreign
products. The J-curve refers to this
drop then ultimate increase in the BOT over time.
Combining absorption A and the BOT
into a single equation,
Y = C( Y T, r ) + I( r ) + G + X(
eP*/P, Y* ) M( eP*/P, Y ).
This equation is the IS curve graphed with r on the vertical
axis and Y on the horizontal axis. The
IS curve shows combinations of r and Y that equalize production Y and spending
A + BOT. Along the IS curve there is product
market equilibrium. Draw the curves.
The IS curve has a negative slope since an increase in
Y is larger on the left side of the equation than the resulting increase on the
right side. Only part of an increase in
income is consumed since the marginal
propensity to consume is less than one.
Also increased income raises import spending M. To return to product market equilibrium on
the IS curve, r must fall.
The IS curve
shifts to the right due to a number of exogenous changes. The IS curve shifts right due to these
changes in exogenous macro variables,
e ↑ depreciation
raises X and lowers M
P* ↑ higher
foreign price level raises X and lowers M
P ↓ lower
home price level raises X and lowers M
Y* ↑ higher
foreign income raises X
G ↑ increased
government spending, a fiscal policy expansion
T ↓ lower
taxes increase disposable income, a fiscal policy expansion.
The IS curve also shifts to the right with the following
behavioral changes:
C ↑ increased
propensity to consume
I ↑ structural
increase in investment
X ↑ increase
in foreign excess demand for home exports
M ↓ decrease
in home excess demand for foreign exports
The IS curve is half of the ISLM
model. The other side of the economy is
based on the money or bond market.
The money side
of the ISLM model is based on equilibrium between the supply and demand for
money. The real money supply is Ms/P where Ms is the nominal money supply and
P is the price level. In units Ms = $
and P = $/good implying Ms/P is the money supply in terms of goods. The price level P deflates the nominal money supply Ms in case of inflation. Over years, most economies have
inflation.
Real money demand L is a function of
the transactions demand for money and
the opportunity cost of holding money
rather than bonds. All agents demand
money for transactions, and higher income Y implies more transactions. A higher real interest rate means a higher
return on bonds or a higher opportunity cost of holding money.
With a zero real interest rate,
holding cash would be as productive as holding bonds. With a very high real interest rate, it would
be optimal to hold as little cash as possible since future income is lost with
idle cash.
The money
market equilibrium is the equilibrium between money supply and demand,
Ms/P
= L( Y, r ).
The LM curve slopes upward due to the signs of Y and r. An increase in Y raises the demand for money
and r would have to increase to lower money demand back to the money market
equilibrium along the LM curve.
The LM curve shifts
to the right as in Figure 2 due to changes in exogenous variables or a
behavioral shift in the demand for money,
Ms ↑ government
expansion of the money supply
P ↓ lower
price level or deflation
L ↓ structural
decline in money demand
improved bond quality with lower risk
increased desire to buy bonds and
save
lower expected future income saving
to smooth consumption over time
lower expected prices and desire to
wait until prices fall
currency substitution, holding
foreign currency instead of home currency
increased use of credit cards.
The interest rate R is linked to the
foreign interest rate R* by interest rate
parity IRP,
1 + R =
[(1/e)(1 + R*)]Ee,
where Ee is the expected exchange rate. IRP says that the return on a home bond 1 + R
must equal the return on a foreign bond due to arbitrage across the international bond market. The foreign return on one unit of domestic
currency 1/e is converted back to domestic currency at the expected rate
Ee.
Simplifying IRP, the home interest
rate is approximately equal to the foreign interest rate plus the expected home
currency depreciation,
R = R* +
(Ee e)/e .
The home interest rate is lower than the foreign interest
rate when Ee < e or the home currency is expected to appreciate.
Investors cover themselves with the
forward exchange rate f in the covered
interest parity CIP condition
R = R* + (f e)/e .
The forward discount on domestic currency is (f e)/e. If f > e the home currency is expected to
depreciate and R > R*. The forward
rate f is an unbiased predictor of e.
Inflation
plays a role in deciding where to invest.
Arbitrage implies exchange rates follow price levels according to purchasing power parity PPP,
P = eP*,
and PPP implies a link between home and foreign inflation
rates,
π = Δe/e + π* .
An inflating currency depreciates. The IRP condition becomes
R = R* + (π π*).
If π < π* then R < R*.
A small open
economy takes the global real interest rate r* as given as in Figure 2. The economy adjusts to r* since home savers
have the option to buy foreign bonds at r*.
The home interest rate r might differ temporarily from the foreign
interest rate r* but there adjustment to r* occurs in the ISLM equilibrium.
The small open economy is open to
trade in the BOT along the IS curve and open to foreign investment at r* along
the LM curve. The following sections put
the IS and LM curves together into the open economy ISLM model.
Combine the IS
and LM curves into an equilibrium at the international interest rate r* and
equilibrium income Ye. At the intersection
of the IS and LM curves, there is an equilibrium in both the product market on
the IS curve and the money/bond market on the LM curve. Full employment output is Yf. If Ye < Yf there is unemployment and for
some reason the wage does not fall to clear the labor market. An increase in output Y would lower
unemployment given some slack in the labor market.
A primary goal
of macro policy is to keep Ye close to Yf although it is far from clear that
fiscal or monetary policy can achieve it.
Some theory and evidence suggest the economy would adjust more quickly
without active policy.
Start in the equilibrium and examine
the effects of a change government policy.
First consider expansionary monetary policy with an increase in
the money supply Ms ↑. The LM curve shifts right to LM′.
The economy adjusts to the point
where the new LM curve intersects the IS curve with a lower interest rate r and
higher output Y. The lower interest rate
makes foreign bonds attractive to home lenders leading to a flow of funds to
the foreign currency that depreciates the home currency. The capital
account KA in the balance of payments
BOP moves to deficit as the economy lends to the rest of the world. Depreciation leads to a BOT surplus and the
right shift in the IS curve. On the new
IS curve the economy returns to BOT = 0.
The secondary shift moves to its new
equilibrium at the world interest rate r* and Yf. Note that Y increases due to the original
shift in the LM curve from the increase in Ms and again due to the subsequent
shift in the IS curve with the depreciation and expanding BOT.
The interest
rate r falls but then rises back to the world level r* and IRP implies the
currency appreciates as r rises. The
exchange rate depreciates and overshoots before appreciating back to its
new equilibrium. Overshooting is a
characteristic of price adjustment in all asset markets. Given a shock, asset prices overshoot their
long term level. PPP implies
depreciation if P rises due to the increase in Ms. In an economy near full employment there
would be no output increase, only depreciation and inflation due to the
increase in the money supply.
Even with slack in the economy, it is
an open question whether expansionary monetary policy is the best way to eliminate
it. Any structural problem in the labor
market causing unemployment should be remedied directly. Without any doubt, continued increase in the
growth of the money supply leads to depreciation and inflation and has no
effect on income. The goal of a stable
price level has proven the most sensible and reliable way to conduct monetary
policy. Active policy of continuously
manipulating Ms to affect unemployment is ill advised and the most sensible
monetary policy target is a stable price level.
Summarizing,
expanding the money supply in a small open economy with flexible exchange rates
causes
a temporary drop in the interest rate
and subsequent return to the world level
increased output if there is slack in
the economy
overshooting depreciation
an increase in the BOT
inflation near full employment.
Expansionary
fiscal policy refers to an increase in government spending G or a decrease
in taxes T shifting the IS curve to the right.
The interest rate r increases, attracting foreign investment and
appreciating the currency. Appreciation
defeats the effect of the expansionary fiscal policy, lowering exports and
increasing imports. This BOT deficit
shifts the IS curve back to its original position and output returns to
Ye. There is no permanent effect on
unemployment.
As a direct result of the
expansionary fiscal policy, the economy has become less involved with the rest
of the world. The increase in the
government deficit G T causes a trade deficit X M < 0. This link is known as the twin deficits. The increase in government borrowing to cover
its deficit raises the demand for bonds increasing the interest rate. The increased government borrowing and higher
interest rate also decrease private investment in an effect called crowding
out.
Summarizing the effectiveness of
expansionary fiscal policy in a small open economy with a flexible exchange
rate, there is
no ultimate effect on output or
unemployment
a temporary rise in the interest rate
currency appreciation
twin government and trade deficits.
Historically, flexible
exchange rates are new. The world economy
has operated mostly on metal standards with each currency defined as so many
ounces of a particular precious metal and exchange rates frozen by the metallic standard. One dollar was worth this many ounces of gold
and by implication so many francs and so many pounds, always and
everywhere. Governments exchanged
currency for metals and were constrained in producing more money by the amount
of metals on hand, and coins contained the required amount of the metals. Efforts to loosen constraints with bimetallic
standards failed since the official metallic rates could not keep up with the
flexible metal prices. Governments moved
off metallic standards in the early 20th century but kept exchange rates frozen
by trying to define their currencies in terms of metals.
The main principle behind
a fixed exchange rate regime is that
any excess demand for foreign currency must be met by government support for
the fixed rate buying or selling foreign exchange, an expensive proposition if
the domestic currency is cheap.
Governments often simply restrict foreign exchange transactions by
import or foreign exchange licenses.
Such government interference ultimately fails unless it is consistent
with the underlying economy. The fixed exchange rate system set up at the
end of World War II collapsed in the early 1970s due to an overvalued dollar,
giving way to the present system of floating exchange rates for the major
currencies.
Fixed exchange rates
remain the most popular exchange regime for small economies while the major
currencies float. The three major
floating currencies are the dollar, yen, and euro. Triangular
arbitrage implies the two effective global exchange rates $/ and $/₯ with
their implied /₯. Most of the other
nearly 300 currencies are pegged to one of these.
Governments find
controlling the foreign exchange rate an effective method of taxation since
many have little chance of collecting business or personal taxes. Fixed exchange rates can be set at levels
that tax importers and subsidize exporters.
Another
motivation for fixed exchange rates is that the effectiveness of monetary
policy and fiscal policy is reversed. An
increase in the money supply shifts the LM curve right. With r falling there is increased demand for
foreign bonds and an international cash outflow. Foreign exchange reserves decline in
order to support the balance of payments deficit and the decrease in reserves
lowers the money supply Ms. A government
that fixes its exchange rate has no monetary policy. To gain control of the exchange rate the
government would have to give up control of its money supply. The money a government prints it gets to
spend, an advantage called seignorage.
Summarizing, with fixed exchange
rates a monetary expansion
temporarily lowers the interest rate
and raises output
leads to cash outflow
decreases foreign exchange reserves.
In contrast, fiscal expansion under a
fixed exchange rate system increases output at least given slack in the
economy. Fiscal tax and spend policy
might also be more consistent with policy goals of a government wanting to
control the exchange rate.
Expansionary fiscal policy with an
increase in G or decrease in T shifts the IS curve right. The result is a BOP surplus and a domestic
interest rate r higher than r*. Cash
flows into the economy and foreign exchange reserves FXR increase raising
Ms. The LM curve then shifts out pushing
r back to r* and increasing Y further due to the increased FXR. The exchange rate remains fixed and the
interest rate returns to the world level r*.
If the economy is near full employment the only effect of expansionary
fiscal policy will be inflation due to the increased foreign exchange
reserves. Ultimately, however, such
fiscal expansion cannot be expected to continue to increase output.
Expansionary fiscal policy with a
fixed exchange rate
temporarily raises the interest rate
increases foreign investment into the
country
increases foreign exchange reserves
raises output given slack in the
economy.
While there may be some temporary ability of fiscal policy to
stimulate output and lower unemployment, there are limits. Continued expansionary fiscal policy has
never led to sustained economic growth and rising per capita income.
Economists are
divided according to whether they are policy activists and if so whether they
favor fixed or floating exchange rates, monetary or fiscal policy, and
government spending or taxes. The
economic approach to fiscal policy is to define the optimal role for the
government and levy taxes to support that level of government spending. The optimal role of government is debatable
and any tax system will tax some people more than others.
Some schools of economic thought
favor active monetary policy or fiscal policy to manage economies in some
circumstances, while others doubt the ability of government and see government
mismanagement as a primary cause of economic downturns. Students of economics should be skeptical of
those advocating quick fixes.
The main point to remember in this
introduction to ISLM is that the choice of a floating or fixed exchange rate
regime determines the effectiveness of monetary policy versus fiscal
policy. Without any doubt, free trade and
free international investment are the best policies for sustained economic
growth. Active monetary or fiscal policy
may offer short term temporary nudges for the economy but do nothing to improve
long term economic performance.