Changes in government spendingAn increase in government expenditure shifts the IS curve to the right. The shift will cause the local interest rate to go above the global rate. The increase in local interest will cause capital inflow and the inflow will make the local currency stronger compared to foreign currencies. Strong exchange rate also makes foreign goods cheaper compared to local goods. This encourages greater import and discourages export and hence, lower net export. As a result, the IS will return to its original location where the local interest rate is equal to the global interest rate. The level of income of the local economy stays the same. The LM curve is not at all affected.
A decrease in government expenditure will reverse the process.
Changes in global interest rateAn increase in the global interest rate will cause an upward pressure on the local interest rate. The pressure will subside as the local rate closes in on the global rate. When a positive differential between the global and the local rate occurs, holding the LM curve constant, capital will flow out of the local economy. This depreciates the local currency and helps boost net export. Increasing net export shifts the IS to the right. This shift will continue to the right until the local interest rate becomes as high as the global rate.
A decrease in global interest rate will cause the reverse to occur.
Under fixed exchange rate regimeWe speak of a system of fixed exchange rates when governments (or central banks) announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency.
Changes in money supplyUnder the fixed exchange rate system, the local central bank or any monetary authority will only change the money supply in order to maintain a level of exchange rate. If there is a pressure to appreciate the exchange rate, the local authority will buy domestic currency in order to decrease the money supply to raise the exchange rate back to its original level. If there is pressure to depreciate the exchange rate, the local authority will buy foreign currency with domestic currency in order to increase the money supply and lower the exchange rate back to its original level.
A
revaluation occurs when there is a permanent increase in exchange rate and hence, decrease in money supply.
Devaluation is the exact opposite of revaluation.
Changes in government expenditure
Increase in government spending forces the monetary authority to flood the market with local currency in order to keep the exchange rate unchanged.
Increased government expenditure shifts the IS curve to the right. The shift results are a rise in the interest rate and hence, an appreciation of the exchange rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed system. In order to maintain the exchange rate and eliminate the pressure from it, the monetary authority will purchase foreign currencies with local currencies until the pressure is gone i.e. back to the original level. Such action shifts the LM curve in tandem with the direction of the IS shift. This action increases the local currency supply in the market and lowers the exchange rate—or rather, return the rate back to its original state. In the end, the exchange rate stays the same but the general income in the economy increases.
The reverse is true when government expenditure decreases.
Changes in global interest rateTo maintain the fixed exchange rate, the central bank must offset the capital flows (in or out) which are caused by the change of the global interest rate to the domestic rate. The central bank must restore the situation where the real domestic interest rate is equal to the real global interest rate to stop net capital flows from changing the exchange rate.
If the global interest rate increases above the domestic rate, capital will flow out to take advantage of this opportunity.(Hot money flows out of the economy) This would depreciate the home currency, so the central bank may buy the home currency and sell some of its foreign currency reserves to offset this outflow. This decrease in the money supply shifts the LM curve to the left until the domestic interest rate is the global interest rate.
If the global interest rate declines below the domestic rate, the opposite occurs. Hot money flows in, the home currency appreciates, so the central bank offsets this by increasing the money supply (sell domestic currency, buy foreign currency), the LM curve shifts to the right, and the domestic interest rate becomes the global interest rate.
Differences from IS-LMIt is worth noting that some of the result from this model differs from the IS-LM because of the
open economy assumption. Result for large open economy on the other hand falls within the result predicted by the IS-LM and the Mundell-Fleming models. The reason for such result is because a large open economy has both the characteristics of an autarky and a small open economy.
In the IS-LM, interest rate will be the key component in making both the money market and the good market in equilibrium. Under the Mundell-Fleming framework of small economy, interest rate is fixed and equilibrium in both market can only be achieved by a change of nominal exchange rate.
ExampleA much simplified version of the Mundell-Fleming model can be illustrated by a small open economy, in which the
domestic interest rate is exogenously predetermined by the world interest rate (r=r*).
Consider an exogenous increase in government expenditure, the IS curve will shift upward, with LM curve intact, causing the interest rate and the output to rise (partial crowding out effect) under the IS-LM model.
Nevertheless, as interest rate is predetermined in a small open economy, the LM* curve (of exchange rate and output) is vertical, which means there is exactly one output that can make the money market in the equilibrium under that interest rate. Even though the IS* curve still shift up, it will result in a higher exchange rate and same level of output (complete crowding out effect, which is different in the IS-LM model).
The example above makes an implicit assumption of flexible exchange rate. The Mundell-Fleming model can have completely different implications under different exchange rate regimes. For instance, under a fixed exchange rate system, with perfect
capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an outward shift of the LM curve would in turn make capital flow out of the economy. The
central bank under a fixed exchange rate system would have to intervene by selling foreign money in exchange for domestic money to depreciate the foreign currency and appreciate the domestic currency. Selling foreign money and receiving domestic money would reduce real balances in the economy, until the LM curve shifts back to the left, and the interest rates come back to the world rate of interest i*.
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(The LM Curve)
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