The Application of the IS-LM-BP Model to Analyze the Impact of External Shocks in an Open Economy
The Effects of Foreign Trade Shocks under Floating and Fixed Exchange Rates
An open economy is influenced by the changes in monetary and fiscal areas and other factors that until now were regarded as unchangeable. These factors distort the balance in the economy, and therefore they are called as macroeconomic shocks.
The development of a mechanism of adaptation to shocks is one of the main tasks of every government. For this, it is important to classify the macroeconomic shocks, because different shocks require different responses. Macroeconomic shocks are divided into two main types: shocks of the real sector and monetary shocks.
The real shocks belong to current account transactions, and monetary shocks - to capital account transactions and financial transactions. Prior to 1970s, most of macroeconomic shocks occurred in the real sector, but over time shocks associated with the capital flows began to acquire greater importance. The real shocks are longer in time and affect both aggregate demand and aggregate supply .
The shocks of the real sector can be divided into changes in world prices and changes in tastes and preferences of consumers. The change in the price level can be affected by the decline of production in developed countries (which is accompanied by a decline in demand for raw materials and a reduced rate of its price) increase in oil prices (increase the cost of production), volatility of inflation in developed countries and other factors.
The real shocks often are changes in the export or import of the country that are taking place, for example, because of changes in the real income of the country itself and its trading partners. Most of these shocks of export and import countries of vital goods (raw materials, coffee, sugar and etc.). The most common shock of such type is a change in the price of oil.
Price changes can occur in two ways: the shock of foreign prices and the shock of the domestic price.
The shock of the foreign prices- it is the adjustment that takes place in an open economy due to the sharp change in the balance between world and domestic prices that are caused by the increase or decrease in the world prices.
The shock of the domestic price - it is the adjustment that takes place in an open economy due to the sharp change in the balance between world and domestic prices that is caused by the increase or decrease in domestic prices.
Suppose, on the world market the price of a certain product has increased. For a given country this product is exported. Rise in price of this product leads to an increase in export, BPo curve shifts to the right to a new level BPi. Export expansion requires a corresponding increase in production, which will mean a shift to the right by ISo to ISi level and there will be an intermediate equilibrium at point A. The inflow of foreign currency from export revenue) increases the demand on the national currency. If the exchange rate is fixed, then to support it the Central Bank is buying up excess of foreign currency, increasing the supply of domestic currency and moving LMo curve to the right at the level of LMi (Fig. 19.1) Macroeconomic equilibrium shifts to point (A) B, where an increase in income from Yo to Y2 is noticed, that at the same level of domestic prices means an increase in aggregate demand.
Figure 9.1. The influence of real shocks on an open economy with a fixed exchange rate
With a floating exchange rate (Fig. 9.2),the displacement of the curve IS0 to the level of IS1 to point A leads to a positive balance of payments. As a result the national currency rate starts to rise, export reduces and import increases, that will lead to a deterioration of the balance of payments, so that the curves IS1, and BP1 shifts to the initial level to IS0 and BP0 respectively, and macroeconomic equilibrium returns to the point E. Thus, both income and aggregate demand returned to the level corresponding to equilibrium at point E. In practice, the equilibrium may not return to the original point of E, because there are other influencing factors, such as the mobility of capital and the cost of inflation, but it will be as close as possible to it.
Figure 9.2. The influence of real shocks on an open economy with a floating exchange rate
The changes of tastes and preferences within the country that are taking place in the real sector of the country, are the changes of tastes and preferences of consumers in favor of national products. As usual it is promoted by government programs to support domestic producers that encourage consumers to buy domestic goods. IS0 curve shifts to the right, and the reduction of import leads BP0 to shift to the right. With a fixed exchange rate this will lead to a positive balance of payments, and the growth of the money supply and the shift of curve LM0 to the right. Automatic adjustment will end when all three sectors will come in simultaneous balance at a higher level of income. In this case, the income increases at a constant price level (Fig. 9.1).
Under a floating exchange rate regime a potential positive balance of payments will increase the rate of national currency. Costs will turn from foreign goods to the domestic ones, demand for the national currency will increase. With the growth of the exchange rate curves IS1 and BP1 will begin to move back to the left, to its initial position (IS0 and BP0) and automatic correction will end at the same level at which it began before changes in tastes and preferences within the country (Fig. 9.2 ). Short-term surge in aggregate demand will quickly run out.
So we see that in each of the two cases, regardless of the shock reasons in the real sector under the fixed exchange rate macroeconomic shock has led to long-term growth of income and aggregate demand in the country, while the floating exchange rate has caused a correction of the relative value of the national currency and has led to continuing growth of revenue and aggregate demand.