1002 ISLM Model With NX Line

zimbabwe_moneyThis post aims to demonstrate the dynamics of the vertical NX line augmented with the ISLM model. It is an extremely useful tool for us to understand simple trade between economies and it is indeed easy to learn as well! I am very sure your lecturers would have also given you a detailed explanation and hopefully, Quickienomics would be able to enhance your learning by supplementing you with a detailed recap!

When using macroeconomic models, we have to be very careful to differentiate between endogenous and exogenous variables. From the basics, we know that endogenous factors cause movements along curves. An example would be the crowding out effect where the economy moves backwards along the IS curve due to an increase in interest rates. Basically, endogenous variables are whatever variable that is on your X or Y axis. An exogenous factor would cause shifts of the curves. For example, we know that consumption and government spending is an exogenous variable of the IS model. Therefore, any changes in C, G or T would cause a shift.

Heading onto more macroeconomic concepts, economies can decide between a fixed or flexible exchange rate. Simply put, governments can choose either to let the exchange rates change due to demand and supply fluctuation of their domestic currency, or intervene by playing around with the forex (foreign exchange) markets. The reasons are simple and you will understand why after watching the video. It has got something to do with the effectiveness of fiscal or monetary policies. i.e. does output change according to what the government wants be it contractionary or expansionary intentions?

We all understand how demand and supply affects the price of a commodity, currency included, but how exactly does the government fix the exchange rates? You will find out the answer in the video but here’s some food for thought: Do you think demand and supply can manipulated? If yes, how can it be achieved? What are the measures one must take to ensure such a thing happens?

At the end of this video, you should be able to:

  • Determine what moves the NX line and what does NOT
  • Differentiate between a fixed and flexible exchange rate policy
  • Explain in detail how an economy keeps its exchange rate fixed
  • Explain the consequences of a flexible exchange rate policy
  • Illustrate all the above in an ISLM model with a vertical NX line

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52 Comments

  1. Dayvid says:

    Hi, so in a way there are only 4 cases to study in detail, which is Contractionary and Expansionary of Monetary and Fiscal Policy. and the rest are just basically pretty standard?

    • Quickienomics says:

      Hi Dayvid,

      Not really, The ISLM can move due to many other reasons. The IS curve can shift because of changes in an economy’s trading partner’s output or even foreign prices. But after you identify what’s going on, everything is pretty much standard. Hope that helps man. 🙂

  2. Tommy says:

    Hi, at 25.40, you mentioned when income decreases, import decreases and it’s understandable that NX is >0, but how would this increase the exchange rate? Please advise.

    • Quickienomics says:

      Hi Tommy,

      The reason why the exchange rate will increase, or what we would prefer to call the domestic currency appreciates, because now that exports are more, it shows that foreigners are buying more domestic goods. However, for them to buy domestic goods, they need to change their currency into the domestic currency before buying the domestic goods and services. Therefore, this leads to an excess demand for domestic currency and using a simple demand and supply curve, we can see that the price of domestic currency would increase, thus an appreciation of the domestic currency.

      Hope that helps, Tommy. 🙂

  3. Tommy says:

    Hi, another enquiry, can I ask, why is it that when Export incease, IS will shift to the right? Thanks! Sorry for the trouble.

    • Quickienomics says:

      Hey there, no problem. 🙂

      Mathematically, we can see that exports is part of the autonomous expenditure when you construct your AE equation. And we know that an increase in autonomous expenditure (C, I, G, X, etc) would mean a larger vertical axis intercept, thus the IS curve will shift right.

      Intuitively, the IS curve will shift to the right because exports mean income for the economy. Just like how increase consumption means income for the economy, exports increase income and shifts the IS right the same way an increase in consumption would.

      Thanks for the good questions, Tommy. 🙂

  4. Arek says:

    Hi!
    I am not sure but there is small mistake. At 25:12 if NX>0 then E should be increasing. I might be wrong, as i am not very familiar with this topic so far.

    • Quickienomics says:

      Hi Arek,
      Yes you are right. Goodness, thank you for notifying me! But the rest of the explanation is correct, I assure you. When E increases, we should expect exports to fall. therefore the IS shifts left. Thank you so much!

      • Amos says:

        Hi, sorry, but I thought if NX>0 then E should fall? Cus when NX>0 meaning X>IM. Hence there’s an excess supply for FC since we’re exporting more and domestic currency appreciates. Since DC appreciates, it means E falls.

  5. Arek says:

    Your welcome! Your video explains quite broad, macroeconomic model in just 33 minutes so this tiny mistake could happen to anyone.
    Anyway, I would like to thank You for all uploaded videos. All are very helpful and everything is clearly explained. I have started a revision (exams in May), so `Quickienomics` website will be visited by me quite often.
    You are doing amazing job.Thank you!
    P.S. I apologize for my english 😉

    • Quickienomics says:

      Hi Arek,
      Thanks for the awesome comments. 🙂 I will continue to do my best to help! All the best Arek! I wish you success!

  6. Cheryl says:

    How does the buying of FC and selling DC increase the money supply?

    • Quickienomics says:

      Hi Cheryl,

      When DC is sold, it is sold to financial institutions, thus increase the M1 money supply.

  7. Bob says:

    Hi,

    what would result if foreign country’s price drops?
    Domestic country would import the same amount but with less amount of money, NX > 0. Would this result in a shift of IS curve to the left because on the left side it is the side with current account surplus? But why would a decrease in imports result in Domestic country’s fall in national output?

    • Quickienomics says:

      Hi Bob,

      When the foreign country’s price drops, the real exchange rate decreases. The domestic country should export more so this would result in a shift of the IS curve to the RIGHT.

      And also, the decrease in imports does not crease a fall in national output. It is the other way round. A fall in national output causes a decrease in imports.

      Hope that helps. 🙂

      • Bob says:

        Thank you very much!

        • Quickienomics says:

          You’re welcome. 🙂

          • Bob says:

            so sorry! but i have one last question.
            In my book my lecturer says that for open economy with flexible exchange rate there is no NX=0 line as the BOP always balances. But from what i see you draw the NX=0 line.
            So why are there differences in both what my lecturer and what you teach?

          • Quickienomics says:

            Hi Bob,

            I’m pretty sure he has his reasons for forgoing the NX line. However, my purpose of including the NX line is to understand where is the new level of output that brings NX back to 0. In different scenarios such as monetary or fiscal policy that tips the NX off 0, there are different dynamics to the ISLM + NX model. Therefore, I would need that line to identify where my new equilibrium would end up.

  8. Chong says:

    Thank you very much! appreciate ur video , hope u upload some more about macroeconomics ~ 😀

  9. Arek says:

    Hi!
    In economy with fixed exchange rate:
    – equilibrium is always where IS and LM are crossing NX?
    – we move only LM curve to reach new equilibrium leaving IS line untouched?

    In contractionary fiscal policy model:
    1. IS curve shifts left, interest rate falls
    a)Y decreases
    b)IM decreases
    c)NX>0
    d)E are going to increase
    e)government increases money supply(domestic currnecy) by buying up foreign currency
    2.LM curve moves to the right where IS curve intersects NX line, interest rate falls further.
    Am I correct?
    It is a lot easier to show this graphically:)

    • Quickienomics says:

      Hello!

      Well, your IS curve might move in a fixed exchange rate due to fiscal policies or change in foreign output. Understand that the LM curve shifting to the new equilibrium is the government’s intervention to keep the exchange rate fixed.

      You are right about the fiscal policy but be sure of the nature of BP. ie is it perfect capital mobility or no capital mobility.

  10. Arek says:

    Thank You for prompt answer!
    When i asked about fiscal policy i had in mind contractionary fiscal policy with fixed exchange rate and without capital mobility. Sorry – my fault;)

  11. Spencer says:

    Hi

    Just a quick question I need answering if you have time?

    In the UOL study guide there are chapter 14 questions which show The IS curve shifting to the left due to a reduction in G, and an increase in the mpc to import. I realise why the IS curve pivots (due to mpc changes) but do not fully understand why the NX=0 line does not shift as far left as the intersection of IS-LM.

    Is this to do with the fact that the IS-LM takes into account both changes in G and IM (i.e. both reduce) whereas the NX=0 only takes into account the reduction in IM???????

    Fantastic work on the vids by the way ….you’ve really helped me well beyond the study guide so thanks, its really appreciated.

    Cheers Spencer

  12. Spencer says:

    Hi

    Just a quick question if yo have time?

    I have been looking at he UOL study guide chapter 14 questions and notice some of the answers to questions show a shift in the IS curve which is greater than the shift in the NX=0 line. There has been an increase in the marginal propensity to import but a decrease in G.

    The book doesn’t really explain the details of this movement so was wondering if yo could help?

    Regards Spencer

    • Quickienomics says:

      Hi Spencer,

      I read both of your comments and I think I understand your confusion. When there is a change in the marginal propensity to import (let’s call it m1), this would affect the slope of the IS curve because your AE equation would be affected. What I recommend is that you write out the full AE equation with your imports and exports function in it then rearrange it in such a way that interest is isolated on the left side and on the right side, you factorize Y, thus getting the coefficient of Y which is also the slope of your IS curve.

      Your NX line basically follows where your new equilibrium lands. It simply shows that this is the level of income where NX equals zero. You could use your keynesian cross diagram to understand this further. So the distance the NX line shifts depends on whether your new ISLM equilibrium is.

      Hope that helps! 🙂

  13. Spencer says:

    Hi

    Thanks for getting back to me its much appreciated.

    Sorry to be a pain but I’m still somewhat confused.

    I think I understand the pivot-shift in the IS curve given the mp to import and I always use the Keynesian cross diagram to demonstarted the changes (I find it easier to be honest). So from this, the slope of the AE diagram in the cross diagram would decrease whilst the slope of the IS would increase to reflect the change in mp to import. The shift would be due to the reduction in G and subsequent reduction in IM. However, in the chapter 14 question the equilibrium position of the IS-LM is greater than that reflected by the NX=0 so its not positioned where the new equilibrium lands. This is the bit I’m confused about? Why the NX=0 does not land where the new IS-LM curves are in equilibrium?

    Again, sorry to be a pain but this stuff can be really confusing when its not covered off very well in the subject guide.

    Cheers Spencer

    • Quickienomics says:

      Hi Spencer.

      No problem at all. 🙂 Could you let me know which question in chapter 14 is it?

      • Spencer says:

        Hi again

        It’s question 2 in the subject guide I was struggling with but I’ve just bought Amos Witzum’s book and it covers this stuff off quite well so I think I’ve got it. He covers the capital formation equation and rearranges so investment is isolated. He goes on to explain the balance of investment remains unchanged whilst income has decreased which means there is a deficit in the NX at the new level of income where IS-LM is in equilibrium. Therefore, in order to restore NX=0 the NX=0 line must be at a lower level of income, and hence moves further to the left than the equilibrium IS-LM position. Does that sound about right?

        Thanks Again for all your effort!

        Spencer

        • Quickienomics says:

          Hi Spencer,

          I find it a little odd to talk about external equilibrium using the capital formation equation. Usually, the decisive factor of where NX should be is the change in imports and exports due to change in income or exchange rate. I would use the capital formation equation in a case where I need to decide whether the new equilibrium should be above or below the new level of interest after the IS and NX shift.

          • Spencer says:

            Hi again

            Thanks for the response, I think maybe I didn’t explain the scenario very well previously so I’ll try and summarize what the book says.

            I think the book suggests an increase in the marginal propensity to import which will reduce demand for NX which shifts IS to the left (and steepens the curve) and a lower level of income to offset tyhe NX. Amos Witzum states that ‘what typifies equilibrium is that planned investment = planned savings + government surplus _ net export’.

            Therefore,

            I(r0) = S(y1) + T – G – NX(y1)

            If I(r0) were unchanged and S fell, T-G remains constant, only a negative NX can restore balance. If NX is negative I.e. in deficit then it means that the point where NX=0 occurs must be at a lower level of y therefore NX=0 lies at a lower level than equilibrium in the goods market.

            This kinda makes sense to me and it fits question 2 in chapter 14, does it seem like a reasonable explanation of the process?

            I really don’t want to take this as given if its not correct or not truly accurate so your feedback, as always is really appreciated.

            Cheers Spencer

          • Quickienomics says:

            Hi Spencer!

            Alright! I got your question!

            It does makes sense because, you see, the Investment Savings equilibrium can be determined in 2 ways. The first way is by using the AE function which in equilibrium, AE=Y. Therefore, we can also use the the equation, Y=C+I+G+X-M to see that since imports has increased, this causes Y to decrease at equilibrium, which explains why we need a lower level of output for the IS to be in equilibrium.

            The second way is to use the capital formation equation as you have mentioned. This makes sense and is reasonable because of the way the equation is derived. It is shown in the textbook that since at equilibrium, Y=C+I+G+NX and income can also be used accordingly to Y=C+S+T, we can substitute the 2 equations and get I=S+T-G-NX. This clearly equilibrium because (1) your AE shows equilibrium and (2) income is also equilibrium because the resources are distributed to consumption, taxes and most importantly savings. It is assumed that all that is saved translates into investment at equilibrium.

            My sincere apologies for the misunderstandings previously and also my lengthy explanation, Spencer. I hope that helps. Thanks for asking an awesome question. 🙂

  14. Parag says:

    Thanks a bunch quickienomics:). U make eco easy….

  15. Parag says:

    Hey
    I remember my professor mentioning abt the NX line shifting more than ISLM intersection.. Can u pls explain that part..

  16. Parag says:

    For example this question:
    An exogenous decrease in export would have no effect on an open economy without capital mobility and a fixed exchange rate. True or false? Explain your answer.

    • Quickienomics says:

      That’s because when there is an exogenous decrease in exports, you will immediately experience a trade deficit in the short run. That’s why NX will be left of new ISLM intersection after IS moves lefts too.

      • jul says:

        Hi, could you help me cos im struggling with this a lot. I don’t understand why the NX has to shift more the the IS. If NX is to the left of IS, wouldn’t that be a surplus?

        • jul says:

          hi, i’m so sorry about the confusion.. I get that part that the new ISLM intersection would be in deficit.. However, i dont understand why we have to move more than the IS. The NX can move less than the IS but still be in deficit right?

  17. Spencer says:

    Great! Thanks for spending the time on this for me, its quite a tricky concept and I was struggling a bit with it 🙂

  18. Alfred says:

    quickieconomics why the background music? That defeats the goal of listening to your wonderful works. Pleaseeeeeeeeeeeeeeeeeeeeeeeeeeeeee the music is a killer.

  19. Mark says:

    Hi

    Can you help me on what are the effects on the home economy when it’s main trading partner pursues a monetary expansion? For a fixed exchange rate system and no capital mobility. Been wrecking my head to understand this ques.

    Thanks!

  20. Anonymous says:

    Why does trade deficit in the short run cause NX to be left of new ISLM intersection?

  21. hey says:

    Hi for the flexible exchange rate no capital mobility I thought there is no NX line? Because central bank won’t intervene hence the exchange rate will adjust to clear the demand and supply for foreign currency to be in balance? Hope you can clarify this thanks!

    • Quickienomics says:

      Hello!

      For a policy with flexible exchange rate and no capital mobility, there is a greater need for the NX line as the Current Account (NX = X – M) fluctuates along with the exchange rate fluctuations. Therefore you need the NX line to show the new level of Income/GDP required to achieve a balanced Current Account which means NX=0. Hope that helps!

  22. lim says:

    Can i ask when do i draw the nx=0 and bop=0 line.

  23. Dean says:

    Hi. I apologise if this may seem elementary. I see that policies on an economy with no capital mobility, the nx line does not shit. Is this true? And when is it that the nx line shift and does not shift? Hope you can help me clarify this. Thanks!