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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 eachof 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 ratesin 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 thedemand 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 themonetary 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.

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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 inunemployment?

2 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 r 1 to r 2 occurs

 because the increase in money supply easily satisfies the demand for money,

which existed at the original interest rate r 1. As the interest rate falls, investmentand 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

Y

r 

LM2

LM1

A*

Y2Y1

IS

r 1

A

r 2

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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 equilibriumexchange 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.

Y

r 

FE

LM2

LM1

IS2

A*

B

Y2

C

Y1

IS1

i  > r*

r*

A

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 theimplications for the model if this assumption did not hold?

Perfect capital mobility refers to the free and efficient movement of capital withinand across borders. In the IS/LM model, capital mobility underlies the

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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 termsof 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

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 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 shortagesor 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 raiseour 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 worthworking for.’ 

 Distinguish between the objectives of government’s 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.