Download - Fixed exchange rates: The BP curve
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Fixed exchange rates:Fixed exchange rates:
TheThe BP BP curve curve
IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates
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O
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r1SURPLUS
DEFICIT
IS-LM-BP analysis: fixed exchange rates
BP
Zero Capital Flows
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r1SURPLUS
DEFICIT
BP
IS-LM-BP analysis: fixed exchange rates
Restricted Capital Flows
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SURPLUS
DEFICIT
Y1
BP
IS-LM-BP analysis: fixed exchange rates
Restricted Capital Flows
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r1
IS-LM-BP analysis: fixed exchange rates
Unrestricted Capital Flows
BP
DEFICIT
SURPLUS
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BP
IS-LM-BP analysis: fixed exchange rates
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r1
Y1
a
Assume that nationalincome rises
Y2
BP
IS-LM-BP analysis: fixed exchange rates
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r1
Y1
a
Y2
Assume that nationalincome rises
Deficit if rate of interestremains at r1
b
BP
IS-LM-BP analysis: fixed exchange rates
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r1
Y1
a
Y2
Rate of interest mustrise to r2 to restore
balance of payments
cr2
BP
IS-LM-BP analysis: fixed exchange rates
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Full equilibrium in theFull equilibrium in thegoods, money andgoods, money and
foreign exchange marketsforeign exchange markets
IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates
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LM
IS
r1
Y1
Full equilibrium in the goods, moneyFull equilibrium in the goods, moneyand foreign exchange marketsand foreign exchange markets
IS-LM-BP analysis: fixed exchange rates
a
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Effect of an expansionaryEffect of an expansionaryfiscal policyfiscal policy
under fixed exchange ratesunder fixed exchange rates
IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates
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IS-LM-BP analysis: fixed exchange rates
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BP
LM1
IS1
r1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
r2
Y2
b
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IS-LM-BP analysis: fixed exchange rates
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r
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BP
LM1
IS1
ar1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
r2
b
Y2
Balance of paymentssurplus causes money
supply to expand
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IS-LM-BP analysis: fixed exchange rates
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r
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BP
LM1
IS1
ar1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
r2
b
Y2
Restoration offull equilibrium
LM2
r3
Y3
c
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IS-LM-BP analysis: fixed exchange rates
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BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
a
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IS-LM-BP analysis: fixed exchange rates
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BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
ar2
b
Y2
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IS-LM-BP analysis: fixed exchange rates
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r
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BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
ar2
b
Y2
Balance of paymentsdeficit causes money
supply to contract
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IS-LM-BP analysis: fixed exchange rates
O
r
Y
BP
LM1
IS1
r1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS2
ar2
b
Y2
Restoration offull equilibrium
LM2
r3
Y3
c
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Effect of an expansionaryEffect of an expansionarymonetary policymonetary policy
under fixed exchange ratesunder fixed exchange rates
IS-LM-BPIS-LM-BP analysis: fixed exchange rates analysis: fixed exchange rates
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IS-LM-BP analysis: fixed exchange rates
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BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
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IS-LM-BP analysis: fixed exchange rates
O
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BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
LM2
Y2
r2
b
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IS-LM-BP analysis: fixed exchange rates
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BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
Y2
LM2
r2
bBalance of paymentsdeficit causes money
supply to contract again
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IS-LM-BP analysis: fixed exchange rates
O
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Y
BP
LM1
IS
ar1
Y1
An expansionary monetary policyAn expansionary monetary policy
Y2
LM2
r2
bFull equilibrium
is restoredback at point a
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Floating exchange rates:Floating exchange rates:
TheThe BP BP curve curve
IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates
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IS-LM-BP analysis: floating exchange rates
O
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BP
SURPLUS
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BP
SURPLUSAppreciation
IS-LM-BP analysis: floating exchange rates
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IS-LM-BP analysis: floating exchange rates
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BP
DEFICIT
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BP
DEFICIT
Depreciation
IS-LM-BP analysis: floating exchange rates
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Effect of an expansionaryEffect of an expansionaryfiscal policyfiscal policy
under floating exchange ratesunder floating exchange rates
IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates
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IS-LM-BP analysis: floating exchange rates
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BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
Y2
r1
r2
b
a
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IS-LM-BP analysis: floating exchange rates
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BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
Balance of paymentssurplus causes the
exchange rate to appreciate
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IS-LM-BP analysis: floating exchange rates
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BP
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
The appreciationcauses the IS curve
to shift to the left
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IS-LM-BP analysis: floating exchange rates
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r
Y
BP1
LM
IS1
Y1
An expansionary fiscal policyAn expansionary fiscal policy
IS2
a
Y2
r1
r2
b
Full equilibrium isrestored at point c
BP2
IS3
Y3
r3
c
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
ar1
IS2
Y2
r2b
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
a
Y2
r1
r2b
IS2
Balance of paymentsdeficit causes exchange
rate to depreciate
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
a
Y2
r1
r2b
IS2
Depreciation causesthe IS curve toshift to the right
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM
BP1
IS1
Y1
An expansionary fiscal policy:An expansionary fiscal policy:BPBP curve steeper than curve steeper than LMLM curve curve
IS3
a
Y2
r1
r2b
BP2
IS2
Y3
r3c
Full equilibrium isachieved at point c
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Effect of an expansionaryEffect of an expansionarymonetary policymonetary policy
under floating exchange ratesunder floating exchange rates
IS-LM-BPIS-LM-BP analysis: floating exchange rates analysis: floating exchange rates
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2
BP1
LM2
b
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 bThe balance of paymentsdeficit causes the BP line
to shift downward
BP1
LM2
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IS-LM-BP analysis: floating exchange rates
O
r
Y
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 bThe depreciation
causes the IS curveto shift to the right
BP1
LM2
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IS-LM-BP analysis: floating exchange rates
O
r
Y
BP2
LM1
IS1
Y1
An expansionary monetary policyAn expansionary monetary policy
a
Y2
r1
r2 b Full equilibrium isrestored at point c
BP1
IS2
Y3
r3
LM2
c