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A GRAPH REPRESENTATION OF A BASIC MACROECONOMIC SCHEME: THE IS-LM MODEL
 

 

by Valentino Piana (1998-2001)

 
 

Contents

  
 
1. Introduction to our graph representation
  
 
2. The rules
  
 
3. The scheme
  
 
4. Reading the scheme: two examples
  
 
4.1. Export-led growth
  
 
4.2. Fiscal cuts
  
 
5. The advantages of this representation
  
 
Appendix 1. Justification for signs in relationships
  
 

Appendix 2. Introduction for absolute beginners

  
 

If you have never heard of IS-LM model click here.

Freely modifiable MS Word version of the graph.

Data for all the variables in IS-LM model

 

 

 
 

4. Reading the scheme: two examples

To read the graph, you simply start from a variable, imposing a change in a specified direction (increase or fall). Then, following the arrows, you see the dynamics of the variables immediately involved, depending on the sign you see: a plus sign means a change in the same direction (increase or fall, respectively), whereas a minus sign has the opposite meaning (fall or increase, respectively).

The impact will usually spread over time, since real processes need time to take place - with the possible exception of financial and monetary movements.

Similarly, the strength of the reaction in the second variable depends on its responsiveness (elasticity) to the first one. The relationships have variable strength; thus the reader can single out what should be particularly responsive in order a certain final effect to take place.

A caveat: All changes in variable levels will take place in the expected direction provided that the other variables around are not changing at the same time ("other things equal" clause). If this does not hold, specific hypotheses on surrounding dynamics should be introduced.

Furthermore, the changes in the second-wave variables will exert subsequent pressure on third-wave variables, until all variables in the graph have been considered.

The longer the chain, the weaker the effects and the longer the time delay since original source.

 

  

 

4.1. Export-led growth
Other things equal, an increase of export will trigger an increase of income.
The increase in income gives rise to 6 main phenomena:
1. an increase of consumption, since households are richer. Consumption growth, in turn, implies a further increase of income (Keynesian multiplier);
2. an increase of employment, since more production requires more labour;
3. the growing income helps the households, by increasing their savings;

4. the growing income helps the State, by widening the tax base, thus the tax revenue. At normal levels of public expenditure, this means a reduced deficit or even a surplus for the State budget;
5. it increases imports;
6. it also produces an increase of the real interest rate, given a fixed real money supply, which in turn depends on a deliberate choice of the central bank not to increase the nominal money supply (not to print money, not to allow more credit from banks to the economy).
The rise of real interest rate is a turning point.
The rise of real interest rate depresses investment, which in turn brakes the income growth.
The initial export push on income is thus supported by consumption and restrained by investment.

The state and the households are main beneficiaries, together with exporters, while firms (especially producers of capital investment goods) are the losers.
The increase in the real interest rate has the further effect of increasing the nominal exchange rate, by attracting foreign capital. Thus the real exchange rate rise as well. With stronger domestic currency, not only imports will further rise but also the exports will be restrained.

A second negative loop is then emerged: a rise in exports will eventually be absorbed by an increase of real exchange rate.
All this depend on the policy of the central bank, which did not increase the nominal money supply, leaving room for interest rate to rise, depressing both investment and exports.

Export-led growth is unsustainable and short living, unless the central bank accompanies the GDP growth with an expansionary monetary policy (larger money supply), so to leave the interest rate at the previous level.
If the central bank acts and keep the interest rate under control, everybody is happy: investment stay at the same level so as the exchange rate, leaving room for export to continue their growth.
Prolonged GDP growth boost employment, as we said, and this reduces unemployment.
To the extent wages are dependent on unemployment, they will rise as well, increasing the cost of production.
This will exert a pressure on firms to rise prices - both in competitive and monopolized markets. Inflation becomes a real risk.
The increase of price level reduces the real money supply: by definition the latter is nominal money supply divided by price level.
Unless the central bank further increases the nominal money supply, the real interest rate will rise, with all its unpleasant consequences on export and investment.
Thus, expansionary monetary policy risks to provoke inflation and a further need for money supply expansion.
[See previous graph]
 Unfortunately, the price level increase is already braking exports by strengthening the real exchange rate, given a stable world price level.
In other words, inflation is damaging exports by increasing the price of domestic goods in foreign terms, even in the event of a fixed nominal exchange rate or an expansion of money supply that keep the real interest rate stable.


If price level is extremely responsive to unemployment, then the task of the central bank is very difficult, since the export-led growth is in danger from different points of attack.

In synthesis, an export-led growth is possible but it requires a careful policy of control in side effects that can menace to erode the basis of the same spurring element: exports.

Crucial is the responsiveness of the variables to changes in the other values. If investment is not really influenced by the interest rate (either exports by the exchange rate), the export-led growth is clearly easier to manage.
Looking again at the graph, the export-led growth will be stronger and more sustainable:
i) the larger the share of exports on GDP;
ii) the stronger the Keynesian multiplier;
iii) the less the interest rate reacts to income;
iv) the less the exchange rate reacts to the interest rate;
v) the less investment reacts to the interest rate;
vi) the less exports are responsive to exchange rate;
vii) the less are wages are responsive to unemployment;
viii) the less prices are responsive to wages;
ix) the less imports are responsive to income.


We started our story from an increase of exports. But what could have provoked it?
A first answer would be a growing foreign GDP with the widening foreign imports it implies. Another would be the opening of new markets for domestic goods abroad, due to marketing efforts of exporters.

Furthermore, it is possible that the export dynamics is the target of conscious economic policies.
To the extent export-led growth is strong, a careful fiscal policy promoting export may be a cute move, since tax revenue will rise throughout the growth.

Alternatevely, a pre-emptive expansionary policy by the central bank could provoke an export increase through international price competitiveness of the country, improved by a devaluation, prompted by the fall of interest rate, due in turn to the increase in nominal (and real) money supply decided by the central bank.

In short, an export-led growth can be triggered by external and internal reasons, accompanied and braked by internal conditions. As an alternative to export-led growth, domestic pulled growth has been proposed as having several advantages in this paper.


We invite the reader to try a similar description and interpretation of a fiscal expansionary policy, relying on an increase in public expenditure. Which will be the immediate and far-reaching consequences?
 
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