Three Pane Model Essay Example for Free

Three Pane Model Essay Utility for Business Managers: Firms resort to macroeconomic analysis to make rational judgments about the effects of global events or policy shocks on the economy and thereby on the business environment. But such analysis is often laden with possibilities for logical missteps. The Three- Pane model (open economy IS/LM model) is discussed here as a tool for explaining key relationships in the economy while avoiding the missteps encountered in macroeconomic analysis. What is open economy macroeconomics? Macroeconomic analysis helps firms to explore the interrelationships among a whole host of markets, while microeconomics focuses on variables like price and quantity, cost and revenue in individual markets. Macroeconomic analysis can be closed-economy or open -economy. Closed-economy macroeconomics deals with movements in and relationships among aggregate variables such as National Income, rate of interest, the aggregate price level, rate of inflation etc. Open economy macroeconomics makes the analysis complete by adding analysis of capital flows, international trade and exchange rate. The objective of this note is to introduce the Three-paned or Open-economy IS/LM model. As we will see, this model is an extension of the simple closed-economy IS/LM model. A Little Bit of History: The IS/LM closed economy model was introduced by the British Economist, Sir John Hicks in 1937. The IS/LM model denotes the simultaneous equilibrium of the two key markets in a market economy, product (real) market and the money market. IS represents real/product market equilibrium and LM, money market equilibrium. IS refers to the fundamental relationship between Investment (I) and Saving(S). LM represents the relationship between L, the demand for money, and M, the supply of money. The open economy version of IS/LM is credited to two economists, Robert Mundell Marcus Fleming and hence called the Mundell-Fleming model. The three-paned model we are discussing here is pretty close to the Mundell-Fleming model. This model is best suited for discussing short-to-medium term changes in the economy, i.e., changes over a few years. The Three-Paned Model [Large Open Economy IS/LM Model]. The model as presented in the below diagram has three panes with one graph in each pane. (1) Pane I depicts the IS/LM model [product money market]. Point ‘e’ in the first graph represents the equilibrium rate of interest and the corresponding level of output/income at which, both the product and money markets are in simultaneous equilibrium. (2) Pane II [capital outflow schedule] shows Net Capital Outflow as a function of the rate of interest. Net Capital Outflow (CF) is defined as the difference between Capital Outflows and Capital Inflows. (3) In Pane III, we have the foreign exchange market, where the exchange rate, E is determined by the capital outflow schedule in Pane two and net export schedule ( NX). NX is the difference between Exports and Imports. PANE I PANE II PANE III Diagram showing the Three-Paned Open-Economy IS/LM Model Explaining the working of the Three-paned Model: Now let us see how the three-paned model works. We begin from point ‘e’, the initial equilibrium, in the ISLM model. Point e represents the simultaneous equilibrium of the product and money markets at an equilibrium rate of interest, ’ r’, and ‘ Y ‘ level of income/output. To determine the equilibrium in the capital outflow schedule, the equilibrium rate of interest, r, is brought over from the first pane to determine the equilibrium amount of net capital outflows. When the rate of interest is r, equilibrium CF in the economy is given by CFo. Suppose the RBI hikes the rate of interest from r to r1. If r* remains constant, r-r* increases. This increases relative returns in the domestic economy which creates two kinds of impacts. One, the capital outflow decreases, and two, the capital inflow increases. Therefore, the net capital outflow decreases, which is shown by the fall in CF from CFo to CF1. Likewise, if there is a fall in the interest rate from ro to r2, capital outflow increases, and capital inflow decreases, leading to an increase in net capital outflow as indicated by an increase in CF to CF2. The Capital Outflow (CF) curve is therefore, downward sloping. This means that, higher domestic rates of interest are associated with lower net capital outflows, and lower domestic rates of interest are associated with higher net capital outflows. As mentioned earlier, the three-paned model plots the net export schedule (NX) with respect to the exchange rate, E. E is defined as the foreign currency per unit of domestic currency. If we drop the equilibrium amount of capital flows CFo from pane II to the third pane we get the equilibrium amount of net exports, NXo, which is determined by the intersection of the perpendicular dropped from the CF schedule with the NX schedule. This also gives the equilibrium nominal exchange rate, Eo. [Here, we are assuming price levels at home and abroad as constant, therefore, nominal and real exchange rates can be considered to be proportional. i.e., they won’t be different]. How do we explain the model in simple economic terms? In a closed economy, the rate of interest decided by the RBI defines the simultaneous equilibrium in the product/goods market and the money market, as shown by the intersection of the IS LM curves (Pane I). Suppose that we open up the economy and also assume that we are considering a large economy [as in the case of India]. Pane II III shows how a domestic interest rate change (assuming foreign rate of interest rate to be fixed) impacts capital flows and thereby the exports and imports and the exchange rate in the economy. A hike in the interest rate by the RBI would attract capital from outside-increase in inflows- and would decrease capital outflows. This would lead to a fall in the net capital outflow. A fall in the interest rate would have the opposite effect, leading to a decrease in inflows and an increase in outflows, thereby increasing net capital outflows. When capital inflows increase due to a hike in the domestic interest rate, let us assume that most of the inflows are in the form FDI. That is, there would be an increase in demand for rupee denominated assets thereby increasing the demand for the rupee in the foreign exchange market, vis-à  -vis the foreign currency, say, dollar. This would appreciate the exchange rate (E to E1) vis-a –vis the dollar (exchange rate E was defined as foreign currency per unit of domestic currency).The appreciation of the exchange rate makes exports costlier and imports cheaper. Therefore, exports fall and imports rise, resulting in a fall in Net Exports as shown in pane III, from NXo to NX1. Similarly, a fall in rate of interest would depreciate the exchange rate, leading to a fall in imports and rise in exports, resulting in an increase in net exports. Thus the three-paned model or the open-economy IS/LM model gives the business decision maker a framework to understand and analyze changes in and interrelationships between rate of interest, capital flows, exchange rate and net exports in a large open economy. â€Å"We can address important questions about how the macroeconomy, capital flows, international trade, and the exchange rate will respond to a wide variety of events and shocks. (1) How will these key variables respond to an increased money supply or an increase in taxes? (2) How does a sudden drop in consumer’s willingness to make purchases or a technological shock that makes investing more appealing affect interest rates, unemployment and the exchange rate? (3) What will be the resulting effects on the direction of the economy and the key variables?† [ 2 ]. Economic Models: An economic model may be defined as a logical framework that is based on explicit assumptions about how key economic variables interact. The links between these variables are based on assumptions rooted in economic theory and are also explicitly defined by the relationships that govern the model. The key to understanding any economic model is to understand the logical structure and its underlying assumptions. The set of assumptions in the model enables the analysis of the impact of changes in one or more variables on the rest of the economy (-while not violating the original behavioral assumptions). [ 3 ]. John Hicks, â€Å"Mr. Keynes and the Classics: A Suggested Interpretation†, Econometrica, 1937. He was awarded the Economics Nobel Prize in 1972. [ 4 ]. For a detailed discussion of the IS/LM model, see Dornbusch,Fischer, Startz-Macroeconomics, Chapter 10, pp219-240,10thedition. [ 5 ]. Net capital outflows as defined earlier, are equal to capital outflows minus capital inflows. Here the assumption is that capital flows are a function the difference between relative interest rates. The domestic interest rate is given as r and the foreign rate of interest rate is taken as r*. Since it is not shown in the graph, r* is assumed to be constant. Therefore, capital flows effectively are determined by the changes in the domestic rate on interest rate. i.e., Net capital outflow, CF = f (r – r* ). [ 6 ]. Quoted from Darden Business Publishing- A Technical Note on The Open –Economy IS/LM Model, 2008.