Finance and accounting free essay: IS-LM Mundell-Fleming Model in Eurozone Debt Crisis
IS-LM Mundell-Fleming Model in Eurozone Debt Crisis
One of the most dominant of Europe’s current affairs involves the economic crisis facing the Eurozone that poses serious ramifications to global economy if unresolved. Despite the fact that the escalation of the crisis which emerged in 2010 affecting a few countries was significantly handled towards 2011, the experienced sluggish recovery poses a threat to the entire Eurozone. Perhaps one of the main issues affecting the recovery plan to this date involves the effective economic policies and interventions that affect macroeconomic decisions (Jeromin, Panizza and Sturzenegger, 2009, p654). In light of the mechanisms at the disposal of authorities across the Eurozone in dealing with the crisis, three recurrent economic tools come into focus than ever before.
These economic tools for consideration are the exchange rates, trade balance and interest rates that determine governments’ decisions in financing their budgets for instance through debts. In the incorporation of the appropriate balance to deal with the debt crisis, Mundell-Fleming Model forms one of the most applicable interventions in debt macroeconomics that could be applied to resolve the Eurozone crisis. In this discourse, various perspectives are discussed to form the basis of possible intervention by a European state outside the Eurozone which is an open economy and conducts much of its trade with the Eurozone.
IS-LM Mundell-Fleming Model
IS-LM Mundell-Fleming Model was separately put together by Robert Mundell and Marcus Fleming building on Hicks IS/LM model of a closed economy to generate a model suitable for the open economy. The Mundell-Fleming model is a representation of the economic nexus with which nominal exchange rate, interest rates as well as input are related. In this model, the performance of the domestic economy must be in tandem with the world economy which is represented by the balance of payment element to the IS/LM model. Two separate settings are envisaged under the two models under domestic and world economies since they are considered differently. Similarly, domestic economies are considered as open or closed depending on the composition of the trade balance defined by real output or input. Under this model, short run interventions of the performance of the economy can be effected using the three tools mentioned above namely; interest and exchange rates as well as trade balance. It is therefore precise to sum up the IS-LM Mundell-Fleming model as the economic model that considers the IS, LM and BOP relationships to determine the appropriate economic policy amid pressure such as from regional and world economic crisis (Dornbusch, 1980, p112).
Application of the IS-LM Mundell-Fleming Model to Stabilize the Client’s Economy
The effective positions of the IS and LM curves are dependent on the exchange rate due to various conditions of the economy designed by the effective policy. Using the adjustment of the exchange rates, it is possible to influence the goods market through the money market. In an open economy, the world economy dictates the applicable interest rates favorable to transactions at the international trade. It therefore implies that the applicable economic system affecting the money and goods market must be responsive to the forces of the world market in terms of import/exports forces (Sarno, 2001). Setting the Gross Domestic Product (Y) path that accommodates the equilibriums in the goods and money markets implies that applicable economic system considers domestic interest rates with comparisons being made on the world economy dictated exchange rates. The IS-LM Mundell-Fleming Model therefore introduces the aspect of the impact generated by the world market on the domestic economy (Dornbusch, 1980, p24).
IS-LM Mundell-Fleming Model Graphical Representation
Relationship of IS-LM Curves
The first element is IS which represents the GDP curve created by the goods market equilibrium which is a function of Consumption (C), Investment (I), Government spending (G) and Net Exports (NX) which is also denoted as;
Y=C+I+G+NX (IS curve)
The second element involves LM which represents the curve generated from the money market equilibrium as a function of Money supply (M), Price level (P), nominal interest rate (i) Liquidity (L) which is also denoted as;
The third element is the representation of the balance of payment (BoP) under a certain interest rate represented as a function of Current Account surplus (CA) and Capital Account surplus (KA) written as;
Domestic interest rates (r) are harmonized with world exchange rates (r’) (Ganelli, 2002, p8).
Altering the Exchange Rates
Within the setting of an open economy, the GDP is a function of local and foreign economic activities, which implies that external forces of the world or regional economy may be felt in certain respects (Lane 2001, p236). As an illustration, trade between two countries experiencing different economic conditions is dictated by the applicable pressure on the two economies, where interventions such as local interest rates may directly affect import/export balance of the trade. In view of the international exchange rates that balance world the economy, it may be necessary to alter domestic interest rates to introduce certain changes to the economy with respect to its current performance.
Figure 1: Setting Interest Rates above World Exchange Rates
There are certain instances when the domestic economy may be forced to interrupt the exchange rate balance to coincide with the applicable interest rates targeted at certain economic outcomes. By setting the interest rates above the world interest rates, net exports will reduce as assets owners will be hold on to their assets which pushes up the exchange rates. Higher interest rates than the world standards are in turn likely to cause a shift of the IS curve to the left experienced in form of a reduced GDP. In such a scenario, the equilibrium achieved by the meeting of the three curves is disrupted and the economy responds by establishing the equilibrium through shifting of the IS curve inwards. As illustrated in Figure 2, the equilibrium expected on the fixed world exchange rates (along r=r’) is disrupted by setting higher interest and can only be achieved by shifting to the right.
In Figure 2 however, interest rates lower than the world rates disrupt the equilibrium that must be established along the curve r=r’ by shifting the IS to the right. In such a scenario, the economy experiences growth in GDP (Y) as witnessed in increased net exports. Lower interest rates attract trade in local goods by foreigners which exceeds imports which are relatively expensive than local products.
Alternatively, when the central bank intervenes by transacting government debt to offset foreign exchange pressures, the government introduces sterilization operations. These interventions are incorporated when the performance of the domestic economy do not correspond with the apparent world exchange rates. Under such circumstances, the central bank may address deficits in the balance of payment by engaging in buying government debt to establish a balance in the money market (Ganelli, 2002, p22). Other similar monetary interventions that the central bank may involve in are aimed at ensuring that the supply of money in the economy supports the set economic equilibrium. This involves the shifting of the LM curve by altering money supply in the economy which effectively translates in changes in growth in output (Y).
Interventions in a Small European Economy outside the Eurozone
In order for European countries to recover from the debt crisis affecting the Eurozone, it implies that the impact of the Euro among the key trade partners can greatly affect the performance of a European country outside the Euro. In a bid to ensure that the Eurozone debt crisis is under control, the European Central Bank regulations including setting up of interest rates implies that the Eurozone is bound to comply (De Grauwe et al, 2011, p27). The Eurozone debt crisis is as a result of aggravated liquidity issues that now border solvency issue as the governments in the Eurozone find it increasingly impossible to meet their debts. The liquidity issue originates from the tendency of the government to borrow in order to meet its expenditure due to lack of liquid assets to meet its debts, which continues to exceed the actual asset base creating debt deficits in entire worth being unable to meet the debts upon insolvency.
With the debt difficulties in the Eurozone, the impact of the debt crisis on interest rates and balance of payment does not favor national growth due to the pressure in the market. GDP aspect as indicated in Figures 1 and 2 above illustrate the connectivity that the exogenous forces of the market have with the economy outside the Eurozone under this consideration. The performance of the Euro and the applicable economic environment for trade in the Eurozone will destabilize trade in the eurozone thereby creating risks in the recovery of the economy. The recovery of the Eurozone faces a challenge in that the net export values cannot offset the imbalance created on the curve shifting them to the left.
IS-LM Mundell-Fleming Model Assumptions
The IS-LM Mundell-Fleming model is based on certain presumptions that make it effective if held to be true. One of the assumptions is the comparison of the domestic economy with the rest of the world’s economy to the effect that the domestic economy is smaller. For practical comparisons, it can only be true that a country’s economy is inferior in size to the global economy which thereby can be assumed to have certain force on the domestic economy. Due to this comparison, the IS-LM Mundell-Fleming model applies the relative terms exogenous and endogenous for the various variables used in the different equations and curves. As an illustration, the IS-LM Mundell-Fleming model treats world economy factors such as world income and world interest rates as exogenous while those factors that can be controlled by the domestic economy system such as domestic interest rates are endogenous.
In addition, the model makes the assumption that the goods market in which the country takes port in is a single product. By assuming that that the goods market in which the country participates is a single composite commodity, it is possible for the model to run on the homogeneity attribute that a single commodity has, without engaging the diversity aspects of various products traded in. This assumption further extends to brand this single commodity as an imperfect substitute for the global production since it would otherwise disrupt the demand and supply logic. Alternatively, the IS-LM Mundell-Fleming model makes an assumption to the effect that the domestic output or input is dependent on market demand. Similarly, domestic and foreign outputs in the model are assumed to have a predetermined price (Dornbusch, 1980, p123).
Effects of the Eurozone Debt Crisis on Aggregate Income in the Client’s Economy
Aggregate income in the European economy under consideration will be affected through spill over impacts of the economic crisis bred by uncontrolled debt levels in the Eurozone. One of the impacts will be created through financial contagion which discourages investment and trade with the Eurozone nations that form bulk of its international trade. Secondly, it is likely that the austerity policies embarked by the eurozone countries will directly affect the demand of the client’s exports making direct trade difficult. Thirdly, any dollar based transactions outside the Eurozone will be affected by depreciation of the Euro against the dollar resulting in reduced aggregate demand (Massa 2011, para. 5).
Effects of the Eurozone Debt Crisis on the Exchange Rate in the Client’s Economy
Exchange rates in the European economy that is not a member of the Eurozone will experience the pressure of a volatile money market dominated by the Euro and the Dollar. Depreciation of the Euro against the Dollar implies that the countries conducting bulk of their trade with the Eurozone will be forced to deal with the reduced demand of exports in their usual market as occasioned by the difficult economic times. Interest rates will eventually be driven higher by the impact of the depreciating Euro in the market. To offset the deficit net export element of the IS curve, it will be logical for the client economy to set the interest rates at a lower level than the world market rates. In setting the interest rates below the world exchange rates, the IS curve will shift to the right causing increased growth in the short run.
Effects of the Eurozone Debt Crisis on the Trade Balance in the Client’s Economy
Difficult economic times in the Eurozone will create deficits in export/import balance thereby affecting the balance of payment in various ways. Since the current account (CA) is a function of the net exports (NX) aspect of the IS-LM Mundell-Fleming model, it implies that the affected net exports will translate to reduced balance of payment in the client’s economy. This is based on the premise that;
Alternatively, the balance of payment (BoP) is a reflection of capital account (KA) balance which is affected by; domestic and foreign interest rates (i and i’) and capital flows alongside their exogenous factors (z and k) given by below.
It therefore implies that the negative influence of the client’s capital account will adversely affect the balance of payment as illustrated above using capital and current accounts illustration (Dornbusch, 1980, p52).
Consequences of Fixing the Value of the Exchange Rate to the Euro
In view of the circumstances of the performance of the Euro in comparison to the dollar amid the debt crisis in the eurozone, high levels of depreciation are experienced. It therefore implies that the application of the Euro in the setting of the interest rates in Europe will be incorrect due to the pressure created by the debt crisis to the economy as experienced by the Euro. The client economy will therefore be introducing certain elements of the depreciation experienced by the Euro into the economy that is out of the eurozone. Since the Eurozone forms the main market for its exports and imports, it is likely to influence the decision of the client’s central bank to follow the progress of the euro to facilitate sustainable trade with the Eurozone. This poses danger to the performance of the economy particularly with the rest of international trading partners who are outside the Eurozone in conducting trade at depreciated interest levels (Massa 2011, para. 5).
Threat of the Debt Crisis to the Stability of the Eurozone
Debt crisis affects the stability of the economies in the Eurozone by introducing difficult trade and exchange rates situation that cannot spur growth of the economy. Whereas the aspect of trade with the Eurozone play a direct role in influencing the growth prospects, interest rates determined by the demand of the euro pose serious ramifications to international trade. Altering the interest rates to match up with the exchange market in the Eurozone is likely to drive away investors and reduces the investment opportunities which in turn cause reduction in GDP (Corsetti and Pesenti, 2001, p432). Volatile economic environment dictated by the interest rates destabilizes the market and compromises growth in the Eurozone. Net export element of trade is likely to be negatively affected as exports will be exceeded by imports in the Eurozone which cannot afford to export due to high cost of production occasioned by expensive credit.
Despite the fact that the debt crisis is directly happening in the Eurozone, its impact can be felt by the rest of the world economies without the Eurozone by virtue of being connected through trade (Jeromin Panizza and Sturzenegger, 2009, p676). In the deliberations of the macroeconomics concept proposed by Mundell-Fleming model, it is clear that open economies are subjected to the exogenous effects of international economies with which trade takes place. In the model, it is illustrated that the exchange rates pressure emanating from regional or international trade economic blocs can infuse into the economy in certain ways of the trade relationship. For a European economy that is not a member of the Eurozone, strong trade links with the Eurozone are likely to translate into an opportunity for the impacts of the current debt crisis spilling over into the open economy. Various alternatives i\of dealing with the problem can be isolated from the IS-LM Mundell-Fleming model in terms of dealing with money market, balance of payment and consumption (Tille, 2001, p426).
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