Chapter 12 Further thinking in macroeconomics: the IS/LM model and schools of economic thought 1 Use the concept of the

4 interacting macro markets to show what happens in each of the other three markets when there is a disturbance in:
a. The market for money because there is a tightening of monetary policy;

If the Reserve Bank of New Zealand (RBNZ) unexpectedly raised the official cash rate (OCR), i.e. tightened monetary policy, in the next monetary policy review this would substantially reduce the money supply and therefore increase interest rates in the money market (represented by a leftward shift of the Ms curve). This is because the registered financial institutions would be facing a higher cost of borrowing overnight from the RBNZ. In terms of the foreign exchange (or currency) market the higher relative interest rates would see an increase in the demand for NZ dollars as international investors seek higher returns (illustrated by a rightward shift out in the demand curve) and hence the price of the NZ dollar in terms of the overseas currency would appreciate. The AD/AS curve can be used to represent the resultant impact on economic activity in the economy and hence infer the likely impact on the labour market as well. With higher interest rates disposable incomes would fall (i.e. after meeting higher mortgage costs) savings would be more attractive and consumption relatively more expensive. Investment would also be relatively more expensive and projects would have to meet a higher internal rate of return to justify funding. Exports would become relatively more expensive and imports relatively cheaper given the appreciation the NZ dollar. This means that consumption, investment and net of exports would all fall leading to a fall in AD (illustrated by a leftward shift in of the AD curve) contributing to a fall in national output. This, in turn, would reduce labour demand and possibly lead to increased level of unemployment.
b. The goods market that comes from an increase in spending on retail goods;

An increase in spending on retail goods is equivalent to an increase in consumption, which would result in an outward shift to the right of the AD curve. This would contribute to an increase in national output but put upward pressure on both wages and prices. To alleviate the subsequent inflationary pressure the monetary authorities (RBNZ) would tighten monetary policy with the same impact as described in part (a).
c.

The foreign exchange market that sees an increased demand for NZ dollar financial investments; An increased demand for NZ dollar financial investments would see a rightward shift out in the demand for the NZ dollar leading to an appreciation. This would make NZ exports relatively more expensive and imports relatively cheaper, which would lead to a fall in net exports. This in turn would lead to a fall in AD but SAS (short run aggregate supply) may also move out as the result of lower imported input prices such as oil. If the net effect was significant an easing of monetary policy (increased money supply) may result.

d. The labour market from an increased supply due to immigration.

If the increased labour supply led to a fall in wages (analysing the labour market as for any other good) then the aggregate supply curves would move outward to the right. It is likely to also lead to an outward shift in the AD curve with more people in employment and hence increased income but with little pressure on prices and therefore no need for the monetary authorities to intervene in the money market. This question could be used to lead into a number of interesting discussions, such as: What would happen if the increased economic activity lead to a significant increased demand for money? What would happen if the migrants brought significant levels of savings with them? What would happen if the increased labour supply led to an increase in unemployment?

Use the IS/LM framework developed in this chapter to analyse the effect of loosening (expansionary) monetary policy in both the closed and open economy cases. Are there any differences in the outcome? In the closed economy IS/LM, expansionary monetary policy shifts the LM curve outward from LM1 to LM2. The resulting fall in interest rates from r1 to r2 occurs because the increase in money supply easily satisfies the demand for money, which existed at the original interest rate r1. As the interest rate falls, investment and autonomous consumption are encouraged, which brings about a rise in equilibrium income from Y1 to Y2, as the economy travels down the IS curve towards its new equilibrium. The increase in Y helps to restore balance between demand and supply in the market for money by reducing the demand for money
r LM1

LM2 A r1 r2 A*

IS Y1 Y2 Y

In terms of the IS/LM/FE model the expansionary monetary policy again causes an outward shift of the LM curve from LM1 to LM2. In contrast to the closed economy case, however, equilibrium is not established at point A*, where LM2 intersects with the original IS curve IS1. The shift of the LM curve moves the economy below the FE line, to point like B, where domestic interest rates are below the international rate r*. This indicates that at the original equilibrium exchange rate a shortfall in demand for New Zealand dollars would be likely to develop, as lower interest rates attract insufficient capital inflows, decreasing the demand for New Zealand dollars. Meanwhile imports will begin to increase as incomes rise, increasing the supply of New Zealand dollars needing to be converted into foreign currency to pay for imports. To maintain equilibrium in the foreign exchange market the exchange rate must depreciate, which is depicted by a movement along the new LM curve toward the FE curve. The depreciating exchange rate stimulates exports but discourages imports, and so the IS curve also begins shifting outwards, from IS1 to IS2.
LM1 r LM2

A r* A* i > r* B

FE

IS1 Y1 Y2

IS2

Equilibrium is thus re-established not at point A*, or point B, but at a point further up the LM curve LM2, to a point like C, where the outward moving IS curve intersects with the FE curve. Compared to point B, the exchange rate change has re-established interest rate parity with the international rate but at a higher income due to the effects of the monetary policy change. In other words monetary policy retains its effectiveness, because the authorities do not need to be concerned about exchange rate effects, that is, they are not targeting a particular level in the exchange rate. This is of course assuming perfect capital mobility (see below). 3 Explain what is meant by perfect capital mobility. Is this a reasonable assumption to make in the IS/LM open economy model? What would be the implications for the model if this assumption did not hold? Perfect capital mobility refers to the free and efficient movement of capital within and across borders. In the IS/LM model, capital mobility underlies the

construction of the FE (foreign exchange curve), which is constructed to show combinations of interest and national income at which there is equilibrium in the foreign exchange market. Under floating exchange rate, equilibrium is maintained by adjusting to ensure there is always a balance in the foreign exchange market between supply (from importers and those seeking to invest abroad) and demand (from exporters and foreign nationals seeking to invest in the local economy). This corresponds to the level where there is no tendency for the local currency to appreciate or depreciate against foreign currencies and the FE curve would be horizontal. Under a floating exchange rate and efficient capital markets as in New Zealand it is reasonable to assume that capital mobility is close to perfect (see text pp. 404-405). If perfect capital mobility does not hold it would mean that the FE curve would have to be drawn to show the different combinations of interest rates and national income to achieve the equilibrium exchange rate. As the level of domestic economic activity increases, the demand for imports would also increase but it is unlikely that this would be accompanied by any increase in the demand for exports. As incomes rise, therefore, the current account surpluses become smaller (deficits larger) so that higher interest rates are required in order to produce the matching capital account balances, the FE curve therefore slopes upward to the right. 4 A country reduces its inflation rate from 18% to 3% over a five-year period. Unemployment rises from 4% to 7%, and the annual rate of growth increases from 2.5% to 3%. Can you conclude that the country is better off than it was at the beginning? This question is best addressed in essay format and focus on the goals of macroeconomic policy (pp. 416-421). The above factors should be identified as the intermediate outcomes that policy goals are usually couched in and should be viewed in relation to how they enhance the well-being of society and the people in it. A good answer is likely to incorporate discussion on living standards, equity and income distribution, and comparative performance with respect to trading partners, etc. 5 What are some of the costs of unemployment for people in the 2000s? In economic terms the cost of such unemployment is typically expressed in terms of forgone production and/or the loss of skills and income, in other words at the very least, a drop in the standard of living. For some it can cause severe hardship and deprivation especially if there are few elements of social protection including the loss of freedom and social exclusion, skill loss and long-run damage, psychological harm, ill health and mortality and motivational loss. Clearly, a number of these problems are likely to be amplified in some sectors and unemployment is likely to exact a particularly heavy toll to those belonging to disadvantaged groups. See text pp. 417-418 & chapter 9. 6 Is inflation currently a threat in New Zealand? If so, what kind of costs are feared? An economy such as New Zealand is reliant on trade to retain its relative

prosperity and, as such, is always susceptible to the threat of an inflationary supply shock such as a the 1970s oil shocks. In mid 2004 the price of oil increased markedly, if this proves to be a sustained increase the impact will be wide spread inflation in the New Zealand economy. Another inflationary threat arises from shortages within the economy, such as skilled labour and housing. Infrastructure bottlenecks can also lead to inflationary pressures due to shortages or delays with recent examples seen in the electricity and transport sectors. Increased compliance costs arising from security concerns are another concern. 7 In her book False Economy Anne Else writes: Without families and communities, the economy means nothing. It has no life of its own. Its only purpose is to enable us to live, to care for one another and to raise our children to take our place. If we lose the power to do that, no matter how fast GDP rises or how much the budget surplus grows we will have no future worth working for. Distinguish between the objectives of governments policy and the ultimate goals of economic policy and purpose of the economy. This question again lends itself to an essay type response distinguishing between the welfare goals of society and intermediate economic goals or objectives. Highlighting the welfare cost of not meeting the various economic goals, such as reducing unemployment or inflation, is one approach to teasing out the relationship between economic and social goals. A good answer would also note that social objectives may appear change over time; different stakeholders may disagree over what the objectives are and the ability of the economy to realize these objectives may also change.