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ISLM Analysis of the Open Economy ( ISLMBP Analysis)

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ISLM Analysis of

the Open Economy

(ISLMBP Analysis)

ISLMBP analysis: fixed exchange rates

Fixed exchange rates:

The BP curve

BP

SURPLUS

r1

DEFICIT

r

O

Y

SURPLUS

DEFICIT

Y1

r

BP

O

Y

a

r1

Y1

r

BP

O

Y

Y1

r

Assume that national

income rises

BP

a

r1

O

Y1

Y

b

r

Assume that national

income rises

BP

a

r1

Deficit if rate of interest

remains at r1

O

Y1

Y1

Y

c

r2

Rate of interest must

rise to r2 to restore

balance of payments

r

BP

a

r1

O

Y1

Y1

Y

ISLMBP analysis: fixed exchange rates

Full equilibrium in the

goods, money and

foreign exchange markets

LM

BP

a

r1

IS

Y1

r

O

Y

Full equilibrium in the goods, money

and foreign exchange markets

ISLMBP analysis: fixed exchange rates

Effect of an expansionary

fiscal policy

under fixed

exchange rates

b

r2

IS2

Y2

r

LM1

BP

a

r1

IS1

O

Y1

Y

An expansionary fiscal policy

r

LM1

b

r2

BP

Balance of payments

surplus causes money

supply to expand

a

r1

IS2

IS1

O

Y1

Y2

Y

An expansionary fiscal policy

LM2

c

r3

Restoration of

full equilibrium

Y3

r

LM1

b

r2

BP

a

r1

IS2

IS1

O

Y1

Y2

Y

An expansionary fiscal policy

BP

IS2

r

LM1

a

r1

IS1

O

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

Y2

r

BP

LM1

b

r2

a

r1

IS2

IS1

O

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

r

BP

LM1

b

r2

Balance of payments

deficit causes money

supply to contract

a

r1

IS2

IS1

O

Y1

Y2

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

LM2

c

r3

Restoration of

full equilibrium

Y3

r

BP

LM1

b

r2

a

r1

IS2

IS1

O

Y1

Y2

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

ISLMBP analysis: fixed exchange rates

Effect of an expansionary

monetary policy

under fixed exchange rates

r

LM1

BP

a

r1

IS

O

Y1

Y

An expansionary monetary policy

b

r2

Y2

r

LM1

LM2

BP

a

r1

IS

O

Y1

Y

An expansionary monetary policy

r

LM1

LM2

BP

a

r1

Balance of payments

deficit causes money

supply to contract again

b

r2

IS

O

Y1

Y2

Y

An expansionary monetary policy

Full equilibrium

is restored

back at point a

r

LM1

LM2

BP

a

r1

b

r2

IS

O

Y1

Y2

Y

An expansionary monetary policy

ISLMBP analysis: fixed exchange rates

Floating exchange rates:

The BP curve

Appreciation

BP

r

SURPLUS

O

Y

Depreciation

r

BP

DEFICIT

O

Y

ISLMBP analysis: fixed exchange rates

Effect of an expansionary

fiscal policy

under floating

exchange rates

LM

b

r2

a

r1

IS2

IS1

Y2

Y1

r

BP

O

Y

An expansionary fiscal policy

r

LM

b

BP

r2

a

r1

IS2

IS1

Balance of payments

surplus causes the

exchange rate to appreciate

O

Y2

Y1

Y

An expansionary fiscal policy

The appreciation

causes the IS curve

to shift to the left

r

LM

b

BP

r2

a

r1

IS2

IS1

O

Y2

Y1

Y

An expansionary fiscal policy

BP2

c

r3

Full equilibrium is

restored at point c

IS3

Y3

r

LM

b

BP1

r2

a

r1

IS2

IS1

O

Y2

Y1

Y

An expansionary fiscal policy

BP1

b

r2

IS2

Y2

r

LM

a

r1

IS1

O

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

r

BP1

LM

b

r2

Balance of payments

deficit causes exchange

rate to depreciate

a

r1

IS2

IS1

O

Y2

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

Depreciation causes

the IS curve to

shift to the right

r

BP1

LM

b

r2

a

r1

IS2

IS1

O

Y2

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

BP2

c

r3

Full equilibrium is

achieved at point c

IS3

Y3

r

BP1

LM

b

r2

a

r1

IS2

IS1

O

Y2

Y1

Y

An expansionary fiscal policy:

BP curve steeper than LM curve

ISLMBP analysis: fixed exchange rates

Effect of an expansionary

monetary policy

under floating

exchange rates

LM2

r2

b

Y2

r

LM1

BP1

a

r1

IS1

O

Y1

Y

An expansionary monetary policy

r

LM1

LM2

BP1

a

r1

The balance of payments

deficit causes the BP line

to shift downward

r2

b

IS1

O

Y2

Y1

Y

An expansionary monetary policy

The depreciation

causes the IS curve

to shift to the right

r

LM1

LM2

BP1

a

r1

r2

b

IS1

O

Y2

Y1

Y

An expansionary monetary policy

BP2

c

r3

Full equilibrium is

restored at point c

IS2

Y3

r

LM1

LM2

BP1

a

r1

r2

b

IS1

O

Y2

Y1

Y

An expansionary monetary policy