IS/LM Model Analysis for European Countries

This report analyzes the effects of monetary and fiscal policies on European economies using the open economy IS/LM model. It examines the short-run impacts of a fall in consumer confidence on key economic indicators like interest rates, consumption, investment, exchange rates, and net exports. The report also discusses the appropriate policy mix to recover from recession, including expansionary monetary and fiscal policies, and their effects on various economic factors. Furthermore, it explores the challenges posed by the liquidity trap in European countries and its impact on the effectiveness of monetary policy. The report concludes that while policy mixes can help economies recover, liquidity traps can render monetary policies ineffective.

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Analysis of Monetary and Fiscal Policy using the open economy IS/LM model for European Countries
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Introduction
An open economy is that economy where there is free flow of goods and services. The countries
have the option to trade with the foreign countries and the international community can be
contacted in any circumstances. Also, there is free flow of funds and investments across
countries in the open economy. The aim of this report is to determine the short run effects on the
various aspects of economy when the confidence of the consumer falls, the effects of the policy
mix on the interest rate, consumption, investment, the real exchange rate, the budget and trade
balances and to determine the impact of the policies in the European countries that are affected
by the liquidity trap.
Short-run effects of a fall in consumer confidence on the interest rate, consumption,
investment, the real exchange rate and net exports
Due to the consumer confidence has declined in the economy, and as a result of that, the total
demand has also decreased. This will lead to fall in the equilibrium output because with the fall
in demand, the overall spending of the people in the economy falls, the rate of interest also falls
(Kapetanios, 2012). Then, the consumption declines which makes the exchange rate and net
exports declines too. This can be explained with the following diagram.
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In the above diagram, the graph 1 shows that the economy was at point A when the consumer
confidence did not decline. At point a, the output produced was Y1 and the rate of interest was
i1. But, with the fall in consumer confidence, the total demand declined and shifted the IS curve
to the left i.e. IS shifted to IS’. With the fall in demand, the investment and the savings of people
fall, so this affects the IS curve. Due to less demand, there is less output produced and Y shifts to
Y’. Also, the rate of interest has fallen from ‘I’ to ‘I’’.
In the second graph, the exchange rate is determined the demand and supply of currency in the
economy. With the interaction of demand and supply at point c, the exchange rate is set at ‘r’ and
the quantity is Q1. When the demand falls, the people use less of the currency and the demand of
currency falls. This makes the rate of exchange fall from r to r’.
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Lastly, when the demand falls, and results in fall of output of the economy, there is fall in the
production of goods and services. Hence, the country is bale to export less and it needs to import
the goods. Thus the net exports are adversely affected and the exports fall.
The appropriate monetary-fiscal policy mix to help the economy recover from recession
When the country suffers from recession, the appropriate monetary fiscal policy includes the
expansionary monetary and expansionary fiscal policy. In this, the government increases the
amount of spending and reduces the amount of taxes that it levies on the people (Napoletano,
2014). This is under the expansionary fiscal policy. Then, under the monetary policy, the central
bank reduces the amount of CRR and SLR; hence the banks lend more to people which increases
the supply of money in the economy (Napoletano, 2014). Thus, the purchasing power of people
in the economy gets increases, they spend more, invest more and hence the economy gets
recovered from recession. This can be explained with the following diagram:
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Before the expansionary policy, the economy was at point Q/r. after the policy, the demand curve
shifted from D to D’ which made the rate of interest and output increase.
The effects of the policy mix on the interest rate, consumption, investment, the real
exchange rate, trade balances and budget
People started to consume more, invest more, the rate of exchange increased too and the budget
and trade balances improved. This is mainly because when people had more money to spend,
they bought more goods and services, hence the demand for currency increased. Also, the output
in the economy increased when people demanded more goods and services and they were
exported too. Thus, the budget of the country improved.
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Policies in the European country that has been affected by the liquidity trap
Liquidity trap is a condition in which the cash is injected in the private banking system by the
central bank that fails to reduce the rate of interests and hence the monetary policy becomes
ineffective. Many European countries like Germany, France, UK etc. faced recession and they
wanted to implement the expansionary monetary policy to recover themselves from the recession
scenario (Pinto, 2014). But, due to the liquidity trap, the ability of the government of these
countries to use the conventional monetary policy vanished and the demand did not get
stimulated. This happened because the short-term rate of interest came close to zero. Basically,
the central banks in these countries try to pump more money in the economy so that the economy
gets stimulated. But, they failed to lower down the rate of interests.
Therefore, when the economies fall into liquidity trap, like it happened in the case of European
countries, the monetary policy gets failed and it no longer becomes effective.
Conclusion
From the above discussion it can be concluded that when the confidence of consumers’ falls,
there is decrease in the output of economy, the rate of interest, exchange rate, investment, and net
exports fall too. For recovering the economy from recession, the mix of monetary and fiscal
policy is required and expansionary policies are used for helping the economy in recovering.
With the policy mx, the rate of interest rises, the exchange rate improves and the economy starts
to boom. But, liquidity trap is one situation that is capable of making the monetary polices
ineffective in the economy.
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References:
Kapetanios, G., Mumtaz, H., Stevens, I., & Theodoridis, K. (2012). Assessing the economy‐wide
effects of quantitative easing. The Economic Journal, 122(564), F316-F347.
Napoletano, M., Roventini, A., Dosi, G., Fagiolo, G., & Treibich, T. (2014). Fiscal and
monetary policies in complex evolving economies (No. 2014-05). Sciences Po Departement of
Economics.
Pinto, J. V. (2014). Liquidity Trap and the Zero Lower Bound: Can Quantitative Easing be the
answer to Euro Zone?.
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