Economic Policies: IS-LM Curve (Research Paper Sample)

Topic of Discussion
Is being in an open economy a blessing or headache for governments wishing to provide a stable environment for private industry? Use the IS-LM framework and draw on examples from the recent economic events such as the global recession of 2008 to support your answer. 

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Introduction
An economic state that lacks barriers to free market entry is considered open. The essence of being open is to allow free market forces to interact. This means that the domestic and international markets are free to interact with each other according to the prevailing forces of a free economy. International business and capital flow across borders is enabled in such a system. Kim (2013, p.92) argues that there is no economy that is completely open. The degree of openness will however vary, according to the policies that have been adopted by the government. Governments in such systems have eliminated tariffs, unionization, taxes, licensing requirements, or any other policies that could interfere with forces of a free market (Shostya, 2014). Providing a stable business environment for private industries requires close government monitoring, and regulation. This is contradictory to the goal of a free economy. This report discusses the characteristics and effects of an open economy in an attempt to establish whether they give governments an easy or difficult path for providing stable markets for private investors in the country. The discussion adopts the IS-LM model, and draws example from real economic situations that the world has witnessed in the recent past.
Economic Policies
Isik & Acar (2006, p.14) assert that the effect of an open economy to the private sector depends on whether the country has adopted a fixed or a floating exchange rate regime. In most cases, an open economy will adopt a floating exchange rate system and a few like China will opt for a managed or dirty regime. When the economy is open, the IS-LM curve is also a function of exchange rates, in addition to the level of income and interest rates. For governments with fixed exchange rate system, the IS curve is constant except when public expenditure and taxes changes or after a currency devaluation and devaluation by the central bank. In a floating or flexible regime, the exchange rate will change according to the forces of demand and supply. Closed economies are strictly under the regulation of government bodies. When the expenditure level of the government rises, the IS curve will shift to the right, as shown below, hence setting a new level of equilibrium. The LM curve will also shift to the right when the supply of money increases. This is due to low interest rates that are associated with increasing money supply, as illustrated below.
Figure SEQ Figure \* ARABIC 1 (Thoma, 2005)
The Open Economy Blessings
Free economies increase the level of competitiveness in the private sector. Obviously, the money market has a way of bringing itself to equilibrium through the forces of demand and supply. However, Gómez-Mera (2011) admits that there are also other externalities such as recession, inflation, credit crunch and oil prices that tend to distort these forces. Holding, the distortions constant an open economy increases the competitiveness of the private sector of an economy though attraction of capital as well as players from the international market (Towards a more effective monetary policy, 2008). Entrance of foreign players increases competition in the private sector. This means that there will be healthy competitions that will increase innovation in the financial instruments as well in the financial markets (Kim, 2013, p.91). With competition, the economy is going to see efficiency in the capital and money markets through development of new financial instruments, availability of more capital as banks become more innovative to take advantage of new players as well as increase in national output due to increase of exports and imports.
An open economy implies that there are capital inflows and outflows from other markets into the domestic economy. When one economy grows, the capital flow is distributed to other economies as it is with China. They can be in form of exports, foreign direct investments, and borrowing through the private sector. These flows ensure that there is adequate supply of money in the economy, which can be used for lending, and investments in the private sector. For instance, if the interest rates in the economy are too high, private sector borrowers can look at other countries for credit with better lending rates and higher returns. According to (Ghosh, et.al, 2014), there is a high degree of integration within the capital markets that has created a scenario where the interest rates of any one country cannot fall too far out of line or out of balance without stimulating capital flows. This has a way of restoring outputs to the global level. According to Shostya (2014) Netherlands is one of the countries that have benefitted from open market operations because nearly 55% of her GDP is net exports (exports minus imports). For instance, if the output level of U.K. falls relative to the U.S output, there will be capital outflow from the U.K.
The Open Economy Headache
In spite of the blessings that come with an integrated economy, it must also content with a number of challenges.
* The contagion effect through mobility of capital and stock movements
The most notable blessing of an open economy is the ability to transfer capital from one economy to another. This has seen diversion of investments from countries with saturated marketplace and excess competition to other economies with investment opportunities but less capital. However, these movements of capital and stock transfer other variables such as inflation, high interest rates, fall or increase in asset values and other forms of contagion. Economic integration brings about excessive financial interdependences between countries that make it easy to induce the contagion effect as seen in the global financial crisis. Emergent countries that rely on the U.S. for flows were worst hit by the crisis and it has taken a lot of intervention and protectionism to recover. This was the case of the 2007-2008 financial crises where approximately 83 countries that are involved with the U.S. were also affected by the global financial crisis (Didier, et.al 2012). According to (Kapan & Minoiu (2014) research has shown that if one country, especially with a dominant currency such as dollar goes through economic shocks or any other form of financial crises, it is likely to transmit these shocks to trading partners or economies that rely on the currency for trade.
Europe is making enormous efforts to stabilize its economies; however, due to the effects of global financial crisis, the economies have found themselves in an imminent euro-zone crisis that requires strict and more efficient monetary tools. A recent OECD survey shows that there are many open economies making efforts to stabilize asset prices through interest rates, government expenditure, and taxes (Making exchange rate policy more flexible and monetary policy more effective, 2009); however, these efforts may not yield fruits when the economy is exposed to other exogenous factors interplaying in the international asset and financial markets. The IS-LM is subject to so many factors such that it is difficult to attain equilibrium in the domestic financial market. For instance, the U.S. was the epicenter of the financial crisis that spread across other economies across the globe. It started with its finance housing market in 2007 (Shostya, 2014), and most countries thought that they will decouple if U.S. troubles will start running deep. After the collapse of Lehman Brothers in late 2008, the liquidity shocks spilled to most institutions, borders, and markets, and were trapped in the crisis. The world saw a record failure of financial institutions and a collapse in asset values in both developing and developed economies. Interestingly, Kapan & Minoiu (2014) noted that after the crisis many countries opted for protectionism for recovering and stabilizing their economies through subsidies and pegged exchange rates.
* Speculation
Speculation influences the activities of investors in the capital markets including foreign exchange, stock, and interest rates. Granato, et.al (2006) define speculation as the expectation of the market players in the future, and can influence a number of macroeconomic variables on its own. For instance, if investors expect that the dollar will appreciate against their domestic currency in the near future, they will rush to sell off their dollars in anticipation of increase in the value of the dollar. This will deplete the reserves held by the Central Bank. This will interfere with lending and interest policies of the private sector as well as the level of output in the economy. The international financial crisis of 1997 and 1998 in Asia was started through speculation as Asian economies had just opened up to capital inflows from the rest of the world. Speculation was also the major force behind the economic meltdown that hit the world in the year 2008. The Federal Reserve tried slashing interest rates and fund rates but it did not help. Hedge funds were already holding more than $ 1 trillion. The move to reduce interest rates would increase money demand. However, this did not take place during the recession period. Interest rates were too low to be manipulated by money supply. A liquidity trap occurred, as illustrated in the diagram below. With low asset prices, there was a massive reduction of the collateral used by banks to issue loans (Kim, 2013, p.96).
Figure SEQ Figure \* ARABIC 2 (Bloomberg, 2011)
* Exogenous shocks through the foreign exchange market<...