While I remember, I want to jot down a couple of points about the two macroeconomic models I have found to be of the most practical use in looking at policy and performance in emerging economies: the full Keynesian domestic economy model, which brings in flexible prices and depends on particular view of how firms are likely to respond to changes set off by a change in demand; and the Keynesian open economy model in the short run, which is for economies in which international trade is significant component. It assesses the likely impact and effectiveness of monetary and fiscal policies—the two main levers of policy control—when the exchange rate of a country’s currency is kept artificially fixed against the currencies of the outside world and when it is allowed to float. These models are best "applied" separately, even to the same economy, in order to simplify the analysis of the expected lines of causation.
ISLMAS(K)AD. In contrast to the situation when we are looking at the knock-on effects of demand changes on the goods and financial markets of the domestic economy only, the introduction of the possibility of changes in the price level produces two new effects for policymakers to consider. In the first, [and in addition to the feedback loops set off between the goods and money markets through changes in interest rates and national income,] a price change caused by a rise in demand in the goods market, reflecting perhaps a fiscal expansion, erodes the real money supply, altering the equilibrium conditions in the money market—that is, its shifts the LM curve down, wiping out some or all of the gain in output from the original change in demand. The second is the effect of a change in the price level on the labour market, understood as working in a particular way. The key features of this model, which give rise to its distinctive results, are the assumptions of flexible prices in combination with "sticky wages"—that is, when nominal wages take time to adjust to changes in the price level, either up or down. Assuming that there is spare capacity in the economy, a boost in government spending or a cut is taxes will push up demand for goods and services, but it will also push up price growth. If the nominal wage fails to adjust upwards to compensate for inflation, the real wage falls, inducing a rise in labour demand (ie firms find it profitable to employ more staff) and a fall off in labour supply (people want on average to work less). This divergence of labour demand and supply temporarily boosts the level of employment and so, as conditioned by a definite level of technological development, economic output and income. At the same time, it reduces the level of involuntary unemployment. In modern economies, at least until the great economic crisis of 2007-09, this was the direction of price movements that interested economists, as it matched, for a time, the broad empirical trends of the economies in which they found themselves. However, I think I'm right in saying that Keynes emphasised the "downward stickiness" of wages, as, writing in the 1930s on the events of the Great Depression, what interested him was, understandably, the impact of deflation, which he identified as a trigger of the intractable and socially damaging problem of high and enduring unemployment. This was because institutional and legal factors prevented money wages from adjusting to a fall in prices by falling themselves, as predicted in classical economic theory. In turn, this tended to boost the real wage and so induce a fall in labour demand from firms and a rise in labour supply, at once reducing both employment and output, and amplifying "involuntary" unemployment.
ISLMAS(K)AD. In contrast to the situation when we are looking at the knock-on effects of demand changes on the goods and financial markets of the domestic economy only, the introduction of the possibility of changes in the price level produces two new effects for policymakers to consider. In the first, [and in addition to the feedback loops set off between the goods and money markets through changes in interest rates and national income,] a price change caused by a rise in demand in the goods market, reflecting perhaps a fiscal expansion, erodes the real money supply, altering the equilibrium conditions in the money market—that is, its shifts the LM curve down, wiping out some or all of the gain in output from the original change in demand. The second is the effect of a change in the price level on the labour market, understood as working in a particular way. The key features of this model, which give rise to its distinctive results, are the assumptions of flexible prices in combination with "sticky wages"—that is, when nominal wages take time to adjust to changes in the price level, either up or down. Assuming that there is spare capacity in the economy, a boost in government spending or a cut is taxes will push up demand for goods and services, but it will also push up price growth. If the nominal wage fails to adjust upwards to compensate for inflation, the real wage falls, inducing a rise in labour demand (ie firms find it profitable to employ more staff) and a fall off in labour supply (people want on average to work less). This divergence of labour demand and supply temporarily boosts the level of employment and so, as conditioned by a definite level of technological development, economic output and income. At the same time, it reduces the level of involuntary unemployment. In modern economies, at least until the great economic crisis of 2007-09, this was the direction of price movements that interested economists, as it matched, for a time, the broad empirical trends of the economies in which they found themselves. However, I think I'm right in saying that Keynes emphasised the "downward stickiness" of wages, as, writing in the 1930s on the events of the Great Depression, what interested him was, understandably, the impact of deflation, which he identified as a trigger of the intractable and socially damaging problem of high and enduring unemployment. This was because institutional and legal factors prevented money wages from adjusting to a fall in prices by falling themselves, as predicted in classical economic theory. In turn, this tended to boost the real wage and so induce a fall in labour demand from firms and a rise in labour supply, at once reducing both employment and output, and amplifying "involuntary" unemployment.
Because the model sets out systematically the relationships between a large number of variables, it is a helpful framework for looking at a wide range of phenomena relevant to assessing the health and stability of economies, from demand-pull inflation and hyperinflation, overheating, soft and hard landings, to the co-ordination of policy with economic recoveries and slumps.
ISLMBOP. In an open economy, which incorporates the impact of inward and outward/net currency flows on the financial and goods markets, fiscal policy is powerful when the country’s currency is set at a specific rate, whereas monetary policy is relatively ineffective. If the authorities allow their currency to find its own level, however, without interfering by buying or selling on the currency market, then the reverse is true: the impact on monetary policy in enhanced and that of fiscal policy weakened. The reason for this is that
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