Macro Islmbp

UOL - Macro I Review
Macroeconomics I
Antonio Cusato Novelli

Sources:
- Mankiw, G. (2013) Macroeconomics, 8th edition. Worth Publishers & Slides by Ron Cronovich
- Feenstra , R. and A. Taylor (2011) International Macroeconomics, 2nd edition. Worth Publishers
- Blanchard, O. and D. Johnson (2013) Macroeconomics. Pearson.
Capital Flows: UIP

E$e
UIP : (1 + i$ ) = (1 + i )
▪ UIP Approximation
E$
 E$e  E$e  E$e 
(1 + i$ ) = (1 + i ) 1 + E  = 1 + i + E +  i E 
 $  $  $ 
E e
1 + i$ = 1 + i + $
E$
E$e
i$ = i +
E$
▪ As we indicate, the equality holds because of arbitrage. Suppose

now that we are talking about the Peruvian Sol and the dollar and:
▪ iS /.  iUS $ + ESe /. perUS $ ES /. perUS $ : deposits in soles are more attractive
than deposits in dollars, Peru should experience capital inflows
▪ iS /.  iUS $ + ESe /. perUS $ ES /. perUS $ : deposits in soles are less attractive,
Peru should experience capital outflows
▪ For that reason, assuming no inflation and no expected
depreciation, we can express the Financial Account (FA) as:
FA =  +  ( rS /. − rUS $ ) =  +  ( r − r * )   0,   0
Capital Flows: UIP

▪ Recall
CA
 + KA
 + FA
 = 0
Current account Capital account Financial account
▪ A CA deficit (NX<0) should be offset by a FA superavit (FA>0)

▪ There will be a FA superavit if there are capital inflows, or
iS /.  iUS $ + ESe /. perUS $ ES /. perUS $
▪ It is more attractive to invest in the local economy (in Peru and

not in the US)
The IS-LM-BP Model

▪ Open economy: transactions with the rest of the world
▪ Goods Market: Production is determined by
Y = C ( Y ) + I ( r ) + G + X (Y * , e ) − M (Y , e )
Exports Foreign Real Imports

income exchange rate
▪ Recall PUS $ Price of a US basket of

e = ES /. perUS $ goods expressed in soles
PS /.
Price of a Peruvian basket of
goods expressed in soles
▪ If e , the goods in the US are relatively more expensive.

This will boost exports and diminish imports
▪ Assume fixed prices
The IS-LM-BP Model

▪ The Balance of Payments (BP) identity indicates
CA + FA = 0
X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
▪ FA = Financial Account (called in the tutorials KA, Capital

Account)
▪ Recall, from UIP with no expected depreciation, the FA is
given by FA =  +  r − r =  +  r − r *
( S /. US $ ) (
  0,   0 )
Typically beta is positive. How to interpret beta? Is how sensitive is
the FA to changes in the interest rates’ differential. Suppose capital
flows are no allowed, then beta should be equal to zero (also
alpha). The idea is that when there is NO capital mobility, the size of
the interest rate gap is irrelevant, the FA is always equal to zero
Derivation of the BP Curve

Def. BP curve: a graph of all combinations of r and Y that result in a BP equilibrium
X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
The equation for the BP curve is
Derivation of the BP curve:
r0
Y
Y0
Derivation of the BP Curve

Def. BP curve: a graph of all combinations of r and Y that result in a BP equilibrium
X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
The equation for the BP curve is
Derivation of the BP curve:
We start at Y0,r0. r BP
If Y increases to Y1:
Imports rise. Interest rates
must rise to achieve the BP
equilibrium (a deterioration in r1
the CA should be offset with
an improvement in the FA).
Intuitively, a higher trade r0
deficit should be financed via
more capital inflows,
something that will only occur Y
as long as the domestic Y0 Y1
interest rate is higher (taken
as given r*)
BP Curve Details
CA + FA = 0
X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
Then X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
r − r* = −
1

( X (Y , e ) − M (Y , e ) +  )
*
r = r* −
1

( X (Y , e ) − M (Y , e ) +  )
*
Lets make assumptions about the functional form of net exports

X (Y * , e ) − M (Y , e ) =  +  Y * −  Y +  e   0,   0,   0,   0
Then
r = r* −
1

(  + Y *
− Y +  e +  )
This is the BP
   
r =  r * − ( +  Y * +  e +  )  +   Y
1 equation that relates
     the local interest rate
(r) with output (Y)
The IS-LM-BP Model

The slope of the BP curve is very important, because its reflects the degree of capital
mobility (which will depend on economic policy)
Different slopes for the BP curve    
r =  r * − ( +  Y * +  e +  )  +   Y
1
    
if  → r Case: perfect
capital mobility**
Case: partial BP
r capital BP
if  = 0 mobility Y
Y Case: low
r capital mobility
if 0  BP
r Case: no capital
mobility***
if  =0 Y
Y
** Interpretation: local and foreign assets are perfect substitutes *** In this case, NX=0 and FA=0
The IS-LM-BP Model: Adjustment to the Equilibrium

In this example with partial capital r IS LM
mobility, the economy has an
internal equilibrium, but the
external accounts (BP) are not in
equilibrium. In particular, the BP
internal equilibrium coincides with r0
an excess of capital inflows (local r rBP =0
is too high: for a given level of Y,
like Y0, r0 is greater that the
interest rate that makes the BP=0,
which for the case of Y0 is rBP =0 ) Y0
Y
   
rBP =0 =  r * − ( +  Y * +  e +  ) +   Y0
1
    
How is the adjustment process?

In this example with partial capital r IS LM
mobility, the economy has an
internal equilibrium, but the
external accounts (BP) are not in
equilibrium. In particular, the BP
internal equilibrium coincides with r0
an excess of capital inflows (local r rBP =0
is too high: for a given level of Y,
like Y0, r0 is greater that the
interest rate that makes the BP=0,
which for the case of Y0 is rBP =0 ) Y0
Y
   
rBP =0 =  r * − ( +  Y * +  e +  ) +   Y0
1
How is the adjustment process?

r IS     
LM
There are two scenarios:
A) Fixed exchange rates: the excess of
capital inflows will change the relative BP
price of the foreign currency (e.g.
dollar). To maintain the value of the
exchange rate, the Central Bank is
willing to absorb (purchase dollars with
“new “soles) the excess of dollars Y

B) Under flexible exchange rates, an
excess of capital inflows means an
excess of dollars. This will determine
that the relative price of the dollar is r IS LM
lower (drop in the exchange rate)
A change in e will affect

Y = C ( Y ) + I ( r ) + G + X (Y * , e ) − M (Y , e ) BP
X (Y * , e ) − M (Y , e ) +  +  ( r − r * ) = 0
A reduction in e will decrease net

exports (X-M). With lower net
exports, the BP curve and the IS curve
Y
will shift to the left
What is the interpretation? With a deterioration of net exports, the economy needs to
finance this higher deficit (or smaller superavit) attracting more capital flows. The BP
curve shifts to the left, reflecting that this is only possible via higher local interest rates
   
r =  r * − ( +  Y * +  e +  )  +   Y
1 The intercept of the BP curve increases, or
     we have higher levels of r for the same Y
The IS-LM-BP Model: UL Study Guide

▪ UL study guide
▪ Using the IS-LM-BP model, they focus on 4 cases:
▪1) Perfect Capital Mobility (CM), fixed Exchange Rate
(ER), fiscal policy expansion
▪2) Perfect CM, fixed ER, monetary policy expansion
▪3) Perfect CM, flexible ER, fiscal policy expansion
▪4) Perfect CM, flexible ER, monetary policy expansion
▪ Lets review these cases
The IS-LM-BP Model: Case 1

Case 1) Perfect CM, fixed ER, fiscal r IS LM
policy expansion
BP
Y

Case 1) Perfect CM, fixed ER, fiscal r IS LM
policy expansion
The fiscal expansion determines a

temporary increase in output and the
local interest rate. Since the local r = r *
BP
interest rate is higher than the
international rate (with perfect CM
both are equal), and there is perfect
CM, there will be a huge capital inflow
Y
To avoid the appreciation of the local r IS LM
currency (drop in e), the Central Bank
buys the excess of dollars in the
market, and this is possible thanks to
an expansionary monetary policy, that
shifts the LM to the right. In general, r = r *
BP
with perfect CM, the BP curve never
moves due to a huge beta
   
r =  r * − ( +  Y * +  e +  )  +   Y
1
r = r*
     Y

Case 2) Perfect CM, fixed ER, r IS LM
monetary policy expansion
BP
Y

Case 2) Perfect CM, fixed ER, r IS LM
The monetary expansion

determines a temporary
increase in output and a fall in BP
the local interest rate. Since
the local interest rate is lower
than the international, this
determines a capital outflow
Y
If there are less dollars in the r IS LM
economy, there are pressures
for an increase in the
exchange rate. The Central
bank must sell dollars, taking
away from the economy the BP
local currency that was initially
injected into the economy
Y

Case 3) Perfect CM, flexible ER, r IS LM
fiscal policy expansion
BP
Y

Case 3) Perfect CM, flexible ER, r IS LM
The fiscal expansion determines

a temporary increase in output
and the local interest rate. Since BP
the local interest rate is higher
than the international rate, and
there is perfect capital mobility,
there will be a huge capital
inflow
Y
r IS LM
Since e is flexible, more dollars in
the economy imply a drop in e.
This will reduce net exports,
shifting the IS to the left, until the
point were the external BP
equilibrium is attained
Y

Case 4) Perfect CM, flexible r IS LM
ER, monetary policy
expansion
BP
Y

Case 4) Perfect CM, flexible r IS LM
ER, monetary policy
expansion
The monetary expansion

determines an increase in BP
output and a fall in the local
interest rate. Since the local
interest rate is lower than the
international, this determines
a huge capital outflow
Y
r IS LM
With less dollars in the
economy, the dollar increases
its value (e goes up). This will
expand net exports, shifting
the IS to the right BP
Y
The IS-LM-BP Model: Beyond the UL Study Guide

▪ Other cases
▪5) Partial CM, fixed ER, fiscal policy expansion
▪6) Partial CM, fixed ER, monetary policy expansion
▪7) Partial CM, flexible ER, fiscal policy expansion
▪8) Partial CM, flexible ER, monetary policy expansion
▪9) No CM, fixed ER, fiscal policy expansion
▪10) No CM, fixed ER, monetary policy expansion
▪11) No CM, flexible ER, fiscal policy expansion
▪12) No CM, flexible ER, monetary policy expansion

Case 5) Partial CM, fixed ER, r IS LM
BP
Y

The fiscal expansion determines BP

an increase in output and the
local interest rate. Since the local
interest rate is higher than the
interest rate that make the
external accounts in equilibrium
(recall rBP =0 ), and there is capital
mobility, there will be a capital
Y
inflow r IS LM
To avoid the appreciation of the

local currency (drop in e), the BP
Central Bank buys the excess of
dollars in the market, and this is
possible thanks to an
expansionary monetary policy,
that shifts the LM to the right
Y

BP
Y

An expansionary monetary policy BP

will lower the local interest rate,
generating a capital outflow.
With less dollars in the economy,
there are pressures for the local
currency to depreciate (an
increase in e). The monetary
authority must increase the
Y
number of dollars in the economy, r IS LM
and they do that purchasing local
currency and contracting the
money supply. The are no final BP
effects over the economy
Y

Case 7) Partial CM, flexible ER, fiscal r IS LM
policy expansion
BP
Y

Case 7) Partial CM, flexible ER, fiscal r IS LM
policy expansion
The fiscal expansion determines an BP

increase in the local interest rate, an
increase in capital inflows, and a
reduction in the exchange rate (more
dollars in the economy)
A fall in e will deteriorate net exports
(increase in M, fall in X), shifting the IS
curve to the left. Also, with lower net
Y
exports, the BP curve shifts to the left. r IS LM
A deterioration in net exports should
be financed with more capital inflows,
then the shift of the BP curve reflects a BP
need for higher local interest rates
Mathematically, recall the intercept of

the BP curve will change due to
   
r =  r * − ( +  Y * +  e +  )  +   Y
1
    
Y

Case 8) Partial CM, flexible ER, r IS LM
BP
Y

Case 8) Partial CM, flexible ER, r IS LM
An monetary policy expansion BP

lower the local interest rate,
generating capital outflows and
increasing e (less dollars in the
economy). An increase in the
exchange rate will determine a
higher level of net exports,
shifting the IS curve to the right.
Y
The BP curve also changes. r IS LM
   
r =  r * − ( +  Y * +  e +  )  +   Y
1
     BP
A higher e decreases the BP curve
intercept, shifting down the BP
curve. An improvement in net
exports requires less capital
inflows, and this is consistent with
lower local interest rates Y

Case 9) No CM, fixed ER, fiscal policy r IS BP LM
expansion
Y

Case 9) No CM, fixed ER, fiscal policy r IS BP LM
expansion
With no CM: FA = 0 = X − M
There is no effect on capital flows,
simply because the FA=0 (i.e. interest
rate differentials are irrelevant). A
fiscal policy expansion will
determined a higher demand for
imports, or a tendency towards a
trade deficit. A temporary trade
Y
deficit implies that the demand for r IS BP LM
foreign currency is higher, creating a
pressure to increase e. The Central
Bank will offset this higher demand
for dollars, selling dollars and
receiving local currency in exchange,
or contracting the supply of local
currency or money (i.e. the LM shifts
to the right to maintain the exchange
rate fixed) Y

Case 10) No CM, fixed ER, r IS BP LM
Y

Case 10) No CM, fixed ER, r IS BP LM
A monetary expansion generates

a temporary trade deficit, no
effect on capital flows and an
upward pressure on the exchange
rate. The Central Bank will undo
the monetary expansion to
maintain the fixed exchange rate
Y
r IS BP LM
Y

Case 11) No CM, flexible ER, fiscal r IS BP LM
policy expansion
Y

Case 11) No CM, flexible ER, fiscal r IS BP LM
policy expansion
There is an initial trade deficit,

capitals are immobile, and there is
pressure to increase e. Because the
exchange rate is flexible, e increase
X (Y * , e ) − M (Y , e ) = 0 =  +  Y * −  Y +  e
An increase in e improves the trade

balance. This shifts the IS to the right
Y
X (Y * , e ) − M (Y , e ) = 0 =  +  Y * −  Y +  e
r IS BP LM
The BP curve, that represents the level

of output consistent with a zero trade
balance, is also affected. Only a higher
level of local output (and consequently
imports) is consistent with a zero
trade balance (that improved due to a
higher e). For that reason, the BP
curve shifts to the right Y

Case 12) No CM, flexible ER, r IS BP LM
Y

Case 12) No CM, flexible ER, r IS BP LM
There is an initial trade deficit,

capitals are immobile, and there is an
upward pressure over e. Because the
exchange rate is flexible, e increase
X (Y * , e ) − M (Y , e ) = 0 =  +  Y * −  Y +  e
An increase in e improves the trade

balance. This shifts the IS to the right
Y
X (Y * , e ) − M (Y , e ) = 0 =  +  Y * −  Y +  e
r IS BP LM
The BP curve, that represents the level

of output consistent with a zero trade
balance, is also affected. Only a higher
level of local output (and consequently
imports) is consistent with a zero
trade balance (that improved due to a
higher e). For that reason, the BP
curve shifts to the right Y
The Exam
▪ El examen de doble grado tiene varias preguntas que son una
aplicacion directa de este framework (IS-LM-BP)
▪ Questions:
▪Q12 of 2014 exam: imperfect capital mobility + perfect capital
mobility + increase in money supply + zero capital mobility
▪Q10 of 2015 exam: perfect capital mobility + fall in
autonomous consumption + UIP with change in expected ER
▪Q9 of 2016 exam: perfect capital mobility + increase in G +
use of the CPI instead of the PPI in the money market
Question 9 of 2016 exam

Perfect Capital Mobility (PCM) case for (a), (b), (c)
Comments on (a): Show how the internal and external equilibria are determined
Definitions
S priv = (Y − T ) − C
S pub = T − G
S = S priv + S pub = Y − C − G
Y − C − G = I + NX
S − I = CA
S  I  CA  0 FA  0
S  I  CA  0 FA  0
S priv + S pub − CA = I
S priv + FA = I − S pub
S priv + FA = I + fiscal.deficit
Comments on (b): Suppose there is an increase in G

No comments

M
= L (Y , r ) , where Pc =  P + (1 −  ) EP .
*
Comments on (c): Money demand
Evaluate an increase in G. Pc
M
=  o + Y Y −  r r
Pc
1  M 
r=   o + Y Y − 
 r   P + (1 −  ) ES /. perUS $ P* 
 1  M    Y 
r =   o − * 
+ Y
  r   P + (1 −  ) ES /. perUS $ P     r 
Question 9 of 2016 exam: Increase in G, fixed ER, PCM

r IS Old case LM r IS New LM LM
r = r* BP BP
 1  M    Y 
LM : r=  o − *  
+ Y
  r   P + (1 −  ) ES /. perUS $ P     r 
Y Y
r IS LM r IS LM
r = r* BP BP
Y Y
Question 9 of 2016 exam: Increase in G, flex. ER, PCM

r IS Old case LM r IS New LM LM
BP BP
 1  M    Y 
LM : r=  o − *  
+ Y
  r   P + (1 −  ) ES /. perUS $ P     r 
Y Y
r IS LM r IS LM
BP BP
Y Y

Comments on (a): Show how the internal and external equilibria are determined
No comments
Comments on (b): Suppose there is a drop in autonomous consumption

No comments
Comments on (c): Use the “complete” UIP theory ( r = r + ( e e ) ) and assume that
* e
the ER is expected to return to its level prior to the change in autonomous

consumption
 ee   * ee 1   
X (Y , e ) − M (Y , e ) +  +   r − r −
* *
=0 r = r + − ( +  Y * +  e +  )  +   Y
 e   e    
If the ER depreciates (appreciates) after the shock, then an expected appreciation

(depreciation) is necessary to return to the initial level. This is an downward
(upward) move in the BP curve

Comments on (a): Imperfect CM. Show how the internal and external equilibria
are determined.
No comments
Comments on (b): Suppose PCM and there is an increase in Ms.

No comments
Comments on (c): Zero CM and there is an is an increase in Ms.
Point: the final equilibrium (after the movements r IS BP LM

in the IS, LM & BP curves) cannot show a bigger
expansion of output. A bigger expansion would
imply a higher interest rate than the initial one,
and a drop in investment. Is the drop in investment
feasible? Recall that “S - I = CA” and note:
1. CA=0 with zero CM
2. Spriv=Y-T-C. Then private and total savings are
rising
3. Investment must rise in order to maintain CA=0 Y

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UOL - Macro I Review

Antonio Cusato Novelli

Capital Flows: UIP

▪ As we indicate, the equality holds because of arbitrage. Suppose

Capital Flows: UIP

▪ A CA deficit (NX<0) should be offset by a FA superavit (FA>0)

iS /.  iUS $ + ESe /. perUS $ ES /. perUS $

▪ It is more attractive to invest in the local economy (in Peru and

The IS-LM-BP Model

Exports Foreign Real Imports

▪ Recall PUS $ Price of a US basket of

▪ If e , the goods in the US are relatively more expensive.

The IS-LM-BP Model

▪ FA = Financial Account (called in the tutorials KA, Capital

Derivation of the BP Curve

Derivation of the BP Curve

Lets make assumptions about the functional form of net exports

The IS-LM-BP Model

The IS-LM-BP Model: Adjustment to the Equilibrium

The IS-LM-BP Model: Adjustment to the Equilibrium

How is the adjustment process?

The IS-LM-BP Model: Adjustment to the Equilibrium

A change in e will affect

A reduction in e will decrease net

The IS-LM-BP Model: UL Study Guide

The IS-LM-BP Model: Case 1

The IS-LM-BP Model: Case 1

The fiscal expansion determines a

The IS-LM-BP Model: Case 2

The IS-LM-BP Model: Case 2

The monetary expansion

The IS-LM-BP Model: Case 3

The IS-LM-BP Model: Case 3

The fiscal expansion determines

The IS-LM-BP Model: Case 4

The IS-LM-BP Model: Case 4

The monetary expansion

The IS-LM-BP Model: Beyond the UL Study Guide

The IS-LM-BP Model: Case 5

The IS-LM-BP Model: Case 5

The fiscal expansion determines BP

To avoid the appreciation of the

The IS-LM-BP Model: Case 6

The IS-LM-BP Model: Case 6

An expansionary monetary policy BP

The IS-LM-BP Model: Case 7

The IS-LM-BP Model: Case 7

The fiscal expansion determines an BP

Mathematically, recall the intercept of

The IS-LM-BP Model: Case 8

The IS-LM-BP Model: Case 8

An monetary policy expansion BP

The IS-LM-BP Model: Case 9

The IS-LM-BP Model: Case 9

The IS-LM-BP Model: Case 10

The IS-LM-BP Model: Case 10

A monetary expansion generates

The IS-LM-BP Model: Case 11

The IS-LM-BP Model: Case 11

There is an initial trade deficit,

An increase in e improves the trade

The BP curve, that represents the level

The IS-LM-BP Model: Case 12

The IS-LM-BP Model: Case 12