Table of Contents Introduction Surfing on the waves of the global economic crises, more precisely dealing with the escalating economic disturbances in the Euro zone, the economy of United Kingdom has suffered significant difficulties under the recession umbrella. Furthermore, given the flexible exchange rate system and a very high degree of international capital mobility within the economy, the government struggles to manipulate the monetary and fiscal policy, thus overcome the complexity and reach the desired, stable condition that currently is vaguely at sight.
In order to clarify the outcome of policy changes, this work will demonstrate, more precisely depict the increase in money supply and government spending through the combination of IS/LM/BP modeling, followed by Phillips curve as well (Lui, 2011). Main Body IS/LM Modeling The model is depicted in figure 1 . Vertical axis represents interest rate (i), whereas horizontal (Y) corresponds to output/income. IS curve is downward sloping thus represents the equilibrium in goods markets. According to Mishkin (2009) IS curve is downhill as it corresponds to the increase in the interest rate that leads to the ecrease of overall output.
Upward slopping curve (LM) depicts the equilibrium in Financial Markets, whereas the increase of income will be followed repeatedly with the growth of the interest rate. E represents the intersect of the equilibrium in financial markets (LM) and equilibrium in goods markets (IS). The IS-LM curves, more precisely their relationship if accepted well by the research add a significant value towards the demand for money, consumption information, certain equilibrium conditions as well as clarification investment reality (Ritter, 2008).
According to Mishkin and Eakins (2011) observation of IS/LM model can contribute to the evaluation of central bank actions towards the money supply and government changes as tax regulation in the rather closed economy conditions (external factors do not account). Figure 1 – IS/LM Model Balance of Payments In order to analyze the open economy, we need to take into account the balance of horizontal BP line represents the equilibrium of transactions.
Therefore, considering the situation when the equilibrium of transactions is not being O, thus there is no presence of external equilibrium. If that was not the situation that would imply that he Central Bank would be losing reserves (bringing it closely, no Central Bank could allow itself to do that in the long time period) or it is going to acquire reserves (in the same way, a Central Bank is reluctant to pursue doing that, unless it strives to possess a current surplus that is likely to permit it to gain significant quantities of international assets).
At the same time, the stratum of domestic interest rates has to be at the stratum of rates being present abroad to acquire external equilibrium. Figures over the BP will match a surplus, whilst the fgures underneath the BP demonstrate a deficit. As could be seen in figure 2, BP is overlapped by the vertical illustration of the full-employment output level. Considering this situation, their overlap “E” is the point where at the same time internal and external equilibrium is accomplished (Darity et al, 2004).
Figure 2 – IS/LM Model In order to accurately analyze the IS-LM modeling within the open economy, along with the assumption of very high, perfect capital mobility, we need to access the Mundell – Fleming model. Therefore, Kneller (2007) implies that under the umbrella of perfect capital mobility a slight disturbance of the interest rate embraces an nfinite capital flows. Equally important is that central bank is not in a position to undertake monetary policy that is independent within the fixed rate regime (Sliber, 1970).
Increase in Money Supply Figure 3 depicts the expansionary monetary policy under the open, flexible (exchange rate regime) economy, whereas BP is constructed as foreign interest rate (if) equals domestic – sterling interest rate (i). Further, the prices are considered to be fixed, hence the Phillips curve is not introduced yet (Dornbuch et al, 2011). Figure 3 – Applying Expansionary Monetary Policy
Boosting monetary policy, more precise increasing the inflow of money supply in an open, flexible (exchange rate) economy will disrupt the primary equilibrium E firstly by the direct response towards the real money supply increase that is the declining interest rates (11) or increasing income (Y 1), hence we get the rightward shift of LM curve (LM’). Therefore, recession (YO ; Y 1) is present and capital outflow, more precise pound depreciation takes place since if (Mishkin, 2009). X lies on the intersection of LM’ and SL, however it cannot be addressed as the equilibrium since we are in the open economy (Mankiw, 2009).
Given the fact that depreciation of pound took place, according to Nelson (2009) this will pull a chain of events, firstly it leads to higher prices of foreign (imported) goods, thus boosts the demand for domestic goods, in other words net exports will rise (exports are increased, while imports have a downturn) and therefore the chain ends with the expansion of the overall domestic output. Last event the IS curve shift to the right (IS’) in anticipation of the scenario where if. Towards the end, expected scenario should be that YO as well, thus the economy reaches the long run equilibrium at point E’.
At this point there are no further tendencies to manipulate whichever of the factors (Dornbusch, 2011). Increase in Government Spending flexible exchange rate regime, under which I-JK government manipulates expenditures or taxes in order to increase the country output. Figure 4 – Applying Expansionary Fiscal Policy As the result of an increase in government spending (G t) output will be in climb (Y t) from YO to Y 1, further followed by the raise of the interest rate for pound (i t) from if to i, therefore capital inflow (i > if) will evolve and sterling currency will appreciate (Mishkin, 2009).
Equally important is the decrease of net exports as an outcome of accumulated imports in comparison to exports, thus this will lead to i (if pulls back towards i) and Y (Yl pulls back to YO), more precisely the leftward shift of IS’ will take place. Since the economy applies flexible exchange rate model, the fiscal policy of boosting expenditures will contribute only to the increase of government debt and through time the original equilibrium (E) will be present. On the other hand, if such fiscal policy is conducted under the fixed exchange rate regime, it would resourceful (Rogoff, 2002).