The IS-LM model under fixed exchange rates

With fixed exchange rates, R is given. We can illustrate this by drawing a new curve in the IS-LM diagram called the FE-curve (FE for Foreign Exchange).


Fig. 16.3: IS-LM-FE.

We have drawn the diagram such that the IS curve intersects the LM curve at exactly the "correct" interest rate R = RU. This is no coincidence - we will describe why the IS curve must intersect the LM curve at exactly this interest rate.

Let us begin by analyzing what will happen when MS increases when we are initially in equilibrium (with say nM = n = 0).

1. The LM curve shifts outwards from LM1 to LM2. We move from A to B.

2. Y falls and R falls. Now R < RF and the demand for foreign currency increases.

3. Our currency will depreciate and the central bank must intervene. They will sell foreign currency and buy the domestic currency which will reduce foreign exchange reserves.

4. When they buy the domestic currency, Ms will fall. LM2 shifts back towards LM1 and the process will continue until R again is equal to RF, LM2 is back to LM1 and we are back at point A.

Monetary policy has no effect when the exchange rate is fixed according to the MF-model. However, as we shall see in the exercise book, fiscal policy will work. Fiscal policy will actually work better in the open economy than in the closed economy. In reality, results are not so black and white. Instead, you should conclude that monetary policy is less effective with a fixed exchange rate - not that it is completely ineffective.

The IS-LM model with flexible exchange rates

With flexible exchange rates we must also consider the expected depreciation, R = RF + nEe. Since nEe is assumed to be exogenous, the FE curve is still horizontal.


Fig. 16.4: IS-LM-FE.

In this case, we analyze what happens when G increases from an initial equilibrium (again, %M = n = 0).

1. The IS curve shifts outwards from ISt to IS2. We move from A to B.

2. Y increases and R increases. Now R > RF + nEe and the supply of foreign currency increases (foreigners will want to buy our currency and invest in our country).

3. Since we have a flexible exchange rate, the central bank will not intervene and the domestic currency will appreciate.

4. When the domestic currency appreciates, exports will fall while imports will increase. This will shift the IS2 curve back towards IS1. The exchange rate will continue to appreciate as long as R > RF + 7tE and the trade balance will continue to deteriorate until R again is equal to RF + nne and IS is back to IS,. E 2 1

Fiscal policy has no effect under flexible exchange rates according to the MF model. Any attempt to stimulate the domestic economy will only succeed in stimulating the foreign economy. However, as we shall see in the exercise book, monetary policy will work (and in this case better than in the closed economy).