Paper Example on IS-IR-IFM Model

Introduction

The key variable of the IS-TR-IFM model is the rate of exchange and can be used for explaining economic shocks for a small open economy, which implies that it is not applicable to provide an explanation of economic issues of the rest of the world. By a small open economy, it means that a country is influenced by changes in the rest of the world, but that change has no impact on the rest of the world. For instance, it can be used to explain the economic shock of the UK economy that led to the depreciation of the sterling pound. The International Financial Markets integration (IFM) line imposes consistency of local money market interest rates with the resulting returns available on foreign assets measured in the local currency (Burda and Wyplosz, 2013).

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The IS-TR-IF model observes the interest rate parity condition where if the international capital markets are integrated perfectly, the rate of return (which is based on the same currency) on the asset sharing the same risk should be identical, designated as i=i*. In this case, i is considered the domestic interest rate while i* is the international rate of return. In instances where ii*, investors are likely to make profits if they borrow in one market and lend in the other. As per the model, arbitrageurs guarantee that whenever the capital markets are fully integrated, i=i*. The equilibrium is at the i=i* defined by the IFM, as shown in Figure 1 below.

Figure 1: The equilibrium defined by the IFM where i=i*

The IS-TR-IFM model is based on the fixed and flexible exchange rate regimes. The central bank, at a fixed exchange rate, can sell and buy currencies at a fixed price but it can intervene whenever there is an excess supply or demand of the currency. On the other hand, at a flexible exchange rate, central banks allow for the readjustment of the exchange rate to equate the supply and demand for the foreign currency. A decrease in the exchange rate leads to depreciation, just as what happened in the UK towards the Brexit referendum, which increases the competitiveness of goods as they become cheaper. Similarly, increasing the exchange rate results in appreciation, implying what the goods become more expensive. The IS curve represents combinations of output (Y) and interest rate (i) consistent with the equilibrium of the goods market. In addition, the aggregate demand is dependent on investment (i) private consumption (C), public demand (G) and net exports (E).

The Taylor rule (TR) describes how the central bank sets interests rate in accordance with the target interest rate, output gap, and inflation (Bernanke, 2015; Gali, 2015). The output gap is considered the deviation of output from its natural level. Foreign financial shocks usually encompass a contractionary impact on the economy of the domestic market, but the devaluation of currencies makes domestic goods more competitive as foreign demand increases, as well as the output (An, Kim, and Ren, 2014; Kohler, 2017). The IS curve then shifts to the right and the output expands from Y to Y' as shown in the figure below.

Figure 2: IS Curve Shifts

As shown in Figure 3, a case of monetary expansion implies that the central bank lowers its target interest i, which is shown by a right TR shift where the economy is originally at point A. However, at point B, the economy is below the IFM line implying that the interest is too low, which leads to capital outflow and ultimately a depreciation in the exchange rate. As highlighted before, the external competitiveness is increased and the current account improves leading to an IS shift to IS'. The new equilibrium is at C. Under flexible exchange rates, IS curve is primarily endogenous and moves to meet TR' and the IFM. If depreciation is anticipated, interest rate parity condition means that the prevailing interest rate should be higher for investors to be indifferent between home and abroad investment. The IFM line shifts to IFM' due to the changes in exchange rates. Using Figure 3, the IS curve shifts to D, the intersection of IFM' and TR'. The interest rate parity condition causes the monetary policy in the short-run to be more expansionary and D lies right of C. The initial shift from IS to IS' mirrors the depreciation caused the capital outflows reflecting the vertical distance from B to IFM line.

Figure 3: Floating exchange rates and monetary policy.

IS-TR-IFM and Brexit

According to Giles (2017), economists were divided as to whether the Brexit would lead to a growth or decline in the economy. While some economists were pessimistic of Brexit in that it would lead to financial gains, others counterweighted by warning that the departure would hurt Britain's economy. The pre-referendum estimates were that Brexit would lead to a 1% to 9% hit on the national income and a Gross Domestic Product (GDP) loss of approximately PS20bn to PS180bn. On the contrary, Brexit economists forecasted that the GDP would increase by 2.7% in 2017. The Treasury and the International Monetary Fund (IMF), predicted a mild recession (Titbomb, 2015; Lagarde, 2017). The Treasury highlighted that the economy would fall with four quarters of negative growth after the referendum and the GDP would be 3.6 lower after two years. This was attributed to the fact that the financial markets would react immediately respond owing to the fall of the pound (Titbomb, 2015; Lagarde, 2017; Bank of England, 2016).

There was almost a unanimous prediction that the vote would make the UK economically worse. What actually happened in the post-Brexit referendum is that it reduced UK growth by about 1%. Even so, within the six months after the referendum, there was a little recognizable impact on various macroeconomics variables besides the fall of the value of the sterling pound (Johnson and Mitchell, 2017). The pound depreciated sharply by the end of June 2017 by about 12%. This was contributed by the inflation rise from 0.5% in June 2016 to 2.6% in 2017 and a decline in real wage growth from 1.5% to -0.5%. The GDP was increasing at 1% by half of 2017 compared to 1.7% in the year preceding the referendum (Sampson, 2017; Office for National Statistics, 2017). Only one of the Treasury's predictions was realized 18 months after the referendum. This was the fall of the value of the sterling pound, which was a shock scenario (Baker et al., 2016). No recession had materialized even after 12 months after the vote. Additionally, unemployment rate did not rise. The depreciation in the sterling pound was advantageous to the UK equity prices and corporate earnings from abroad became worth more in sterling pounds. Essentially, this befits the IS-TR-IFM model in that currency devaluation leads to the promotion of exports and competitiveness of local goods (Petrof, 2016). Additionally, there was no sign of an economic slowdown in the second half of 2016 and no recession, contrary to what the IMF and the Treasury predicted. After four quarters of data, GDP in 2017 was estimated at 1.8%. Even though there as a fall in growth of consumption in 2016, business investment was healthy in 2017, as opposed to the decline in 2016.

As such, there were different views pertaining to the short-term impact of the Brexit referendum. While some of the Economists predicted positive growth of the economy, many more, implying a unanimous decision, forecasted a recession and a weighty decline in the economy. From my viewpoint, the differences in the prediction were caused by the use of different economic forecasting models. In addition, the economists, the Treasury, and the IMF used varying models that take into consideration of different factors. According to Fernandez-Villaverde, Guerron-Quintana, Kuester, and Rubio-Ramirez (2015), there are many market volatilities that cannot all be put into consideration, and thus, using variant models presents volatile results that are different. This implies that the different results lead to a lack of consensus on what the Brexit would result in during the short-term period. The parties also used different assumptions due to the impact of uncertainty, which based on the results have proved to be wrong (Haddow, Hare, Hooley, and Shakir, 2013). The parties also use assumptions in obtaining the impact of Brexit vote on the financial markets effects. Increases were assumed in the interest rate employed on loans and equity risk premia, which proved wrong. The depreciation of the pound and its impact in raising share prices was also missed by the Treasury. Lastly, parties assumed that government expenditure and short-term interest rates would remain unchanged, but bank rates were lowered meaning that the expenditure increased.

As such, the IS-TR-IFM model was correct in that a decrease in the exchange rate leads to depreciation of the sterling pound, which is the only factor that economists, IMF, and the Treasury predicted correctly. The model performed correctly in that shocks lead to a contractionary effect. Even though the effect was negligible, the model was right to some extent.

Conclusion

Several features of the IS-TR-IFM model contribute to the findings. According to Figure 3, and in accordance to Brexit vote, Britain had a case of monetary expansion, which led to the Bank of England to lower its target interest i, which is shown by a right TR shift where the economy is originally at point A to point B. At point B, the economy is below the IFM line implying that the interest is too low, which leads to capital outflow and ultimately a depreciation in the exchange rate. In consequence, the external competitiveness is increased and the current account improves leading to an IS shift to IS'. Therefore, this leads to the promotion of exports, implying that there will be no sign of economic slowdown and business investment becomes healthy.

References

An, L., Kim, G. and Ren, X., 2014. Is devaluation expansionary or contractionary: Evidence-based on vector autoregression with sign restrictions. Journal of Asian Economics, 34, pp.27-41.

Baker, J., Carreras, O., Ebell, M., Hurst, I., Kirby, S., Meaning, J., Piggott, R. and Warren, J., 2016. The Short-Term Economic Impact of Leaving the EU. National Institute Economic Review, 236(1), pp.108-120.

Bank of England, Financial Policy Committee (2016), News Release, March 2016.

Bernanke, B.S., 2015. The Taylor Rule: A benchmark for monetary policy?. Ben Bernanke's Blog, 28.

Burda, M. and Wyplosz, C., 2013. Macroeconomics: a European text. Oxford, UK: Oxford University Press.

Fernandez-Villaverde, J., Guerron-Quintana, P., Kuester, K. and Rubio-Ramirez, J., 2015. Fiscal volatility shocks and economic activity. American Economic Review, 105(11), pp.3352-84.

Gali, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton, NJ: Princeton University Press.

Haddow, A., Hare, C., Hooley, J. and Shakir, T., 2013. Macroeconomic uncertainty: what is it, how can we measure it and why does it matter? Bank of England Quarterly Bulletin, 53, 2, pp. 100-109

Johnson, P. and Mitchell, I., 2017. The Brexit vote, economics, and economic policy. Oxford Review of Economic Policy, 33(suppl_1), pp.S12-S21.

Gile, C. (2017). The real price of Brexit begins to emerge. [Online]. Available at https://www.ft.com/content/e3b29230-db5f-11e7-a039-c64b1c09b482 (Accessed 27 April 2018).

Kohler, K., 2017. Currency devaluations, aggregate demand, and debt dynamics in economies with foreign currency liabilities. Journal of Post Keynesian Economics, 40(4), pp.487-511.

Lagarde, C. (2017). Transcript of Press Conference by IMF Managing Director Christine Lagarde. [Online]. Available at http://www.imf.org/en/news/articles/2017/04/20/tr042017-press-conference...