2. • The M-F model is an extension of the IS/LM
model
• It can also be called as the IS/LM model in the
open economy
• Here, imports and exchange rates are additionally
considered
• For exchange rates, they are in the form of
domestic/foreign (for eg. US $/ euro when we
consider US as home country)
• Another assumption is that inflation and its
effects are ignored
4. • Goods market equilibrium
Y = C (Y-T) + I (Y,r)+ G + X(Y*, e) – M(Y,e)
(+) (+,-) (+, + ) (+, -)
• Money market equilibrium
M = L(Y, r)
P
5. Shifts
IS curve to right –
• increase in government expenditure
• Decrease in taxes
• Increase in foreign income
• Increase in exchange rate
LM curve to right –
Money supply(as price level assumed to be
constant)
6. Perfect capital mobility
Situation when foreign interest rate = domestic
interest rate initially
Also, it is assumed that foreign interest rate rf is
constant
7. Flexible exchange rate
(fiscal policy)
• Increase in government spending
• IS shifts right to IS1
• Domestic interest rate increases,
massive capital inflow(as people
invest more inside US)
• To invest in US, people convert
more to dollar (dollar demand
increase, hence exchange rate
fall(dollar appreciation)
• Fall in exchange rate, domestic
goods expensive, exports reduce,
output falls, to initial level
r1
r0
Y0
LM
e0
r
Y
IS
IS1
8. Flexible exchange rate
(monetary policy)
• Increase in monetary supply
• LM shifts right to LM1
• Domestic interest rate
decreases, massive capital
outflow(as people invest more
outside US)
• To invest outside US, people
convert more to others (dollar
demand decrease, hence
exchange rate rise(dollar
depreciates)
• rise in exchange rate, foreign
goods expensive, exports rises,
output rises back to initial level
of interest rate
Y1
r0
Y0
LM
e0
r
Y
IS
IS1
LM1
e1
9. Balance of payments
• Accounts which record transactions of a country with
outside world for 1 financial year
Consists of
• Current a/c – records transactions of trade of goods
and services, transfer payments
• Capital a/c – records capital transaction
• Equation: X – Z + F(r – r’) = 0
F = (net capital inflow)
BOP schedule: plots all interest rate-income combinations
that result in BOP equilibrium at a given exchange rate
It is upward sloping in case of imperfect mobility bcoz
domestic and foreign assets are not perfect substitutes
Perfect mobility, horizontal schedule.
10. Fixed exchange rate(fiscal)
• Govt. expenditure rise
• IS shifts right to IS1
• Domestic rate >foreign
interest rate
• Capital inflows
• Central bank to maintain fixed
exchange rate, increases
money supply
• LM right to LM1
• Interest rate back to old level,
exchange rate maintained,
output further increases
Y1
r0
Y0
LM
e0
r
Y
IS
IS1
LM1
e1
BP
Y2
r1
= rf
11. Fixed exchange rate(monetary)
• Monetary supply
increases
• LM shifts to right
• Domestic interest<
foreign interest , capital
outflow
• To maintain exchange rate
fixed, central bank
reduces money supply
• LM1 back to LM, at
previous equilibrium
point e0
r0
Y0
LM
e0
r
Y
IS
LM1
BP
r1
= rf
12. Imperfect capital mobility
fixed exchange rate( monetary)• Increase in money supply,
equilibrium shifts from e0
to e1
• Interest rate falls, income
rises
• New equilibrium below BP
schedule, shows BOP
deficit
• Inference: expanding
monetary policy here
increases output puts BOP
in deficit, so not a good
solution
Y1
r0
Y0
LM
e0
r
Y
IS
LM1
e1
BP
r1
13. Imperfect capital mobility
fixed exchange rate( fiscal)
• Increasing govt.
expenditure shifts IS
curve to right
• If BOP schedule flatter,
then equilibrium is above
BP curve, hence BOP
surplus(better way to
increase output)
• If BOP schedule steeper,
then equilibrium is below
BP curve, hence BOP
deficit(not so good way to
increase output)
Y1
r0
Y0
LM
e0
r
Y
IS
e1 BP
r1
IS1
14. Imperfect capital mobility
flexible exchange rate( monetary)
• Money supply increases, LM
to LM1, equilibrium From e0
to e1
• E1 below BP schedule, BOP
deficit
• Due to flexible exchange
rates, the rate rises and
subsequently, exports rise
due to which BP schedule
shifts to right
• Increase in exports causes
shift in IS curve also and by
equal amount
• Final equilibrium at e2
Y1
r0
Y0
LM
e0
r
Y
IS
e1
BP
r1 IS1
BP1
LM1
r2
Y2
e2
15. Imperfect capital mobility
flexible exchange rate( fiscal)
• Increase in govt. spending, IS
shifts to right to IS1, moving
equilibrium point from e0 to
e1
• BP schedule flatter than LM
and e1 above BP hence there
is BOP surplus
• Due to this, we cut down
exports as we already have
surplus, exchange rate will
fall, BP falls and shift to left
• Now, IS curve falls by equal
amount, and new equilibrium
set up at point e2. hence,
overall output increases by
utilising surplus
Y1
r0
Y0
LM
e0
r
Y
IS
e1
BP1
r1
IS2
BP
r2
Y2
e2
IS1
16. Conclusion
• The overall result of this model shows that fiscal
stimulus is likely to have little effect on the value
of the currency but reduce net exports, while
monetary stimulus is likely to have little effect on
net exports but reduce the value of the currency
• The model thus suggests that a combination of
fiscal expansion and monetary contraction would
boost the value of the currency and reduce net
exports.
• Conversely, fiscal contraction and monetary
expansion would boost net exports and reduce
the value of the currency.