Question

Use an IS-LM diagram to show what happened to the UK in 1992 after it left the Exchange Rate Mechanism.

Short answer

Leaving the ERM led to a rightward shift in the IS curve, increasing output and potentially affecting interest rates.

Step-by-step solution

Understanding the Scenario

In 1992, the UK left the Exchange Rate Mechanism (ERM). This meant the government allowed the pound to float freely in the forex market instead of maintaining a fixed exchange rate. This can have significant effects on interest rates and national income, which can be analyzed through the IS-LM model.

Explanation of IS-LM Model

The IS-LM model combines the Investment-Saving (IS) curve, showing the equilibrium in the goods market, and the Liquidity Preference-Money Supply (LM) curve, showing the equilibrium in the money market. The intersection of these curves determines the equilibrium levels of interest rates and output.

Initial IS-LM Equilibrium

Initially, before leaving the ERM, the IS-LM diagram was at equilibrium point E0, where the IS curve intersects with the LM curve, indicating the initial interest rate i0 and output level Y0.

Currency Depreciation Impact

After leaving the ERM, the UK pound depreciated. A weaker pound makes UK exports cheaper and imports more expensive, increasing export demand and shifting the IS curve to the right, from IS0 to IS1.

New IS-LM Equilibrium

With the IS curve shifting to the right, a new equilibrium is established where the new IS1 intersects the LM curve, at a higher output level Y1 and potentially a different interest rate i1 (depending on the responsiveness of the LM curve). This reflects an increase in national income.

Key concepts

Exchange Rate Mechanism

The Exchange Rate Mechanism (ERM) was a system introduced by the European Economic Community with the aim of reducing currency exchange rate variability and achieving monetary stability in Europe. Imagine it as a safety net that helps countries keep their currencies at stable levels by pegging them to one another. This means countries agreed to keep their exchange rates within agreed bands.
When a country leaves this system, like the UK did in 1992, it allows its currency to float freely. When the currency floats, its value is determined by market forces such as supply and demand, rather than being tied to the stability of other currencies.
This change can have significant implications for a country's economy, including its trade balance, inflation, and overall economic stability.

currency depreciation

Currency depreciation refers to a decrease in the value of a country's currency in relation to foreign currencies. For example, when the UK left the ERM in 1992, the pound sterling depreciated. A weaker currency makes exports more competitive and imports more expensive.
When exports are cheaper, other countries are more likely to buy goods from the UK, boosting demand for UK products. This can lead to an increase in production and jobs back home. On the flip side, people in the UK will find foreign products more expensive, which can reduce import consumption.

• Boost in Exports: A weaker pound means UK goods are cheaper abroad, which can increase demand.
• Expensive Imports: As the pound depreciates, imports become more costly, affecting consumer choice and cost structures for businesses relying on foreign goods.

Together, these shifts can lead to changes in the country's GDP and potentially affect the job market and prices.

interest rates

Interest rates are a crucial part of the IS-LM model because they influence economic activity. They represent the cost of borrowing money. When interest rates drop, borrowing becomes cheaper, encouraging both businesses and consumers to take out loans and spend more.
In the context of the UK leaving the ERM, currency depreciation could lead to inflation as imported goods become more expensive. To control inflation, the central bank might adjust interest rates. This delicate balance is a dance between stimulating the economy with lower rates and controlling inflation with higher rates.

• Influence on Borrowing: Lower rates encourage more spending and investment.
• Inflation Control: Higher rates might be used to prevent the economy from overheating as the cost of imports rises.

Understanding these dynamics is key to grasping how economic policies are crafted and why changes in the IS-LM equilibrium matter.

national income

National income is the total value of all goods and services produced in a country. It's an important indicator of a nation's economic health. In the IS-LM model, a shift in the IS curve can indicate a change in national income.
After the UK left the ERM, the depreciation of the pound led to a rightward shift in the IS curve, signaling an increase in national income. This shift occurred because the cheaper pound boosted exports, raising the country's GDP.
In simple terms, as national income rises, people generally have more money to spend, which can further spur economic growth. However, this growth can also lead to inflation if not carefully managed.

• Increased GDP: A higher national income typically means a growing economy.
• Spending Power: More income generally enhances consumer spending, boosting economic activities further.

This intricate dance between currency value, inflation, interest rates, and income shows how interconnected economic policies are.