The opposite will occur when the Central Bank undertakes a
contractionery monetary policy. That is, the LM curve will shift to the
left, because the currency has been taken out of the economy and the
real interest rates are now higher. There will be a discrepancy be-
tween the IS-CM curves and LM curve. The domestic real interest
rate will be higher than the one the “World” is imposing on a small
open economy, causing the domestic investment to be more attractive
to the foreign investors. This will attract foreign capital, causing capi-
tal inflow and the LM curve will shift back to its original position and
equilibrium with the IS-CM curves. Again we can see that the con-
tractionary monetary policy in a small open economy with high capi-
tal mobility is also ineffective.
Summa summarum of this analysis is the fact that in a small open
economy monetary policy, in either direction, is ineffective. The cap-
ital mobility from the “World” and into the “World” offset any policy
measures imposed by the Central Bank. This is a very powerful con-
clusion when it comes to the decision making inside the walls of a
central bank.
3.4 FISCAL POLICY
Now I will turn my focus to the government side of policymaking.
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Recall that the government spending equation is g = g° and g° = t + v.
The government revenues are composed of taxed collected from con-
sumers, firms, and the v part, which is borrowing.
In a closed economy model the government is responsible for the IS
part of the model. That is in the case the country is in recession the
government can increase the spending the thus through the multipli-
cation effect increase the aggregate demand in the economy and in-
crease the level of GDP.
The increase in the government spending will cause the shift in the IS
curve to the left. Now the IS curve will be out of the LM-CM equilib-
rium. The interest rates in the country will be higher that the one that
is imposed by the world. The domestic investment will be very attrac-
tive to the foreign investors and this will cause an inflow of capital.
This capital inflow will decrease the interest rates and the IS curve
will shift back into the original IS-LM-CM equilibrium.
Here like in the case of monetary policy the fiscal policy is also inef-
fective. This is very interesting for a small open economy and it es-
sentially shows that the government structures because of the in-
crease in the world globalization have to pay attention to the decision
making when it come to fiscal policy as well.
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3.5 MONETARY AND FISCAL POLICY
Reader that is more careful has probably by now already concluded
that the only way to stimulate aggregate demand in the economy is
through the use of the IS-LM-CM model is to have coordinated move
by both the government and the Central Bank.
The only way to stimulate the aggregate demand and to increase the
level of GDP is to have simultaneous increase in the government
spending and expansionary monetary policy. This can be done very
easily, when the budget is made for the following year both monetary
and fiscal policies are matched and there will be a simultaneous shift
in the IS and LM curve along the CM curve. The new IS-LM-CM
equilibrium will be established along the CM curve, but at the higher
level of GDP.
This is the only way that the government and Central Bank can stimu-
late the aggregate demand and thus offset the existence of the CM
curve.
3.6 CONCLUSIONS ABOUT MONETARY AND FISCAL
POLICY
From the three examples that I have presented above it is clear that
upon a small open economy strong limitations have been imposed
due to the capital fluctuation and capital mobility. Such mobility is
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very good when the government wants to stimulate the foreign invest-
ment, but it can also be an inhibitor when it comes to the movement in
IS and LM variables.
In reality, the capital mobility and the CM curve are forcing separate
parts of the system to function together.
4. INTRODUCTION TO DATA ANALYSIS
In the previous part, I have analyzed the model and some problems
that can be solved using the model. In this part I will take an in depth
look into the correlation of the data and the model. The main objec-
tive of this part is to see does the data fit the predictions made by the
model
4.1 FISCAL POLICY
Fiscal policy has been very strong and important in Croatia. Most of
that importance is the perception. In central planning economy like
Yugoslavia the government was the integral part of life. The govern-
ment owned all of the firms and bureaucracy was the Big Brother.
Now that Croatia is an open capitalist economy the government is try-
ing to change its role, but still a lot of people’s perception of the gov-
ernment is the same.
Croatia is still in a post war period, the government has taken an ac-
tive roll as a source of investment. The government capital expendi-
tures are per years: 569 million dollars in 1995, 928 million dollars in
1996, 782 million dollars in 1997, 1023 million dollars in 1998, 1252
million dollars in 1999, 644 million dollars in 2000 and 468 million
dollars in 2001.
As it is obvious, from the data, the capital expenditures peaked in
1999 and have been falling down in last two years. There are two
main reasons for that. The first one is the fact Croatia is getting mas-
sively indebted. As a percentage of the GDP, foreign debt was 20.2%
in 1995, but in 2001, it was 57.4%. The obligation to repay that debt
has put a tremendous strain on the government budget and it caused
cuts in government spending. (The data about the government debt is
in the appendix). In fact for the 2003 the debt repayment has been pro-
jected to be 20% of the government budget.
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