IS-LM curves – derivation, slope & shift factors; monetary and fiscal policy effectiveness in is–lm model. Unit II: IS-LM Model for Open Economy (1 Credit) IS, LM & BP schedules; slope & shift factors; policy effectiveness under perfect & imperfect capital mobility in flexible & fixed exchange rate regimes.

Here's an explanation of the IS-LM model for both closed and open economies: 1. IS-LM Model (Closed Economy) This model determines the equilibrium interest rate (r) and national income (Y) in the short run. IS Curve* (Investment-Saving) Derivation: Represents all combinations of r and Y where the goods market* is in equilibrium (total output = total demand: Y = C + I + G). Investment (I) is inversely related to the interest rate. Slope: Downward sloping*. A lower interest rate encourages more investment, leading to higher aggregate demand and thus higher equilibrium income. Shift Factors: Changes in government spending* (G) Changes in taxes* (T) Changes in autonomous consumption (C) or investment* (I) An increase in G or C, or a decrease in T, shifts IS to the right*. LM Curve* (Liquidity Preference-Money Supply) Derivation: Represents all combinations of r and Y where the money market* is in equilibrium (money supply = money demand). Money demand depends positively on income and negatively on the interest rate. Slope: Upward sloping*. A higher income level increases the demand for money for transactions. To maintain money market equilibrium with a fixed money supply, the interest rate must rise to reduce speculative money demand. Shift Factors: Changes in money supply* (M) by the central bank Changes in the price level* (P) An increase in M shifts LM to the right*. Policy Effectiveness (Closed Economy)* Fiscal Policy (e.g., increase in G): Shifts the IS curve right. More effective when the LM curve is flatter* (money demand is very sensitive to interest rates, so interest rate rise is small, less crowding out of investment). Less effective when the LM curve is steeper* (money demand is less sensitive to interest rates, so interest rate rise is large, more crowding out). Monetary Policy (e.g., increase in M): Shifts the LM curve right. More effective when the IS curve is flatter* (investment is very sensitive to interest rates, so a small drop in r leads to a large increase in Y). Less effective when the IS curve is steeper* (investment is less sensitive to interest rates, so a large drop in r leads to only a small increase in Y). 2. IS-LM-BP Model (Open Economy) This model adds the Balance of Payments (BP) curve to account for international trade and capital flows. IS Curve (Open Economy)* Derivation: Y = C + I + G + NX, where NX (net exports) depends on domestic income (Y), foreign income (Y), and the exchange rate (E). Slope: Still downward sloping*, often flatter than in a closed economy because higher income leads to more imports, reducing net exports and dampening the effect on Y. Shift Factors: Same as closed economy, plus changes in foreign income, exchange rate, or trade policies*. LM Curve (Open Economy)* Derivation, Slope, and Shift Factors: Same as in the closed economy model. BP Curve* (Balance of Payments) Derivation: Represents all combinations of r and Y where the balance of payments is in equilibrium (BP = Current Account + Capital Account = 0). The Current Account (CA) depends on Y and E. The Capital Account (KA) depends on the interest rate differential (r - r). Slope: Generally upward sloping*. Higher domestic income (Y) increases imports, worsening the CA. To maintain BP equilibrium, the KA must improve, requiring a higher domestic interest rate (r) to attract capital inflows. Capital Mobility: Perfect Capital Mobility: The BP curve is horizontal at the world interest rate (r = r). Any deviation of r from r* leads to infinite capital flows. Imperfect Capital Mobility: The BP curve is upward sloping* but steeper or flatter depending on the degree of capital mobility. Policy Effectiveness (Open Economy)* Fixed Exchange Rate Regime* (Central bank intervenes to maintain E) Fiscal Policy (e.g., increase in G): Perfect Capital Mobility: Highly effective. Fiscal expansion shifts IS right, increasing Y and r. r > r causes capital inflow, putting upward pressure on E. To maintain fixed E, the central bank buys foreign currency, increasing money supply (M), which shifts LM right. This reinforces the increase in Y. Imperfect Capital Mobility: Effective*. Similar to perfect capital mobility, but the LM shift is less pronounced as capital flows are not infinite. Monetary Policy (e.g., increase in M): Perfect Capital Mobility: Ineffective. Monetary expansion shifts LM right, decreasing r. r < r causes capital outflow, putting downward pressure on E. To maintain fixed E, the central bank sells foreign currency, decreasing M, which shifts LM back to its original position. Y returns to its initial level. Imperfect Capital Mobility: Ineffective*. Similar to perfect capital mobility, the central bank's intervention to maintain the exchange rate negates the monetary policy. Flexible Exchange Rate Regime* (Exchange rate adjusts freely) Fiscal Policy (e.g., increase in G): Perfect Capital Mobility: Ineffective. Fiscal expansion shifts IS right, increasing Y and r. r > r causes capital inflow, leading to exchange rate appreciation. This makes exports more expensive and imports cheaper, reducing net exports (NX). The fall in NX shifts the IS curve back to its original position. Y returns to its initial level (complete crowding out via exchange rate). Imperfect Capital Mobility: Less effective*. Fiscal expansion shifts IS right, increasing Y and r. Capital inflow causes E to appreciate, reducing NX and shifting IS partially back left. Y increases, but less than in a fixed regime. Monetary Policy (e.g., increase in M): Perfect Capital Mobility: Highly effective. Monetary expansion shifts LM right, decreasing r. r < r causes capital outflow, leading to exchange rate depreciation. This makes exports cheaper and imports more expensive, increasing net exports (NX). The rise in NX shifts the IS curve right, reinforcing the increase in Y. Imperfect Capital Mobility: Effective*. Similar to perfect capital mobility, the exchange rate depreciation boosts net exports, making monetary policy effective. What's next? 📸