The model as presented in the below diagram has three panes with one graph ineach pane.(1) Pane I depicts the IS/LM model [product & money market] . Point „e‟ in the first
graph represents the equilibrium rate of interest and the corresponding level ofoutput/income at which, both the product and money markets are in simultaneousequilibrium. (2) Pane II [capital outflow schedule] shows Net Capital Outflow as a function ofthe rate of interest. Net Capital Outflow (CF) is defined as the differencebetween Capital Outflows and Capital Inflows.
(3) In Pane III, we have the foreign exchange market, where the exchange rate, Eis determined by the capital outflow schedule in Pane two and net export schedule( NX). NX is the difference between Exports and Imports
Explaining the working of the Three-paned Model:
Now let us see how the three-paned model works. We begin
from point „e‟, the
initial equilibrium, in the ISLM model. Point e represents the simultaneous equilibrium of the product and money markets at an equilibrium rate of interest,
‟r’, and Y-‘level of income/output. To determine the equilibrium in the capital outflow schedule, the -equilibrium rate of interest, r, is brought over from the first pane to determine the equilibrium amount of net capital outflows4 .When the rate of interest is r, equilibrium CF in the economy is given by CFo. Suppose the RBI hikes the rate of interest from r to r1. If r* remains constant, r-r*increases. This increases relative returns in the domestic economy which creates two kinds of impacts. One, the capital outflow decreases, and two, the capital inflow increases. Therefore, the net capital outflow decreases, which is shown bythe fall in CF from CFo to CF1. Likewise, if there is a fall in the interest rate from ro tor2, capital outflow increases, and capital inflow decreases, leading to anincrease in net capital outflow as indicated by an increase in CF to CF2. The CapitalOutflow (CF) curve is therefore, downward...
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