Macro in Action Review last week Another case study or 2 The open economy: Introduction What determines NX?

slide 1 2.…causing the interest rate to rise IS Y r LM 2 r2r2 Y2Y2 Y1Y1 r1r1 LM 1 3.…which decreases investment, causing output & income to fall. 1.  M < 0 shifts the LM curve inward Monetary policy: UK decrease in M

slide 2 causing output & income to rise. IS 1 Brazil: increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r This raises money demand, causing the interest rate to rise… …which reduces investment, so the final increase in Y 3.

slide 3 Interaction between monetary & fiscal policy  Model: Monetary & fiscal policy variables (M, G, and T ) are exogenous.  Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.  Such interaction may alter the impact of the original policy change.

slide 4 The Fed’s response to expansionary fiscal policy  2001 U.S. recession  Bush cut T & increased G.  Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant  In each case, the effects of the  G are different:

slide 5 Higher G and lower T, the IS curve shifts right. IS 1 Response 1: Hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

slide 6 IS 1 Response 2: Hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results: Higher G and lower T, the IS curve shifts right. Accommodating monetary policy. (In fact, the Fed actively cut r, as we discussed.)

slide 7 IS 1 Response 3: Hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3 Higher G and lower T, the IS curve shifts right. Offsetting monetary policy